In one of the biggest tax changes to property taxation, the Labour Government has surprised taxpayers by introducing at short notice (A) Increase to the Bright-line Test from 5 to 10 years (except new builds which remain at 5 years), and (B) Disallowing interest expenses incurred in deriving rental property income.
While the change to the Bright-line test is generally accepted as trying to reduce property speculation, denying interest expenses for all residential property investment may not deliver the right outcomes, and has effectively dealt a heavy blow to genuine property investors. As far as the potential impact on first home-owners, put simply, first home buyers will likely find it more difficult to save for a first home deposit as, if they are renting, landlords will seek to increase rent in order to pass on this extra tax cost or, if they own property investment, their property investment returns will now be much less due to not being allowed to claim interest expenses against rental income. These changes do not address taxpayers who trade in houses.
The taxation levers that have been pulled will not likely achieve the increase in supply that is needed – in the meantime, more compliance and reporting is being thrust onto property investors which may result in a move, to some extent, in asset classes where better returns can be achieved.
Read on to see how this could affect you…
What does today’s announcement mean for you?
A summary of the changes include:
- Extending the bright-line test to 10 years.
- Amending the main home exclusion, which would require tax to be paid on gains made for periods the property is not used as the owner’s main home.
- Allowing newly built homes to continue to use a 5 year bright-line test.
- Disallowing interest on loans and mortgages as an expense.
While the changes will only apply to residential properties acquired on or after this Saturday, 27 March 2021, practically speaking, you are going to have to decide whether this extra tax cost is going to be sustainable going forward. These changes will result in tax physically having to be paid so, we suggest forecasting the tax impact of these changes to ensure there are no surprises.
We discuss this in more detail below, along with some actions you can take now:
Bright-line Test
The bright-line test means if you sell a residential property within a certain period after acquiring it, you will be required to pay income tax on any profit made. The current bright-line period is 5 years. The Government is extending the bright-line period to 10 years for residential property, except new builds.
Inherited properties and those which have been the owner’s main home for the entire time they owned it will continue to be exempt from all bright-line tests.
Use the following flow-chart from Inland Revenue to determine what length of bright-line test a property is subject to.
When a property is acquired
There are special tax rules that determine when property is “acquired” – this is not necessarily the settlement date for both parties!
Introduction of “change-of-use” rule for main homes
For residential properties acquired on or after 27 March 2021, including new builds, the Government intends to introduce a “change-of-use” rule. This will affect the way tax is calculated if the property was not used as the owner’s main home for more than 12 months at a time within the applicable bright-line period. The owner of a property, subject to the change-of-use rule, will be required to pay income tax on a proportion of the profit made through the property increasing in value.
If a property switches to, or from, being the owner’s main home and the period when it is not their main home is 12 months or less, they do not need to count that as a change-of-use. For example, if an owner takes a few months to move into a property, or owns it for a few months after moving out, this does not trigger the bright-line test. However, periods longer than 12 months may cause tax to be payable on the sale of this main home.
What this means for you…
- You will have to hold your properties for 10 years or more if you do not wish to pay income tax on the sale of residential property.
- If you acquire a new build, the bright line period is reduced to 5 years.
- If you sell the property within 10 years of acquiring it (or 5 years for a new build), and it was your main home for the entire time you owned it, you will not pay tax under the bright-line test on any gain in value.
- The legislation will also ensure that residential properties used to provide short-stay accommodation, where the owner does not live in the property, are subject to the bright-line test, and cannot be excluded as business premises.
- If the property was your main home but was used for other purposes for more than 12 months, you may have to pay income tax on the profit.
Interest deductions on residential property income
Interest deductions on residential investment property acquired on or after 27 March 2021 will not be allowed from 1 October 2021. Interest on loans for properties acquired before 27 March 2021 can still be claimed as an expense. However, the amount you can claim will be reduced over the next four income years until it is completely phased out. This means that in the 2025–26 and later income years, you will not be able to claim any interest expense as deductions against your income.
If money is borrowed on or after 27 March 2021 to maintain or improve property acquired before 27 March 2021, it will be treated the same as a loan for a property acquired on or after 27 March 2021 (i.e. the interest will not be deductible).
Property acquired before 27 March 2021
If you acquired a property before 27 March 2021, you could still claim interest (for loans that already existed for that property) as an expense against your residential property income, but this amount will reduce by 25% each income year until the ability to deduct the interest is completely phased-out from the 2025–26 income year. If you have a standard balance date, the proposed change will be phased in as follows:
Offer made before, but property acquired after 27 March 2021
If you’ve made an offer on a property on or before 23 March 2021, but the offer is accepted after 27 March 2021, and you could not withdraw the offer before 27 March 2021, your property will be treated as if it was acquired before 27 March 2021, meaning you can claim interest as an expense until the ability to deduct it is completely phased-out.
Borrowing on or after 27 March 2021
If you acquire a property before 27 March 2021, the interest on any borrowings for the property will generally be able to be claimed as an expense in a phased-out manner over the next four income years. This includes the situation where the settlement does not take place (and therefore the loan is not drawn down) until after 27 March 2021.
Loans for business use secured against residential property
The Government’s intention is that the rule change will not apply to loans for non-housing business purposes. In addition, property developers and builders will still be able to claim their interest expenses as it is a business expense.
How can we help?
We appreciate that the above changes may seem complex on first read. Please don’t hesitate to contact one of our tax support team if you need further clarification. Particularly, we can help with:
- Forecasting future tax liability
- Reviewing current borrowings to see what options, if any, are available to you.
