Reflecting on the impacts of the 10-year Brightline and removal of Interest Deductibility

By now, the shock of the Government’s unprecedented and unheralded move to phase out the deductibility of interest for residential investors will be beginning to sink in.

To refer to this change as the closing of a tax loophole demonstrates unbelievable naivety at best or a cynical manipulation of the truth at worst. The ability to deduct interest on the financing of an income earning asset is a foundation principal of our tax system. A rule so fundamental nobody seriously considered this rug would be pulled out from under our long maligned residential sector. We feel for middle New Zealanders who made large debt funded investment decisions believing that they could at least rely on the fundamentals of our tax system remaining intact.

The move to extend the Brightline to 10 years and thereby create a backdoor capital gains tax on residential land was a bit like the death of an elderly relative, not unexpected but still unwelcome when it came.

Let’s not forget, National’s stated purpose with 2-year Brightline was simply to strengthen the intent provisions. Look where this has led now. Labour was not bold or clever enough to introduce a fair, even handed, universal capital gains tax but instead have taken the easy option to extended the Brightline to lay a punch on residential land owners.

In this article we reflect on some observations and likely consequences from these changes.

The rules create three different classes of property. Commercial, existing residential and new build residential. Each class of property now has its own set of tax rules. Accountants are used to counting dollars, but it now seems counting days will be first priority. Three separate changes to the Brightline dates and now different Brightline dates for new builds and existing stock.

So, what’s the impact on the market going to be?

What is becoming clear is that investors are doing their sums on what the removal of interest deductibility will mean to their cashflows. Many who are highly geared are making very little surplus and are forced to conclude they simply won’t have the cashflows to service debt and pay this artificially imposed income tax. Especially those who will become provisional taxpayers for the first time with tax bills exceeding $5000.

Investors who can’t afford the tax must sell. Many are already making the heart-breaking decision to list at a time when buyer demand will be low through no fault of their own.

New builds look attractive, but not as attractive as commercial, where there is no Brightline and no loss ring fencing at all.

Whether first home buyers will now take their opportunity and make acquisitions remains to be seen, but don’t be surprised if they also remain on the side-lines if prices do start to fall as they are notoriously nervous buyers who would fear a negative equity situation if prices could fall.

On a positive note, the new rules do mean interest rates are likely to remain lower for longer. Perhaps its time to gain some certainty by fixing some longer-term rates. But remember that break penalties apply if you pay down fixed rates so factor this in if you are considering selling.

The decision to exempt new builds from the 10-year Brightline and the interest deductibility denial is clearly aimed at incentivising more construction of dwellings. To have made this announcement without providing a definition of a new build though is indefensible. All we have is a vague suggestion that a new build might be one acquired within a year of a code of compliance, many unanswered questions remain, especially for investors who have recently completed debt funded new builds. Investors who are in the market will certainly want clarity on this key point before committing themselves further.

New builds though are never cheap. Developers will quite rightly demand full retail prices.  A price point difference could well open up between a new build where interest is deductible and its existing stock cousin where it isn’t. A further consequence of creating different rules for different classes of property.

Surprisingly, the governments promise to never apply Brightline to the family home has also been broken. The new Brightline announcement contains a “change of use” rule that waters down the main home exemption. Any home acquired after 27 March that is rented out for more than one year during the tenure of ownership must have a gain on sale within ten years returned as income in the proportion of the time it was rented verses the time it was the taxpayer’s main home. This will bring a lot more taxpayers into the Brightline rules than was otherwise the case, and unfortunately, many of these taxpayers will probably not see this coming as the matter may well be out of sight and out of mind when a sale decision of what they consider to be the family home, is made.

We recommend taxpayers continue to track and record their interest costs despite the inability to deduct them against rent as it seems likely that the new rules may allow an interest claim if a gain on sale is taxable due to a sale within the Brightline period. At present, this is not necessarily the case but it would be grossly unfair to continue to deny a deduction for interest if a gain on sale is taxed.

Much is being made of the fact that rents must rise as a consequence of the extra tax cost being imposed on investors. Be aware that firstly, don’t assume tenants have the ability to stand major increases. Most are on fixed incomes that are not rising as we battle our way through Covid recession.  Secondly, don’t be surprised if we see a rent freeze introduced if rents do start rising. Any government that can undermine a foundation rule in our tax system to achieve a social agenda is entirely capable of freezing rents.

It’s a time now to take a breath, examine the landscape, do your numbers, think carefully and weigh up your options. Set the anger aside and focus on the facts. If selling is inevitable, get the process started. Even if triggering tax on a sale within Brightline, the tax is a by product of exiting with a profit. Reducing your debt and that unexpected tax bill may be more important than holding onto the hope of a tax-free gain beyond your Brightline period.