The Government has released its draft legislation to remove interest deductions for residential rental property owners, from 1 October 2021. This sets them apart from other property-owning businesses, like builders, property developers and commercial property owners who can continue to claim interest expenses when calculating taxable income.
A residential rental property classified as a "new build" qualifies for a five year bright-line test (instead of ten years) and interest deductibility for 20 years. The definition of "new build" has been extended from the original draft, increasing the number of properties eligible for the new build exemptions.
The Government's intention seems to be to reduce investor demand for existing houses and push them towards new builds, making the older houses more affordable for first-home buyers. IRD's regulatory impact statement casts doubt over whether the new legislation will improve housing affordability.[i] Perhaps then, the decision was made more for appeal to the voter base then an actual belief that the policy would work to improve affordability.
From 1 October, you can continue to claim interest if you acquired the property before 27 March 2021, but the percentage of the interest claimable reduces each year until 31 March 2025.
Development Exemption and New Build Exemption
The development exemption will apply for interest relating to land that you develop, subdivide or build on to create a new build.
The new build exemption is for properties which received its Code of Compliance Certificate on or after 27 March 2020 (not 2021 as stated in initial draft). It can include modular and relocated homes. If you convert and existing dwelling to multiple dwellings or a commercial building into residential dwellings, they can qualify as new builds. It applies also for purpose-built rentals, large-scale residential developments.
The exemption will apply to anyone who owns the new build within the 20-year fixed period, and the exemption does not reset when the property is sold.
Borrowing for Business Purposes and Land Business Exemption
If you're borrowing against your residential property to fund your business, e.g. buying a truck for your transportation business, then you can still claim the interest deduction.
Similarly, the land business exemption will allow you an interest deduction if you are developing, subdividing, or in the business of land-dealing or erecting buildings.
Flatting or Home Business Exemption
The interest limitation would not apply for income-earning use of an owner-occupier's main home, such as a flatting situation. Nor would it apply for emergency transitional, social or council housing. Other exemptions for residential property include hotels, motels, employee accommodation, student accommodation, retirement villages.
If you use part of a residential property for your business, such as consulting rooms then that portion of the interest may be claimed as a deduction.
Bed and breakfast operations offering short term accommodation may be able to claim interest where the owner lives on the property, but not when it is a separate property.
The interest limitation also applies for properties that rent out and also use privately like holiday home.
Taxable Sale Exemption
If the sale of property is taxable, e.g., under the bright-line rules, then previously denied interest deductions may become available to offset the gain on sale.
Refinancing for rental property bought before 27 March 2021
If your initial loan drawdown for settlement was after 27 March 2021, but the acquisition date was before 27 March, you can follow the staged removal as if the loan was drawn before 27 March 2021. But if you borrow further, such as to make improvements, the interest on the new debt is not deductible from 1 October 2021.
If you have a revolving credit or other variable loan, only the interest on the 27 March 2021 loan amount will be eligible for the interest limitation calculation. The rest of the interest will be non-deductible.
Transferring to Related Entities
If you restructure how you hold the property after 27 March 2021, you may be able to carry over the same interest deductibility during the interest phase out period. This includes some transfers to family trusts, to or from look through companies (LTC) or partnerships, relationship property settlements and transfers on death.
The summary above relates to draft legislation, so it may yet change as it goes through Select Committee and Parliament. You can read further details on the IRD website[i].
We have a calculator to help you estimate the cashflow requirements for your rental property with the interest deductibility changes. If you would like a copy, please email the author. For those of you with businesses and investment properties, it may be possible to restructure your loans to maximise interest deductibility.
The recent announcements will cushion the blow of introducing the interest limitation, by extending the new build exemption and allowing for transfers to related entities. Interest on pre-27 March 2021 loans will be mostly deductible until 31 March 2023, so there is time to work out what you will do with your existing rental properties. The policymakers are hoping for houses to be more affordable, but it will require more work on the supply side as well.
- Serena Irving
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Serena Irving is a director in JDW Chartered Accountants Limited, Ellerslie, Auckland. JDW is a professional team of qualified accountants, auditors, business consultants, tax advisors, trust and business valuation specialists.
A well-written article like this, which is general in nature, is no substitute for specific tax advice. If you want more information about the issues in this article, please contact the author.