Housing tax changes announced

The Government’s housing policy announcements today include some significant tax changes.

• For residential investment property acquired on or after 27 March 2021, a 10 year (rather than the current five year) bright-line test and amending the main home exemption so that it better reflects the split between personal and rental use.
• No interest deductions for residential rental property acquired on or after 27 March 2021 and for already acquired properties a phase out of interest deductions over four years.
• The bright-line period extension is not intended to apply to “new builds” (with consultation on how this should be defined to come). The Government will also consult on whether the proposed interest deduction restrictions should apply to new rental builds. [See update at the end of the article].

The bright-line changes are in a Supplementary Order Paper (“SOP”) to the Taxation (Annual Rates for 2020-21, Feasibility Expenditure, and Remedial Matters) Bill (the “Bill”). The Bill is expected to be law shortly. The interest deduction restrictions will be legislated later this year, with effect from 1 October 2021.

In addition, the SOP to the Bill:

• Contains the new Business Continuity Test for carrying forward tax losses; and
• Allows a deduction for the cost of donated trading stock. 

The current bright-line test applies to residential investment property that is bought and sold within five years. However, the test does not apply if the property is predominantly used as the owner’s main home.

The SOP to the Bill:

• Extends the bright-line period from five to 10 years for residential investment properties where a binding sale and purchase agreement for the property is entered into on or after 27 March 2021. The extended period is not intended to apply to newly built houses (“new builds”), which will be subject to a five-year bright-line. The definition of a new build will be subject to consultation later this year, with a retrospective law change once this is confirmed.
• Introduces a new “change of use” rule for residential investment properties acquired on or after 27 March 2021. For example, if a residential property was used as a main home for six out of eight years, 25% of the gain on sale in year eight will be taxable. The change in use rule will apply to both existing and new builds but property that is sold within 12 months of a change of use will not be taxed. 

The bright-line extension is a missed opportunity to undertake a more comprehensive stocktake and review of the land taxing rules. Instead this continues the trend of ad hoc tax measures by multiple Governments. In our view, they detract from the overall coherence of the system. Debate will also rage as to whether increasing the bright-line test period is contrary to the Government’s election tax policy pledge.

The change of use rule is more understandable. It produces a fairer result than the current “predominantly used as a main home" test for bright-line property. (It is also consistent with a legislative clarification to the “dwelling” definition in the Bill to include unoccupied property for bright-line and rental loss ringfencing purposes). This will however mean that, depending on the property’s acquisition date, different tests will apply. So extra care will need to be taken when applying the tax rules.

Interestingly, the regulatory impact statements accompanying the SOP highlight stark divergences in view between Inland Revenue and Treasury on extending the bright-line period. Inland Revenue was opposed to any extension, whereas the Treasury’s view was that the bright-line period should be 20 years (with no concessions for new builds). 

The Government will introduce legislation later this year which, with effect from 1 October 2021, will:

• Remove interest deductions for residential investment property acquired on or after 27 March 2021 (as well as on new borrowings on or after this date to maintain or improve a property acquired before 27 March 2021).
• Phase out interest deductibility from this date for all other residential investment property over four years, with full interest denial from 1 April 2025.

The Government intends to consult on a number of design issues, including how to ensure interest deductibility where loans secured against residential property have a business purpose and whether interest deductibility should also be restricted for new rental builds.  

This is a significant change to the structure of the tax rules. The current rules do not require any apportionment for dual purpose (i.e. rental and capital gain purposes). There is a policy argument that interest should not be deductible to the extent it is used to derive non-taxable income or gains. Where the return comprises a mix of rental yield (taxable) and capital gain (non-taxable), the appropriate response is an apportionment of interest deductions. The question is how much should be deductible? This might vary with the gain actually made but this would not be known until a sale is made. An arbitrary 50% would acknowledge the dual purpose of the borrowing. However, such policy nuances have not been accepted – the Government has landed on a default 100% deduction denial.

This means all interest will be automatically non-deductible in the case of residential rental properties acquired after this Friday (and for any new lending after this date on existing properties) and over the next four years for existing residential rental properties. The only area where the Government is still weighing up its options is whether interest deductibility restrictions should also apply to new residential rental builds. The interest deductibility rules are unchanged for developers and builders.  

There are a number of detailed design issues that will need to be resolved. Some questions that immediately spring to mind are:

• What types of residential property will be subject to the interest deductibility restrictions – e.g. are retirement villages intended to be caught?
• How will the deductibility restrictions apply where debt is held in a company? We expect debt stacking rules, similar to those in the mixed-use asset rules, given automatic interest deductibility at present for companies.
• For offshore rental properties, if the interest is denied, should the foreign exchange movement (gains and losses) on the mortgage also be ignored for tax?
• The continued need for rental loss ring-fencing? 

In addition to the tax changes, the Government has announced:

• Funding of $3.8 billion to unlock more land for housing development, support the provision of critical infrastructure for housing development, and support the delivery of a wider mix of affordable housing for ownership and rental. This funding includes re-prioritisation and re-directing of previous COVID-19 allocated funding.
• Changes to the First Home Loan and Grant Scheme by increasing both the income and house price caps. 

More on these policies can be found here.

The SOP to the Bill also contains draft legislation:

• Implementing the Business Continuity Test for carrying-forward tax losses, where there has been a breach of the shareholding continuity rules – you can read our taxmail on this here.
• Removing the need to add back the market value of donated trading stock, for trading stock donated between 17 March 2020 and 16 March 2022. This will effectively provide a deduction for the cost of donated trading stock, where the donation is to a non-associate or to an associated charitable organisation. 

Tax Policy Officials have indicated the Government intends to exclude new builds from the proposed interest deductibility restrictions. Consultation on the detail of this will be undertaken later this year.