Key tax differences - Commercial versus Residential property

October 2022

Ben McCormack's Spring article for the Otago Property Investors Association

Over the past few years, we have seen increased focus and scrutiny around the tax settings applied to property and in particular residential property.  This has created a distortion in how different types of property investment is taxed and we can say that investment in residential and commercial property is no longer treated equally or fairly under the existing tax laws. 

We have been having more discussions with investors who are looking at the current tax rules and exploring their options around their investment strategies.  We have seen some investors holding back in either reinvesting or adding to their portfolios in the current market.  I will cover some of the significant tax differences between residential and commercial below. This will help you think about considering adding commercial property to your portfolio, as an alternative to simply halting your current property investment strategy altogether, under the tax settings. 

By definition, residential properties are homes or apartments. These might be single-family houses, townhouses, studios, etc. Most people who invest in residential property but don’t live in it themselves will rent it out to others, so they can generate income from the property. Commercial property, on the other hand, is any property not primarily used as a residence: office spaces, retail spaces, warehouses, and even hotels. Commercial property owners may run a business out of their space, but investors in such properties usually lease them out to other businesses.  Something as simple as a carpark space is in fact a commercial property and commercial, in the tax sense, can also include rural property like farms, vineyards and forestry blocks. 

Under the new tax rules IRD have defined the definition of what they consider residential property or “Residential Land” to be property with a dwelling on it, or capable of taking a dwelling.

So, what are the key tax differences between commercial and residential from a tax perspective now? 

1. Depreciation. From 1 April 2020 the ability to depreciate commercial buildings at 2% was reinstated as a Covid-19 relief measure. There is still no depreciation allowed on residential buildings. 

2. Depreciation of Chattels and building fitout. Whilst there is a modest list of residential chattels that can be depreciated if they are not physically attached to the building, the list of items that can be depreciated within a commercial building is extensive. The ability to depreciate these at much higher rates than the building rate provides a generous deduction that is not impacting cashflow at all. 

3. No Loss Ringfencing. This prevents a loss from being offset against any income other that residential rental. A tax loss on a commercial property investment is not ringfenced though, meaning it can be offset against other income, offering an immediate and material tax saving, especially for those in the new 39% tax bracket. 

4. No Brightline. Whilst residential investors are tied up in knots by the dilemma over whether to opt for a new build with a 5-year Brightline or an existing stock property with a 10-year Brightline, commercial acquisitions have no Brightline at all. 

5. Interest deductibility. Deductibility of interest has been removed on residential acquisitions of existing stock residential and phased out for existing residential investment loans, on the other hand lending for commercial property where full deductibility of interest is available.

6. GST. Residential property investment remains an exempt activity for GST whereas commercial property is generally subject to GST. Being GST registered though, for a commercial investment, has no bearing on existing residential property.

Finally, many people shy away from commercial investment because it’s perceived to be a little bit harder to get to grips with than residential. It’s certainly true that length and strength of lease is a main driver of value in the commercial property arena and gaining an understanding of leases and sqm rent rates in a particular area can be a bit daunting.  There are risks involved in commercial property so you will need to seek professional advice before purchasing a commercial property but the above will help you understand how the tax treatment of these properties differs.

 The PKF Dunedin Team

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