Labour has already enacted changes to trusts that will affect the self-employed as well as residential property investors and mortgage advisers will need to be aware of them.
The tax rate is rising from 33% to 39% on trusts from 1 April to align with the top marginal tax rate and Gilligan says that will be a big step up in tax rates for people who derive their income from a trust.
Outlining what will happen at Bayleys’ recent Old vs New Property webinar, he says trusts, of course, can distribute income to beneficiaries using their marginal tax rates. “It is called income splitting. It's one of the benefits of a trust.”
However, one change that will pop up is what Gilligan calls a top-up tax, which is the difference between the company tax rate and the trust tax rate. “If a dividend is declared from a company to a trust, the company is taxed at 28%, the trust is taxed at 33%, and under existing rules a 5% top-up tax is paid. From next year it will become 11%.”
He says, for example, a company earning $250,000 and owned by a trust will pay tax at 28%, which is $70,000. When a dividend is declared to the trust the difference between the trust tax rate and the company tax rate will have to be paid. So the top-up tax more than doubles to $27,500 next year from where it would be this year at $12,500.
“Many people using trusts need to be thinking about what they are going to do with income splitting and distributions to beneficiaries to try and get around this,” Gilligan says.
When this is coupled with Labour’s scrapping of rules allowing tax deductibility for mortgage interest payments, it bites even harder, Gilligan says.
In the 2024 financial year ending on 31 March next year, property investors get a 50% deduction for mortgage interest payments, the following year it's dropping to 25% and the year after it is completely phased out.
Exemptions to this rule are second hand houses used for social housing, residential new builds, and reclads. If 75% or more of a property is reclad, then an exemption is given from the interest deductibility rules.
Gilligan says if the higher trust tax rates and scrapping of interest deductibility rules are taken together, it is a massive change.
“On a portfolio of three properties earning $105,000 in rent, when operating expenses are taken off the net yield is $82,000. Taking off interest on the properties, 7% of 1.5, that's $105,000. Under old rules, it means a net cash loss of $22,500. There are no tax refunds because losses are ring fenced.
“Roll it forwards and tax has to be paid on the mortgage interest payments that were previously able to be deducted. So effectively it's going to be taxable right up to the value of the net yield. So tax on the net yield, because there is no interest deduction to offset that, is $32,000. So the property owner is paying $32,000 tax on what is negative cash flow of $22,500.
“Cashflow goes from -$22,000 to -$54,000. This is just a rort, unpopular and a very political issue that is reducing the supply of housing,” Gilligan says. “It is arguably an imprudent rule.
“Couple it with the 39% tax rate and you can see not only are investors paying more tax, but you've got the full effect of this tax on the net yield because you don't get to deduct interest. That is something that everybody's thinking about.”
Of the major political parties - Labour and the Greens like the rules, National says it will phase them out over two financial years and Act says it will repeal them.