On November 27, 2019, the government announced huge changes that affect thousands of international real estate investors living in Japan. The changes regard a tax loophole that has previously allowed many individuals to reduce their income taxes payable in Japan. This would further reduce other taxes payable such as Resident Tax, National Health Insurance tax, etc. The closing of the loophole has numerous implications. Those currently using the loophole will not be able to use it anymore. Additionally, where will they will invest their real estate investment budget moving forward? What will the impact be on real estate prices both inside and outside of Japan? How will this affect the fate of entire corporations?
Which tax loophole will the government close?
The tax loophole pertains to overseas real estate investment by those who pay taxes in Japan. In Japan, real estate investors can take advantage of generous depreciation deductions to lower their taxes. The closure of the tax loophole will only affect overseas, not Japanese, real estate investments.
Why does the government of Japan allow deductions for building depreciation deductions?
The rationale is that a building degrades over time and loses value. This is a notional loss for tax purposes. Usually, the government allows a taxpayer to deduct losses from his/her taxable income. Eventually, the owner will have to perform maintenance. Make repairs. Even tear down the building and build a new one. Therefore, he or she gets a tax break.
In Japan, this deduction makes sense. In Japan, buildings typically do not have a very long lifespan. According to the government, a wooden building depreciates fully after 22 years (38 for brick, 47 for concrete). In reality, though, these are underestimates. The buildings usually last longer than that. However, overall, these depreciation numbers make sense—for Japan. After all, Japan has earthquakes, typhoons, etc. that reduce the lifespan of a building. It is also generally better to build a less expensive structure with a shorter lifespan in Japan.
For example, imagine that you buy a new wooden house. The building has a value of ¥22,000,000 (the deduction does not apply to land). The house will depreciate by ¥1,000,000 each year, for 22 years. Each year, you can deduct ¥1,000,000 from your income tax. Why? Because real estate revenue/expenses and wages from your day job are both in the same “income” taxation category.
Once a building is fully depreciated, it is possible to use depreciation again on an accelerated schedule. If you buy a fully depreciated building, you can depreciate the full value in a much shorter time. For a wooden building, this is four years (brick buildings: seven, concrete buildings: nine).
Suppose you have had 22 good, long years in that wooden house. You decide to sell it to Mr. Satō. The house now has a value of ¥10,000,000 according to a real estate appraiser. Can Mr. Satō use depreciation deductions, too? Yes, he can, deducting ¥2,500,000 each year:
¥10,000,000 ÷ a 4-year depreciation schedule = ¥2,500,000 that he/she can deduct each year from taxable income
What if Mr. Satō has a high income and is in the 50% marginal tax bracket? That would be ¥1,250,000 less per year in income tax.
Just imagine how much a billionaire could save on his taxes by buying the famous ‘Kiyomizudera’ temple. It is the world’s oldest wooden building, from 778 A.D.! Better yet, two billionaires could hand the 1,241-year-old temple back and forth every four years, saving a bundle! We digress…
This tax law is a great mercy for homeowners and investors with real estate in Japan. However, the problem with the law was that it did not specify the country. Japan? America? Germany? Therefore, many savvy investors took advantage of the tax depreciation deduction loophole. They bought properties in the US, for example.
Are these depreciation schedules really appropriate for overseas properties?
In the US, structures typically last longer. A wooden house in America could easily last 100 years, even 200. A 22-year depreciation schedule is inappropriate for such a building. Furthermore, we must draw a distinction between “purchase price” and “value.” This is another area where, until now, foreign real estate had a huge advantage. For example, in Japan, a house might go for a purchase price on the market of ¥30,000,000. However, it might only have a value of ¥15,000,000 (half the purchase price). Depreciation would be based on the value, so depreciation would be less. However, for foreign real estate, one could declare a value that was much closer to the purchase price. This value could even be 100% of what the building would go for on the market. This gave foreign real estate a major advantage for tax depreciation deduction purposes vs. Japanese real estate.
These investors are usually wealthy Japanese, but a few foreigners, as well. First, they buy real estate overseas. Then they depreciate it using official Japanese government depreciation tables, writing off the “loss” on their Japanese income taxes. This is despite the buildings being very strong, in seismically inactive areas with few natural disasters like typhoons. The result is massive tax savings. Yet the building is worth just as much as (if not more than) before, thanks to capital appreciation. A great deal for wealthy investors, who can, in some cases, avoid income tax altogether. Not such a great deal for the government’s revenue, and those dependent on the government.
Then the Japanese government announced some changes to the tax laws…
The government and the ruling party are planning to prevent tax savings through investment in overseas real estate. In November 2019, the Tax Examination/Review Committee announced changes to the Income Tax Law. Owners of Japanese real estate may continue to use generous tax deductions, but for investors in overseas real estate, the party is over! Well, not quite yet. In 2020, they will officially change the “Tax Reform Outline” to include the closure of the loophole. It will be effective from 2021.
What was their rationale? They explained that it was because the wealthy use it as a tax avoidance strategy. The wealthy have enough money to buy overseas real estate, unlike the poor. The wealthy are knowledgeable of the law, often thanks to expensive financial advisers, whereas the poor are not. The loophole was allowing the shifting of the burden of filling government coffers from the rich onto the poor.
Impact on Corporations of Closing the Tax Loophole
The Open House (オープンハウス) corporation (Stock Ticker: 3288), specialises in real estate in the US for wealthy Japanese investors. On the day of the government’s announcement, their stock plunged 15.3%, to 2,889. This was 521 lower than the previous day.
If you are currently enjoying depreciation from an overseas property, enjoy it while it lasts. You have two more tax years at this point, 2019 and 2020. This could decrease Japanese investment into US and other overseas real estate. It could also increase investment into Japanese real estate and prices, because Japanese real estate depreciation deductions are unaffected. However, at this point, this is just speculation. No one has a working crystal ball.
Now more than ever, it is important to consider a building’s return on investment (ROI), not just tax benefits. Be tax-aware, but not tax-driven. There is no point in crying over spilled milk. Just remember that now, for Japanese tax depreciation deduction purposes, investors can still use Japanese real estate depreciation schedules.
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