14 October 2021
With the release of legislation on the removal of interest deductibility for certain residential property and new build definitions, it is interesting to consider what the overall tax system now looks like for New Zealand residential property owners.
Like a patchwork quilt, it is only when the various pieces are taken together can you assess the usefulness of the blanket that you have created. But have the steady flow of changes to the rules over the past few years, trying to remove inequity of home ownership to make it more affordable and accessible, created a mismatch of patches considered in isolation that don’t resemble what the final quilt should actually look like?
When it comes to residential property, many tools have been used with tax playing a key role, alongside other changes like the healthy home standards and tenancy law reform. With these changes largely in place, will they stitch together a coherent plan?
Life before these changes was fairly straightforward, with the rules largely fitting within the objective and purpose of New Zealand’s low-rate broad-based tax system.
If rental income was derived, it was returned as taxable income after claiming costs, such as the interest on the mortgage used to acquire the property. Generally, tax wasn’t paid on sale, unless you were a dealer or if you undertook a development of some description on the land.
However, with house prices rising, more was expected and so this started to change in 2015, with the introduction of the two-year Brightline Test. It wasn’t a perfect rule, but overall was fairly simple to understand and enforce. While there was certainly some collateral damage (such as those facing a change of circumstances or mum and dads helping their children into property), for most, holding onto property for two years wasn’t too difficult to wait for.
However, with a new government, further changes were introduced. First was the extension to a five-year Brightline Test. Again, this wasn’t too difficult to administer, but the extent of the collateral damage became more prolific with a five-year period, as people simply couldn’t wait like they could under a two-year timeframe.
The tax rules became a little more complex with the introduction of the residential ring-fencing rules, aimed at denying rental property owners from being able to offset any rental losses against other income.
In principle, the rules seem reasonable and simple, however, implementation is always the true testing ground and it is arguable that these changes have been more of a compliance drag rather than effective tax policy.
While the underlying application uses the Brightline residential land definition, there are additional exemptions, which can actually drag a property into and out of the rules on an annual basis. Then there is the requirement to assess whether a property is part of a portfolio, which is not as simple as it would appear. Along with this, the extra detail in the tax return hasn’t been straight forward, and the requirement to keep a track outside of this is another compliance burden for such owners. With a loss of interest deductibility, will any remaining effectiveness be extinguished?.
This then brings us to the March 2021 changes, with a restructure of the Brightline Rules and the introduction of rules to deny interest claims.
We say restructure, because while there was the obvious extension to the ten-year timeframe, there were also new builds to consider (subject to a five-year timeframe), along with a change to the main home exemption both in terms of space and time used as such.
All these added considerable complexity to what once was a straight-forward two-year test. It also introduced an element of intention to the rules which was the very thing they were trying to avoid when first introduced.
The other consideration is ascertaining who is denied an interest deduction. While these rules do use some of the same rules, they are not the same and, therefore, require some additional classification on the part of taxpayers. For some, there will be an apportionment to consider where borrowings are intermingled.
In addition to the above changes, there are other considerations for property owners, such as depreciation rules. For non-residents, there are additional considerations with cross border transactions, such as loans sourced from overseas.
For those who undertake some short-term rental activity from their residential rental properties, the rules are even more complex, as they have further layers to consider in addition to the above.
For instance, depreciation is not as simple. There can be additional fit-out claims to consider, plus with the re-introduction of depreciation on commercial buildings, there are new rules that need to be considered that do not use the same Brightline base.
There are also the mixed-use asset rules to consider if a property has a mixture of private and income earning use. These impose additional specific apportionment requirements.
There is also the added complexity of GST potentially applying. Depending on the extent of rental income, this could be an additional and costly obligation within which there are multiple variations that can apply depending on how property is owned.
Therefore, it is feasible for short term rental property owners to contend with:
- Three bright line eras plus new build.
- Multiple versions of the main home and business premises exemptions.
- Mixed use asset rules.
- Depreciation fit-out.
- Depreciation of buildings.
- Residential Ring Fencing.
- Loss of interest deduction.
- GST – which has multiple variations depending on how owned.
Keeping in mind that property ownership and use is not the same between taxpayers, with multiple nuisances causing quirks across these rules. The fact that they don’t fit neatly into each other has certainly imposed a significant compliance burden on such owners.
While we can debate the intent behind all of these rules and whether they are going to actually help address the housing crisis, it is important to sit back and assess the end product we now have and more importantly the structure of our entire tax tapestry holistically.
In this respect, even the IRD did not recommend the government proceed with the March 2021 changes. The fundamental reasoning includes the erosion of our basic tax principles, such as if you incur a cost in deriving income, you should be entitled to claim that cost.
The end result is that residential property owners are picking up the tab, a cost that will need to be paid or passed on. Time will tell if it has been worth the cost.