The Unknown Tax Cost of Foreign Property
Are you migrating or returning to New Zealand? Are you aware of the tax implications of such a move? Many people move to New Zealand having kept overseas properties. Sadly, these new Kiwis can easily be caught out by the tax traps involved in this, leading to both undesirable and unexpected outcomes.
This article will explore some of the key issues and considerations that catch out unsuspecting new Kiwis who retain property overseas. While this article covers some of the common issues involved when retaining overseas property, separate advice should always be sought from an international tax expert in order to assess individual circumstances.
Many people will have heard of transitional residency, or the “four year exemption”. This is a crucial time that allows new Kiwis to seek professional advice in order to restructure their affairs in a tax efficient manner. It is important to note that transitional residency only applies to passive income and is very easily cancelled by the new Kiwi without realising. Once the transitional residency exemption has been cancelled, you cannot get it back, even if you didn’t mean to cancel it.
When first arriving in New Zealand, migrants are usually considered a transitional resident and, as such, are usually relieved from the tax implications of owning property outside New Zealand. Once the transitional residency period ends, or for those who do not qualify for transitional residency, it is vital that you are aware of the many tax implications of retaining overseas property.
Rental Income is Taxed in Both Countries
While this might seem obvious to some, it is widely misunderstood that rental income can be taxable in both countries once you are no longer a transitional resident. This is because the income is usually subject to tax in the home country as it is sourced in that country, and then subject to further tax in New Zealand due to the recipient being a New Zealand tax resident. It is a common assumption that you do not need to declare rental income in New Zealand if it has been declared in an overseas tax return. Unfortunately, this is incorrect.
It is not all doom and gloom as you can claim a foreign tax credit for tax correctly paid in the home country. However, it is not as simple as translating the net figure to NZD as the tax laws in each country can differ and how that income is calculated might result in very different outcomes. For example, if depreciation is claimed on the building in the home country, New Zealand tax laws do not allow this deduction.
New Zealand Ring-Fencing of Losses Rules
On 1 April 2019, New Zealand implemented ring-fencing of rental losses, including overseas rental properties, until any future profit is generated. This essentially means that rental losses cannot be used to offset other income and must be carried forward until there is income from the property. Ring-fencing does not apply to certain properties such as the taxpayer’s main home, property held by the taxpayer on revenue account, property provided as employee accommodation, and several other specific situations. The new rules impose additional burdens for tax preparation as taxpayers (and their accountants) are required to track losses and profits from their residential properties to ensure that any deductions are only being claimed as allowed and carry forward any additional losses over many years.
The key factor in determining where mortgage interest is sourced is where the payer is located. People are often unaware that interest will be considered to be sourced in New Zealand even if the interest payments and loan arrangements are made outside of New Zealand. It is irrelevant that the mortgage, property and bank account that pays the mortgage might all be overseas.
When the lender (the person who provides the mortgage) is a non-tax resident of New Zealand, if the borrower is New Zealand tax resident then they obligated to deduct Non-Resident Withholding Tax (NRWT) from the interest payments and return this to New Zealand’s Inland Revenue Department (IRD). However, in practice, the lender is not going to be happy to receive the interest net of the NRWT, so this is another out of pocket expense for the borrower.
New Zealand has double tax agreements (DTA) with many countries, including our main trading partners, which provide relief from tax in certain circumstances. When the lender is tax resident of a country with which New Zealand has a DTA, the NRWT rate is limited to 10%.
As outlined above, lenders are highly unlikely to accept a 10% loss to their expected interest payment, so it usually falls on the borrower to “gross up” the mortgage interest payment. This means that for every $10 interest payment the borrower must now pay NZ$11, with the additional NZ$1.1 going to IRD.
All is not lost; it is possible for the borrower to elect to become an “Approved Issuer” and utilise the Approved Issuer Levy (AIL) regime which can reduce the 10% to 2%. This cannot be backdated and, therefore, should be done as soon as possible and before the end of the transitional residency period.
Again, this is not only an additional cost to be paid but it creates further compliance obligations for the new migrant. Returns and payment of AIL/NRWT are to be made monthly or six-monthly.
New Zealand’s Hidden Capital Gains Tax for Properties
New Zealand does not have a comprehensive capital tax regime. However, property is an area that has its own body of tax laws which turn what might be considered a capital transaction into a taxable transaction.
IRD has a well-established “property compliance team” which enforces these property tax rules. The effect is that the chances of being caught are significantly increased if you fail to return tax on the sale of a property that should have been taxable. If you have failed to pay tax on a property transaction (or any transaction) additional interest and penalties are added to the initial tax amount which can significantly increase the amount owing.
One key principle in New Zealand is that any property acquired with an intention or purpose of sale will be taxable upon sale. This is tested at the time of the acquisition of the property. The development of land or division into lots is also taxable in many cases. Other unknown traps include areas around zoning and transferring land to associated parties.
When no other land tax provisions apply, the bright-line test comes into play. This imposes income tax on properties (other than the main home) bought and sold within 5 years, regardless of intent or circumstances surrounding the purchase.
For more information on New Zealand capital gains property tax, read ‘Confusion still reigns over Capital Gains’.
Tax on Unrealised Gains
Foreign loans can be subject to tax in New Zealand on their New Zealand dollar equivalent. The “financial arrangement” regime imposes tax on realised and unrealised gains from loans, term deposits, and bank accounts. Depending on the New Zealand dollar figure value of the financial arrangements (all added together) they may need accounting for annually but, if the value is low, they will only be calculated on a cash basis with a “wash up” calculation at the end of the loan.
This taxing regime is stringent and catches many people out as the exchange gains and losses do not necessarily create a benefit if they are not “cashed up” at that time. Exchange rate changes can cause the value of a loan to fluctuate in NZD which can create taxable gains or losses, while the loan itself does not change value in its own currency.
It’s No Longer If You get Caught but When You get Caught
Unfortunately for most new migrants, ignorance of tax law is not a defence to any breaches of tax legislation. International revenue authorities are working together and also obtain additional information through banks and other financial institutions. When IRD sees a mismatch between offshore income disclosed in tax returns and the data held by overseas authorities, they often reach out to taxpayers and allow them to explain, and encourage them to submit a voluntary disclosure (where relevant).
If no disclosure is made, or no acceptable explanation is provided, then IRD usually undertakes an in-depth review, investigation or audit. IRD has already proved that this automatic exchange of information with other tax jurisdictions is a powerful tool in fighting tax evasion. This will leave less room for an honest lack of knowledge.
The “Common Reporting Standards” in September 2019 allowed the first significant exchange of information. Within months IRD received more than 1.5 million records relating to New Zealand tax residents from 74 jurisdictions. IRD then sent out over 200 letters to taxpayers based on this information and will continue to send out letters.
While renting out your previous family home (once you move to New Zealand) might seem like a nice safety net, it is important to be aware of the many tax implications this creates and assess the value of the safety net in comparison to the possible tax costs.
If you believe any of these issues may apply to you or are considering moving to New Zealand and would like to understand your tax obligations, you should contact a specialist international tax lawyer.
The above is intended for informational purposes only and should not replace specific tax advice. For personalised advice on all tax issues please contact Julia Johnston at Saunders & Co.
Please note that the bright-line test has been updated. For more information, see the following Property Investors Hit Hard by Tax Reforms.