A guest post from a reader:
Minsky, the property market and IRD failing to properly tax landlords
The Economist recently ran an article on the work of Hyman Minsky, a 20th century economist whose work on financial collapses and their causes was really only appreciated after the 2008 global financial crisis.
Minsky’s work looked at how businesses finance themselves and how they tend to expose themselves to more and more risk as the business cycle progresses. His theory can be applied to the rental property business, which like most other businesses generates regular income and can be funded by debt. Most New Zealand landlords also have other sources of regular income, such as the salary from a permanent job, which lessens their overall risk but also encourages them to take more risk in their property business.
Minsky described three types of financing. The first type of financing, which is the least risky, he called hedge financing. This is when the loan funding the business is low enough for the business income to be sufficient to meet normal loan repayments that pay off that loan.
The second type of financing he called speculative financing, is when business income is sufficient to meet only interest on the loan. This is more risky because the business relies on the loan being rolled over to stay afloat.
The third and most risky type of financing Minsky called Ponzi financing. This is when the business income is not sufficient to meet interest on the loan or repay any principal. The business is betting that the business assets will appreciate faster than liabilities or, in the case of landlords with other income, that the eventual capital gain will more than make up for the extra money required to keep the business afloat. If the expected capital gain fails to materialise, the business becomes vulnerable. If the other income of a landlord dries up then the rental business may collapse, with a distressed mortgagee sale likely.
Landlords might make the point that as rents increase a loss making property will, after a few years, start to pay its way. That is generally true, but if you look at the current Auckland property market it might take 10 years or more for a rental property to start paying its way.
For example, three bedroom bungalows in areas like Onehunga in Auckland are now selling for around the $1 million dollar mark but can be rented out for only around $600 a week. Even if we assume the new requirement for 40% equity, the repayments on a $600,000 loan with a term of 20 years and interest rate of 5% are $911 a week. Rates, insurance and a minimal amount of maintenance will cost at least another $100 a week, leaving a shortfall of $411 a week. An interest only loan would be $577 a week so the rent would just cover that but rates can’t be avoided so the financing would be bordering on being classed as Ponzi.
If it is assumed that the rent could be increased by 5% each year and expenses also increase at 5%, it would take until year 14 (when rent would be $1,131 and expenses $189, leaving $943 a week) for the property to be cashflow positive.
If the landlord has other properties allowed to be used as equity to meet the 40% requirement and so borrows 100% of the purchase price then the financing for the particular property is hugely Ponzi. The property would not make an accounting profit until year 8 and it would not be cashflow positive until the loan was paid off after 20 years.
On average, houses are sold about every 7 years. Even if we assume the landlord purchasing the totally debt financed Onehunga bungalow holds it for double that, 14 years, the property would not generate a surplus. Losses of about $92,000 in first 7 years would offset profits of $92,000 in the second 7 years. Similarly, assuming a marginal tax rate of 33%, the property would give the landlord tax refunds totalling about $30,400 in the first 7 years which would only be completely offset if the property was held for more than a further 7 years and the landlord continued to pay down the loan.
IRD should not be allowing a tax refund to landlords of Ponzi financed (also known as negatively geared) properties, or it should be ear-marking the property to tax the gain on sale. This is because it is clear that a purpose of the purchase was to resell at a profit, and that makes it taxable. Without the expectation of a capital gain, the business case for purchasing a Ponzi financed property does not stack up, even if it is held for well over the average ownership period.
Yet IRD provide only vague and simplistic guidelines for landlords on when resale is taxable. There is no attempt at all to use the financing arrangements of rental properties to set some rules. Instead, IRD spends millions and millions of dollars investigating the most blatant breaches of the ‘purchased with intention of resale’ provision, while leaving the vast majority of landlords using Ponzi financing to effectively get a tax subsidy from the rest of us. These landlords get a tax deduction for their losses during ownership and then usually a tax free capital gain on resale. That is tax evasion but IRD can’t see the wood for the trees!