This article originally appeared in LawNews (ADLS) and is here with permission.
Property and tax lawyers’ telephones rang hot on the day after the government announced its controversial housing policy package late last month.
The removal of mortgage interest tax deductibility on investment properties has shocked investors and speculators alike. And alongside the shock, there is confusion and uncertainty about critical details which are still missing from the government’s package.
Exactly whom will be caught by the new interest deductibility rules? How will the family home exemption from the new, extended bright-line test work? The fine print which will, in many cases, determine whether investors and home owners are caught by the new rules remains frustratingly unclear.
These details, we are told, will be ironed out after some form of consultation. Again, it is not clear who will take part in this consultation and how long it might take.
Specifically, property owners are wondering how the government will define ‘own/family homes’ and ‘new builds’ when deciding who will be caught by the 10-year bright-line test and who can still claim full deductibility on mortgage interest. Family homes are exempt from the bright-line test and those buying new builds as rentals after 27 March can continue to deduct mortgage interest.
The definitions, once finalised, will have huge consequences for investors and some owner-occupiers.
The key changes for investors are:
- The bright-line test (a tax on capital gains) is extended from five years to 10 for second-hand property, but remains at five years for new builds. Gains on own homes that switch back or forth to rental accommodation might also fall into the bright-line test regime.
- Mortgage interest will no longer be tax deductible on rental properties bought after March 27 and will be phased out over four years for existing rentals. It is not yet clear whether new builds will be exempt from this rule, meaning landlords could still deduct mortgage interest. But this depends on how ‘new build’ is defined.
All this uncertainty makes it difficult to advise clients, says property lawyer Nick Kearney of Schnauer & Co.
What is an ‘own home’?
Owner-occupiers are said to be excluded from the bright-line test. Or are they?
If an own-home bought after 27 March switches to, or from, being the owner’s main residence and is rented for periods of more than 12 months at a time, the owner will pay income tax on the proportion of the profit made, less standard deductions. In the past, homeowners were caught by the bright-line test only if they rented out the home for periods totalling 50% or more of the time it was owned.
Former ADLS President Joanna Pidgeon, of Pidgeon Judd, says the new rules will make completing withholding tax statements more complex and the form will most likely need redrafting.
Some owner-occupiers let parts of their homes such as sleepouts to tenants, boarders, or short-stay guests. Or there may have both commercial and residential elements to a property. If a property has a mix of commercial and residential uses, the IRD looks at the predominant use. Business news website interest.co.nz reports that the government is still to decide whether interest can be deducted for residential properties which are also used as workplaces.
An alternative to the predominant-use concept could be a formula for apportioning deductibility based on the floor area or rental income generated by each type of usage, or it could just exempt them altogether.
Purely commercial property is excluded from the new policy rules.
What are new builds?
To encourage development, new builds escape the 10-year bright-line test (though the previous five-year rule will still apply). New builds might also escape the interest deductibility rules when owned by investors, but that is yet to be determined, says Pidgeon.
The big ‘if’ is the actual definition of a new build, which will be worked out in consultation with the tax and property communities over the coming months, but it is intended to include properties that are acquired within a year of receiving their code compliance certificate under the Building Act 2004.
But how might the new rules apply to investors who bought a house off-the-plans and had an unconditional agreement two weeks before 27 March, when the government’s new changes took effect?
Will this yet-to-be-built house be classified as an existing property for the purposes of interest deductibility because the purchasers had a binding sale and purchase agreement in place before 27 March? Or will it be classified as a ‘new build’ and, thus, subject to the five-year bright-line test rather than the new 10-year rule?
Tax consultant Terry Baucher says it’s likely the government will be hit with an avalanche of submissions in its consultation process, and he expects it will be generous in its definition because it wants to encourage new builds.
Shockwaves reverberated around investment and professional communities at the new rules, especially the removal of interest deductions for residential property. They came out of the blue and were not signalled in advance, says Baucher.
Under the previous rules, residential investors could deduct the interest on loans in calculating their taxable income and this reduced their tax bill.
The government called it a loophole, but investors argue they are no different from any other business that can claim its costs. Baucher says it was an anomaly because investors used loans to derive capital gain but were taxed only on the rental income portion of their total return.
Whatever the government decides, it could have trouble collecting its dues on the bright-line test. Writing in interest.co.nz, Jenée Tibshraeny said compliance with the previous five-year bright-line test could have been below 50%.
Other rules in the Income Tax Act 2007 that can tax gains on the sale of land (including residential land) continue, regardless of when the property was purchased. That includes the associated persons rules for speculators, land developers and dealers. Rules still apply for property bought with the intention of making a capital gain. In that case, capital gains are taxable at any stage.
The bright-line tests potentially apply only if none of the other land sale rules apply.