Residential Property Investors: Bright-Line Test and Interest Deductibility

March 2021 brought big, sudden news for residential property investors. The Bright Line Property Test has been extended to 10 years for residential property from 27 March 2021. Interest expenses are non-deductible for residential rental property bought from 27 March 2021 and gradual elimination of interest deductibility for current residential rental property owners. Is this capital gains tax in disguise?

The Government's efforts to slow down the house price escalation has caught even our tax commentators on the hop, with the rapidity that the measures have been introduced. The Bill to make these changes has not been passed yet, so there may further clarification or changes when we get the final legislation before 1 October 2021.

Acquisition Date

Acquisition date is the date a binding sale and purchase agreement is entered into.

Hand holding house keys

Bright-Line Test Extended to 10 Years

The bright-line test makes the sale of residential property taxable if it is sold within a set period of acquiring it. Properties bought on 27 March 2021 or later, will be subject to a 10-year bright-line test, instead of the previous 5-year bright-line test. Simply put, if you sell the property within ten years, you will pay tax on the gain in value from the sale.

Gain in Value from Sale

The gain in value from the sale = selling price – purchase price – cost of capital improvements – cost of buying and selling the property

The taxable income from the sale is included in the income tax return of the property owner(s) relating to the period the property was sold, and tax calculated at their applicable income tax rate. Companies 28%, trusts 33%, individuals 10.5% - 39%.

Exceptions

If you inherited the property or it was your main home for the entire period of ownership, then the property is exempt from the bright-line test. If the property qualifies as a "new build" then the 5-year bright-line test applies.

What is a "New Build"?

There is be further consultation on the definition of "new build" but it is intended to include properties that are acquired within a year of receiving their code compliance certificate under the Building Act 2004.

Short Stay Accommodation

Properties used solely for short-stay accommodation will not qualify for the business exemption and will be subject to the 10-year bright-line test.

Changes in Use During the 10-Year Period

If the period that the property is not your main home is 12 months or less, then this is NOT a change in use. For instance, if it takes you several months to move in or it takes several months to sell after moving out.

If the change in use is for greater than 12 months, then you multiply the profit on sale across
 the percentage of time it was not a main home. E.g. If the gain in value was $50,000 and it was not a main home for two of the eight years you owned it, then $50,000 x 2/8 = $12,500 taxable income.

This differs from the previous all-or-nothing approach taken for the 5-year bright-line test.

If bright-line test doesn't apply it might still be taxable

If you are a builder, speculator, developer or dealer in land, then the old land sale rules still apply.
Similarly, if you purchase property with the intention of selling, you must pay tax on the gain anyway.

Interest Not Deductible for Residential Rental

Government proposes to take away the ability for residential rental property owners to claim interest on loans as an expense against rental income, 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.

If you bought the property from 27 March 2021 onwards, you can claim interest until 30 September 2021, then no further interest claim from 1 October. You'll still be able to claim other rental costs for calculating taxable income, just not the interest.

Staged removal of deductibility for existing property

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.


Figure 1 IRD table: Rental interest deductibility

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.

Uncertainty for some sectors

We're still trying to get clarification on how the interest non-deductibility will apply in some cases.  Changing lenders; operating a retirement village; borrowing for mixed commercial/residential properties; borrowing in a company (which currently has an automatic interest deduction. We encourage those of you who are affected to make a submission.

Effect on tenants and first home buyers

Initially, at least, landlords will be looking at increasing their rent incomes from tenants. But rents can only rise so far, before you run out of tenants who can afford rents.

The Government may be hoping that investors exiting the residential property market and an increase in infrastructure funding will help increase the housing stock for first home buyers. Perhaps it would have been better to have more housing available, before attacking property investors, because it is going to backfire on tenants.

The removal of interest deductibility is directly targeted at residential property investors over other forms of investment. While interest rates are low, it may still be an investment option for some, but it will be another story when interest rates increase.

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 a Government vehemently opposed to capital gains tax, the extension of the bright-line test does look like a capital gains tax in disguise. The Government has its sights set on villainous landlords, but in the short term at least, it may be the tenants who have the most to lose.

-          Serena Irving

Download a PDF copy here or contact the author

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.