On 28 September 2021, the Government released the much-awaited draft legislative proposals to limit the deductibility of interest on residential investment properties. What will the proposed legislative changes mean for your property portfolio?
In short, the proposals provide that from 1 October 2021:
- Interest will not be deductible for residential properties acquired on or after 27 March 2021.
- New builds will not be subject to the interest limitation rules.
- Interest deductions for residential properties acquired before 27 March 2021 will be phased out between 1 October 2021 and 31 March 2025.
- A new five year bright-line period will apply for new builds.
- New builds are generally determined by the date when the code of compliance certificate is issued.
- Certain transfers of property within family groups will not trigger the bright-line rules.
Some residential properties are excluded from the interest limitation rules and other limited exemptions also apply.
The draft legislative proposals appear consistent with those outlined in the Discussion Document issued in March. While the proposed rules are complex in certain areas, it is pleasing to see that where a range of options were suggested, the ‘softer’ and more compliance-friendly versions have generally been chosen.
In this article, we outline key details of the proposed legislative changes relating to interest limitation and the bright-line test, then conclude with some perspectives on the likely impacts and next steps from here.
Proposed changes
1. Interest limitation
- The interest limitation rules will apply to residential property regardless of whether it is being used for short-term or long-term accommodation. Airbnb accommodation will generally be subject to the rules.
- Residential property covers land in New Zealand with a residence on it. It also covers land in New Zealand where there is an arrangement to build a residence on it, or the owner is allowed under the relevant district plan to build a residence on it. As expected, the interest limitation rules will not apply to residential property outside of New Zealand.
- ‘New builds’ will not be subject to the interest limitation rules. New builds include all residences with a code of compliance certificate issued on or after 27 March 2020. Land where there is an agreement to build a residence which will have its code compliance certificate issued on or after 27 March 2020 is also included. A new build will remain a new build for 20 years, generally starting from the date when a code compliance certificate is issued, irrespective of how many owners it has had (investors or owner-occupiers). This is one of the ‘softer landings’, which is good to see, especially from a compliance cost perspective. The original proposal suggested that a new build might cease to be a new build if an owner-occupier had lived in the property, which would have been problematic to determine for subsequent purchasers.
- Converting one residence into multiple residences and converting commercial property into residences can constitute a new build, but the devil is in the detail for these kinds of situations.
- Some other types of residential properties are excluded from the interest limitation rules including:
- An owner-occupier’s main home (if used to earn income from a flatmate or boarder)
- Bed and breakfasts where the owner lives on the property
- Business premises
- Hotels, motels and hostels
- Rest homes and retirement villages
- Farmland
- Student accommodation
- Employee accommodation
- Certain land owned by a Māori authority and Māori excepted land (land with a Māori land status or subject to a Treaty of Waitangi settlement)
- Residential land that is leased to the Crown (e.g. Kāinga Ora) or to registered community housing providers that is used for emergency, transitional or social housing.
- Certain entities will be exempt from the rules, broadly as follows:
- Companies whose core business does not involve residential land (e.g. where residential property including new builds makes up less than half of their total assets). This generally does not apply to close companies, unless they are a Māori authority or are wholly owned by a Māori authority.
- Kāinga Ora and its wholly-owned subsidiaries
- Registered community housing providers that are not tax exempt to the extent residential properties are used for emergency, transitional or social housing
- Council controlled organisations in relation to Council-provided housing to people eligible for accommodation at less than market rent.
- While developers are not explicitly exempted, there are exemptions from the interest limitation rules for developing land. However, these development rules are complex.
- Interest deductions will be phased as follows:
Date interest incurred % Deductible 1 April 2020–31 March 2021 100% 1 April 2021–31 March 2022 (transitional year)
1 April 2021 to 30 September 2021
1 October 2021 to 31 March 2022
100%
75%1 April 2022–31 March 2023 75% 1 April 2023–31 March 2024 50% 1 April 2024–31 March 2025 25% From 1 April 2025 onwards 0%
- Any disallowed interest deductions may be available when residential property is sold if the sale is taxable, although the deduction may be limited to the gain on sale.
- There is some complexity around variable loans such as revolving credit accounts, and the proposals contain a ‘high water mark’ which sets a level of deductible debt that was outstanding on 27 March 2021, which will of course be subject to the interest limitation rules.
- Interest on loans denominated in foreign currencies for residential property in New Zealand will not be subject to the phasing out of interest. Instead, interest will be fully non-deductible from 1 October 2021.
2. Bright-line test changes
- The bright-line test has already been extended from five years to ten years for residential property acquired on or after 27 March 2021.
- The proposed changes create a special class of residential land subject to a five-year bright-line test, which is aimed at new builds. It generally applies where the residential property has been acquired within 12 months of it first meeting the definition of a new build. This will generally mean that only the first purchaser of a new build gets the benefit of the five-year bright-line test.
- A number of further changes to the bright-line test are also being made to provide roll-over relief or otherwise reduce instances where the bright-line test is unnecessarily punitive. For example, relief is proposed for some transfers to family trusts and for transfers to and from look-through companies and partnerships. While there are complexities yet to be worked through, this is a step in the right direction for some ‘accidental bright-liners’; those people who inadvertently get caught out when transferring residential property within their same economic group.
Legislation impacts and next steps
As the Minister of Finance noted in the media release announcing the draft legislation, the tax system is not the cause nor solution to housing supply and affordability.
Clearly the draft legislation errs strongly on the side of encouraging investors into new builds. As noted above, the interest limitation rules will not apply to residential property used for emergency, transitional and social housing that is leased to the Crown or community housing providers. This change was suggested by the Ministry of Housing and Urban Development on the basis that private landlords supply both the Crown and community housing providers with housing. Will we see highly leveraged investors rushing to lease residential properties to the Crown to preserve interest deductions? Like with the carve-out for new builds, this appears to be tax policy being used to solve a social need, which might be asking too much of the tax system.
The complexity in the draft legislation will need to be carefully worked through. There will no doubt be issues that need clarification, and there could be the odd remedial change to correct any ambiguities given the need to get draft legislation released before 1 October. In the meantime, taxpayers and their advisers will need to come to grips with the new rules quickly to ensure they can assess what it all means for them.
We are not quite there yet, as we only have draft legislation which may change as it goes through the parliamentary process. That continues to create uncertainty, as the law will not be passed before the rules take effect - with interest deductions becoming wholly or partly non-deductible from 1 October 2021.