Tax Changes to Residential Properties Investments

Back in February the Government announced bold plans were afoot to “tilt the playing field” towards first time home buyers; and today we have the announcement.

Here are the headlines:

  1. Bright-line test timeframe to double from five years to 10;
  2. No deductions for interest on residential property held for investment purposes.

And now to the detail.

Bright-line test extension

The bright-line rules currently provide that a sale of residential property is taxable if sold within five years of acquisition and the property is not your main home.  Other exemptions can apply.

The announced changes increase the bright line test to 10 years for residential property acquired on or after 27 March 2021. 

Property acquired before 27 March 2021 (and after 29 March 2018) remains subject to the five-year bright-line test. 

“New builds”, which are yet to be defined but are expected to include properties acquired within a year of receiving their code of compliance certificate, will continue to be subject to the five year bright-line test. 

Property is generally acquired for tax purposes on the date a sale and purchase agreement is entered into (even if some conditions still need to be met).

Interest deductions

From 1 October 2021 no deduction will be available for interest on loans used to acquire residential rental property.  The premise is that tax should not provide a shelter to reduce the cost of ownership for investors.

These rules will apply to residential property acquired on or after 27 March 2021. 

Interest on loans for property acquired before 27 March 2021 remains deductible, however on a reducing basis over the next four years (a progressive 25% reduction each year); with no deductions (for any residential property acquired at any time) for interest from the 2025/26 and later income years.

However, consideration is being given to excluding “New Builds” from the interest limitation rule, and whether people who are taxed on the sale of a residential property (for example under the bright-line test) should be able to deduct their interest expense at the time of the sale.

Deductions will remain permitted for items such as rates, insurance, repairs and maintenance and limited depreciation claims.

We attach two Inland Revenue facts sheets providing further guidance.

BDOs’ Eyes on Tax

Irrespective of the Government’s assurances that it won’t introduce a capital gains tax, there comes a point where this assurance loses its shine.  The bright-line test was initially introduced to curb “property speculators”, where the Inland Revenue was apparently having difficulty applying existing rules which already taxed land acquired with “purpose or intention of sale”. 

The bright-line test simply introduced an objective test, making it easier for Inland Revenue to enforce when residential land (excluding the main home) was bought and sold within a two (then five, now 10) year period. 

The bright-line test is one of many tax rules which treats capital gains as ordinary income.  While it may not be called a capital gains tax, it is one of many land taxing provisions that taxes capital gains as income.  The TV ad “togs, togs, togs, undies” comes to mind.

The extension of the bright-line test to 10 years runs the risk of exacerbating the already many issues, including accidental victims of the rule.  This was a problem with the extension from two to five years and will become more pronounced with the extension to 10 years (along with the adjustments for change of use from a main home to a residential rental property). 

We aren’t surprised with this change, there have been whispers, but we lived with a little bit of hope. 

With respect to deductibility (or non-deductibility of interest), this appears to have been modelled on a similar change presented in the UK. 

It remains to be understood whether a deduction for the interest would be available in the future if the residential property is sold and taxed under the bright-line test (or other land taxing provision).   Will the interest be another example of “black-hole” expenditure?

We already ring-fence tax losses arising from residential properties, which may be rendered partly or wholly redundant in an interest limitation world, and it’s against the premise of the fundamentals of our tax system; that is, you are generally afforded a deduction for expenditure that is incurred to earn income.  This really is a targeted push to curb demand, as signalled.  Therefore, as a consequence, we aren’t surprised that “new builds” are excluded from both changes on the presumption that increasing supply is very much desired.

The tax changes announced today while flagged have not gone through the generic tax policy process that NZ is admired for.  It is, however, pleasing to see that the proposed interest limitation rule has been flagged for consultation. 

On the brighter side, we are grateful that the changes are prospective and, for interest, time provided to adjust for those that have already committed to borrowings.  And at least it wasn’t a land tax (charging taxation on an unrealised basis) or a stamp duty… 

Time will tell whether these changes have the desired demand side effect on residential investment or whether there will be unintended consequences in the housing and rental market as a result.