A review of the New Zealand's Government release of a discussion document on Interest Deductibility

Interest Deductibility Consultative Document

On 10 June, the Government released a consultative document of 143 pages on the proposals announced in March 2021 to deny interest deductions on money borrowed to acquire residential rental properties. The consultative document provides a comprehensive analysis of the issues and the options the Government has in front of it and, while on a very tight time frame, seeks consultation and feedback from interested parties.

The Government’s aim is to reduce the incentive for people to buy or retain existing rental properties by making interest non-deductible. By doing so, this rental stock will be more freely available to home buyers.

The Government is also trying to use this as a means to increase the supply of new housing stock in New Zealand by permitting, in proposed limited circumstances, interest deductibility on newly built residential rental properties. It is also proposed that the Brightline test for new built residential rental properties will be 5 years, although this may also apply to new beach houses or second homes as well.

You will recall that:

  • for residential properties acquired on or after 27 March 2021, interest will be non-deductible from 1 October. The same applies to money borrowed to extend or improve existing properties.
  • for residential rental properties acquired before 27 March 2021, the deductibility for interest will be phased out so that by 1 April 2025 on no interest will be deductible at all.

So what do the new rules apply to and what is excluded?
The exclusions are:

  • Land outside New Zealand.
  • Employee accommodation.
  • Farmland.
  • Care facilities such as hospitals, convalescent homes, nursing homes and hospices.
  • Commercial accommodation such as hotels, motels and boarding houses (but not Air B n B etc).
  • Retirement villages and rest homes.
  • The main home.

There is a natural interplay between the operation of the Brightline rules and the denial of interest deductibility. There is also a similar interplay with the existing mixed-use asset rules and rental property loss limitation rules (prohibition of negative gearing). The inter-relationship between these various provisions all need to be considered and resolved before the law can be passed.

The Government is questioning whether if interest is non-deductible, but a property is sold and the gain is subject to the Brightline test, whether interest should be permitted as a tax deduction. Interest will be tax deductible for property developers and those who are taxable on the gain irrespective of how long a property is held, where the property is on revenue account irrespective of when it is sold.

The definition of a new build is going to be a key facet of the proposed new law. This is because potentially interest deductibility can be obtained for the acquisition of new builds, and secondly, a lesser 5-year Brightline test will apply.

As noted above, potentially this will apply to not just rental properties, but also to baches etc that are new builds.

A new build is likely to constitute:

  • Where a dwelling is added to vacant land
  • Where an additional dwelling is added to a property, whether stand-alone or attached
  • Whether a dwelling (or multiple dwellings) replaces an existing dwelling
  • Renovating an existing dwelling to create two or more dwellings
  • Where a dwelling is converted from commercial premises such as an office block into apartments

It is not clear whether a relocated house as an example would be considered to be a new build, even if it is relocated onto a new site and a new house is built on the existing site. There are still some areas that will need to be considered.

The Government proposes that a new build will provide interest deductibility and the shorter Brightline test for what it calls “early owners”. These will be taxpayers who acquire a new build no later than 12 months after its code compliance certificate (CCC) is issued. The question then arises as to what happens if those new builds are on sold? Does the exemption or exception only apply to the first early owner or does it run with the property for its life? Similarly, should the interest be deductible forever while that new owner holds the property, or should it only be for a period of time?

As many readers will be aware, the existing Brightline rules have caused some degree of hardship particularly in circumstances of family reorganisations. Where for instance the beach house is transferred from individuals to a trust, between trusts or from a trust to an individual, the Brightline test restarts. Thus you may have owned the family bach for 30 years, but on a transfer like one of these on or post 27 March 2021, the 10-year Brightline test would recommence. There is discussion around softening these to provide limited grandfathering rules, as currently occurs upon death and under relationship property agreements.

So whether the Government’s objective of tilting the playing field away from property investors and towards first home buyers will be achieved or not will depend on the final details of the rules. However, in our opinion, by providing an exemption for new builds, investors will be encouraged to buy these and to sell their existing residential property stock.

What the Government has perhaps failed to consider is that probably the largest group buying new builds are first homeowners. By encouraging investors to compete against this very group that the Government is trying to favour, it is likely to push up the prices and reduce the availability of new builds to first home buyers. This is the very opposite that it is wanting to achieve. There is also a question about how quickly the building industry can gear up to increase the stock of new builds available anyway.

The rules will end up being exceptionally complicated. There will be large difficulty in complying with it and likely mass non-compliance, especially for Mum and Pop investors who prepare their own tax returns each year. As is always the case, there is likely to be the need for further remedial legislation even after consultation and the passage of time, as the problems are identified with the passage of time.

We will continue to keep you appraised of the proposals, particularly once the final format of them is announced by the Government in a few months time.