Property investors, whether they are following the trading strategy and/or the buy and hold, will need to be aware of the wide ranging and often complex taxation ramifications. Taxation (including GST) is the largest single expense you will face. For example for traders their personal tax rate from profits may likely be 33% or even 39%. (note, these rates could be reduced through trusts)… Added to these rates, is the need to factor in the GST component on traders’ profits of 12.5%, which could bring these totals up to 45.5% and 51.5% respectively.
Tax Freedom Day
For a full time trader, after adding additional Government taxes such as GST on private expenditure which is not claimable on the business, such as food, clothing, fuel, alcohol, tobacco, holiday accommodation etc. and Local Body rates, the trader taxpayer could likely have to work effectively for well in excess of 5 months of every year for the Government before they start working for themselves, which is generally described as their “tax freedom day”.
As a comparison, the average New Zealander’s average tax freedom day has been estimated to be June 1st after 151 days working to pay taxes. These figures above, can climb even higher if the taxpayer is a provisional taxpayer personally, or is operating through a structure which even by default rather than selection, falls into the provisional tax net, and should they be caught by shortfall penalties and/or use of money interest (UOMI), which can be part and parcel of the provisional tax regime. This is when the real ‘fun’ starts.
What is Provisional Tax?
Just as salary and wage earners pay tax throughout the year, a taxpayer who earns income which does not have tax deducted at source is also required to make payments of tax in the same period the income is being earned. These provisional payments, as with PAYE, represent a payment of tax on account of the year’s tax liability, and are payable by those with residual income tax (RIT) which exceeds $2,500.
Provisional tax is generally paid in three instalments due on or before the 7th day of the 4th, 8th, and 12th months of the taxpayer’s year. For example for those taxpayers with a standard 31 March balance date, provisional tax is due on 7th July, 7th November, and 7th March. If there is an amount of tax still payable after allowing for any provisional tax paid and for any other tax credits, this is the terminal tax. For taxpayers with standard 31 March balance dates, terminal tax is due on the following 7th February. If the taxpayer’s return is linked to a tax agent, the terminal date is extended to 7th April.
New provisional tax payers are not obliged to pay provisional tax because they would have not had RIT for the previous year. However if their RIT for this first year is more than $2,500, they will be hit with UOMI. Investors involved only in the buy and hold strategy, should generally not be troubled by the penalties from provisional tax, because for approximately the first 6 years of ownership of each property, tax losses will be experienced, mainly resulting from depreciation.
Then from the break even point forwards, the profits are easily budgeted and without unexpected peaks in income, provisional tax can be accurately calculated. However provisional tax can be troublesome for certain traders.
Other Problem Areas which can hurt
There are two methods of calculating provisional tax. The standard method, being 105% of the taxpayers’ residual income tax for the previous year, payable in three equal payments.
This method can be referred to as the “safe harbour method” for taxpayers (particularly property traders, other than a trustee), because taxpayers can be safe from shortfall penalties providing they pay the due tax on time. Individual taxpayers who have RIT of $35,000 or less, and adopt the safe harbour method, are not subject to Use of Money Interest (UOMI) where the provisional tax paid is less than the actual tax liability for the year provided: (i) the tax is paid by due date; and (ii) the individual does not hold an exemption certificate from Resident Withholding Tax on interest and dividends.
The alternative method, is the estimation method. Under this method, the provisional taxpayer estimates their residual income tax for an income year and pays on the basis of their estimate. This estimate can be revised at any time up to the third instalment date. Taxpayers in this regime are vulnerable to shortfall penalties of 20%, if they do not take reasonable care when making their estimates and pay less than the minimum amount of provisional tax. They will also suffer UOMI calculated at 13.08% per annum as shown in the example below.
This will apply even where the amount paid by the third instalment date exceeds 105% of the previous year’s residual tax. An example of the danger of this method, is a trader taxpayer who has paid their 3rd provisional tax payment on say 7th March based on their earlier estimate. Then for example on 15th March they have an unplanned trade sale, which settles before 1st April produces a sizeable profit.
They will face a hefty shortfall penalty calculated on the 3rd provisional tax payment unless they can show as at 7th March the estimate was reasonable, together with UOMI on provisional tax underpayments going all the way back to the first instalment date of 7th July. The following table will illustrate the effect.
Profit on transaction on 15th March 06 = $20,000 x tax of 33% = $6,600 Penalty taxes 20% are potentially payable on $6,600 = $1,320 Plus UOMI Payable 7 July 2005 $2,200 at 13.08% p.a. for 123 days = $ 97 Payable 7 November 2005 $4,400 at 13.08% p.a. for 120 days = $ 189 Payable 7 March 2006 $6,600 x 13.08%p.a. for 337 days to 7 February 2007 = $ 797 Total Payable = $9,003 Total penalties and UOMI = $2,403
Summary on how to resolve these problems
This demonstrates the difficulty for the trader trying to hit a moving target, and just how expensive their total tax bill may be, including income tax and GST, plus if they get it wrong, shortfall penalties as well as UOMI. In this example, it would have been far more advantageous to have had better planning and deferred the property settlement until after 1 April being the new tax year. A Tax Pool specialist company could also be consulted in attempt to purchase tax for an earlier date to eliminate the penalties and reduce the interest. Trust structures, together with sound accountancy and tax advice can ameliorate the situation.
Disclaimer: This information is educational material only and should not be relied upon exclusively. The reader is directed to seek professional advice before proceeding. It is essential to seek specific professional advice pertinent to the individual’s requirements as circumstances and conditions may vary.