Significant tax changes on the way for residential property investors

23 March 2021

​​The Government has announced a suite of new measures intended to address housing affordability in New Zealand.

Among the new measures are two significant changes to the taxation of residential property investments, with the extension of the bright-line test to 10 years for existing builds and the elimination of any tax deduction for interest against residential rental income.

Housing affordability has been a hot topic in New Zealand politics for well over a decade. As early as 2007, Sir John Key (then the Leader of the Opposition) decried the “home affordability crisis" that had seen home ownership decline by 5% over the preceding five years. A decade later, the Labour Party came to power on the back of a campaign platform that included promises to address housing affordability through measures including, most notably, its KiwiBuild programme. Despite this, house prices have risen from a national median of $349,000 in April 2007 to more than $730,000 in February 2021. The measures announced today represent the latest in a long line of efforts to improve housing affordability for first homebuyers – or at least, to slow rampant house price inflation.

Changes to the bright-line test

The so-called “bright-line" test was introduced by the National Government in 2015, with then-Revenue Minister Todd McClay describing it as “an important tool to ensure property speculators pay their fair share of tax". The new bright-line test applied to sales of residential property, with exceptions for the family home, inherited property or property transferred in a relationship property settlement. Properties that were sold outside of the two-year period remained subject to the existing “purpose or intention of disposal" test in the Income Tax Act 2007. The two-year period for the application of the bright-line test was subsequently extended to five years by the Labour-New Zealand First Government in 2018.

The Government today announced a further extension of the bright-line test from five to 10 years, for residential properties other than newly built houses (new builds).

The extension is included in a Supplementary Order Paper to the Taxation (Annual Rates for 2020-21, Feasibility Expenditure, and Remedial Matters) Bill that was released today and will apply to properties acquired on or after 27 March 2021. Legislation detailing the exception for “new builds" will be drafted over the coming months in consultation with the tax and property communities and will apply retrospectively to all new builds acquired on or after 27 March 2021.

The Government has also announced changes to the application of the main home exception, introducing a new “change-of-use" rule. The new rule will apply where a residential property was not used as the owner's main home for 12 months or more during their period of ownership. In that case, the owner will be required to pay tax on a proportion of any profit derived on the sale of the property.

Changes to interest deductibility

Under existing law, owners of residential property can deduct interest on borrowings against rental income derived from investment properties, reducing their income tax liability. Since 1 April 2019, these deductions have been ring-fenced to rental income (i.e., the interest expense cannot be set off against other income of the property owner).

The Government today announced its intention to eliminate deductions for loan interest incurred in respect of borrowing to acquire residential properties altogether. The new rules will apply from 1 October 2021 for residential properties acquired on or after 27 March 2021. Interest on loans relating to residential properties acquired before 27 March 2021 may still be claimed as a deductible expense for the time being. However, the amount of the deduction will be gradually reduced over the next four income years until the deduction is phased out (echoing a similar approach applied in the UK). From the 2025-26 income year, residential property owners will not be able to claim any interest expense as a deduction against rental income.

The Government will consult on the detail of the new proposals over the coming months. Matters for consultation include a possible exception for owners of new builds and whether people who are taxed on the sale of a residential property (whether under the bright-line test or otherwise) should be entitled to deduct accrued interest expenditure at the time of sale.

What does this mean for property owners?

The extension of the bright-line period to 10 years represents a substantial change from the original scope and purpose of the bright-line test. The bright-line test was originally conceived by the IRD as a mechanism to overcome difficulties in establishing whether investors acquired property with a purpose or intention of resale under existing rules. The idea was that if an investor held only for two years, then it could be reasonably inferred that they acquired the property for resale. However, it is probably not reasonable to infer that all investors holding property for less than 10 years acquired the property for resale. One view is that the 10 year rule effectively amounts to a de facto targeted capital gains tax on residential investment properties rather than a proxy for resale purpose.

One of the criticisms of the bright-line test was that it was a blunt instrument, and captured sales within the bright-line period where it was clear the property was not acquired and held on speculative basis. Selling the family bach, for example, within the bright-line period would trigger a taxable event, regardless of the circumstances around the acquisition of the property and the reasons for selling. Situations where parents co-purchased homes to help their children get on the property ladder were caught if the child bought out the parents within the bright-line period. These issues and the risk of perceived overreach by the tax rules will be magnified with an extension of the bright-line period to 10 years. It also seems logical that the extension could produce a lock-up effect with property owners deferring sale until the expiry of the bright-line period.

Commenting on the tax changes generally, Finance Minister Grant Robertson said that the changes would remove tax loopholes for investors to dampen demand and tilt the balance towards first homebuyers.

The narrative around tax “loopholes" for property investors has been dominant in conversations regarding housing affordability in New Zealand, but warrants some further examination. Tax laws have not historically favoured property investors, who have been subject to tax on the same basis as all other investors.

The tax changes announced today are expected to impact demand for residential property investment generally, while retaining some incentive for investors to invest in new builds relative to existing housing. In this regard, the changes represent a significant departure from the principle of tax efficiency – the concept that taxes should not impact the allocation and use of resources across the economy. The concept of using tax to address specific behaviours is hardly new. However, significant distortions to the income tax system, like those that are likely to result from the changes announced by the Government today, are rare. Whether the proposed changes do, in fact, generate the intended outcomes remains to be seen.

If you have any questions about the matters raised in this article please get in touch with the contacts listed or your usual Bell Gully advisor.

Disclaimer: This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.