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Update: Tax Report and Risk-Free Rate of Return

AUTHOR: Matthew Gilligan

POSTED: 22 January 2010

The tax report seems to reveal a concern/realisation by the group that any tax change causing a significant drop in values in property, will be politically unacceptable. This was a view that I formed and I generally disregarded this option as too radical when I recently read the report.

But it is the government's actions and decision that count.

Risk Free Rate of Return (RFRR)

Rents non assessable, costs non deductible
Pay tax on equity (not debt)
Tax payable irrespective of market going up or down
Tax payable despite asset not being sold - you have to find the tax out of cash flow
Leveraged investors relying on tax refunds to survive / get to break even cash flow, will go broke.
Westpac's estimation that house prices will drop 34% if this option comes in, is in line with Sweden's experience where they ring-fenced tax losses and house prices fell 35% and mass insolvency enveloped the nation. The policy was reversed and the government thrown out at the next election. Sorry I don't know the year this happened. I am told that similar experiences have happened in Aussie with state taxes trialled targeting property.

Example Application of RFRR Tax and Outcome

Here's an example scenario for Joe Bloggs...

He has a rental property and earns $65k, has 2 kids, and a spouse who works part time earning $15k. All household income is required to survive. The rental property is negative cashflow by $7,000 before tax refund, break-even cashflow post tax refund. The market value of the property is $400k, and the debt $350k. Currently Joe and his family get by - paying their living costs and mortgage payments (just). The market equilibrium assumes the tax refund, and hundreds of thousands of 'Joe Bloggs' are doing this.

Enter this tax. Now Joe does not get a tax refund. He has to pay tax on 6% of $400k (MV)-$350k (debt) = $50k which is $3k times 33%, $1k tax. So previously he was getting $7k tax refund, now he pays $1k, meaning he is $8k worse off.

The outcome is he has to sell in a market that is flooded with other Joes. He goes broke and is mortgagee sold. He stops spending and kicks off another recession with the thousands of other Joe Bloggs in the same predicament. They all vote Labour for the rest of their lives and everyone blames National for the massive blunder. The next government throws out the unpopular tax, and the market reverts to where it was before...WHICH IS EXACTLY WHAT HAPPENED IN SWEDEN WHEN THEY RING-FENCED LOSSES.

Banking would also be destabilised and credit would stall again.

So this tax would cause huge loss in property values, hardship, destabilise banking, reduce consumption (credit will tighten and consumption drop), and kick off another recession....

I ignored it in my overview above as a clever idea that does not work in the real world. A cynic would observe that it makes the other options seem more palatable.

Also RFRR requires a lot of work for IRD, is subject to abuse (through manipulating valuations) and will stimulate heavy leveraging.

Example of Potential Abuse of the Tax

Example 1

1. Little Jonny owns a rental worth $300k with debt of $250k.

2. He pays RFRR tax on $300k - $250k = $50k times 6%*33%, $1k tax.

3. Little Jonny's friend has a similar house, similar suburb.

4. They sell each other their respective houses at $250k each, now 100% financed.

5. They achieve 100% financing by cross securing their respective investments to their homes, so they can borrow 100%. Valuers will now tend to view the market value of the houses as $250k, i.e. cost.

5. Now Little Jonny has zero tax to pay, under RFRR, $250k (MV) - $250k (debt) = $0 equity times 6%*33%=$0 tax, i.e. no tax.

Is this tax avoidance? Probably, but the point is, the tax is open to abuse.

Example 2

1. Little Jonny owns a rental worth $300k with debt of $250k.

2. He pays RFRR tax on $300 k -$250k = $50k times 6%*33%, $1k tax.

3. Little Jonny's friend has a similar house, similar suburb.

4. They sell each other their respective houses at $350k each, and loan each other $50k - now they are 100% financed and pay no equity tax.

There are a hundred permutations of ways to do this via trusts etc. Is this tax avoidance? Probably - but the point is again, that the tax is open to abuse.

I give Key and the Nats more credit than to bring in something this radical, this dangerous. They are pro-business and clever people - no question about that.

They understand that undermining consumption by destabilising banking, kicking off another recession and causing mass insolvency, is political suicide and not in the public interest. There is a better way in the other options of getting there (to a level playing field and weaning Kiwis off property investment – if that is what the Government wants), and the change needs to be more gradual.

Summary

Gilligan Rowe & Associates are 100% opposed to Risk Free Rate of Return. We see it as a clever idea that does not work in New Zealand at this time. We don't believe the government will bring it in - we give them credit for being rational.

Someone might like to email this to Mr English or Mr Key if they agree with our thoughts, or create their own version. My advice is to please be respectful and constructive in what you send them.

Use the following email addresses:

bill.english@national.org.nz

john.key@national.org.nz

Request a Meeting

Matthew Gilligan
Director

09 522-7955

mg@gra.co.nz

© Gilligan Rowe & Associates LP

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