How will the government's tax deductibility changes impact my property portfolio?

Last Updated 25/03/21

Introduction

How will the government's tax deductibility changes impact my property portfolio?

Many property investors will pay more tax after the government's recent announcements.

That's because the IRD will soon view investment properties as more profitable than actually are in practice. This is due to changes in how interest costs will be treated when you calculate your property’s annual tax bill.

This article will focus specifically on the interest deducibility changes and how they are likely to impact you as an investor.

What The Changes Are

What are the interest deductibility changes? And how are they different from right now?

Before the changes come in, investors calculate their taxable profit like this:

Interest Tax Deductibility Calculation Before and After

You then multiply your taxable profit by your tax rate, e.g. 33% if the investment is held in a trust.

Interest makes up about 43% of your total expenses when you acquire a new property using the standard set up we use here at Opes Partners.

By removing these expenses when calculating your tax, your property will look more profitable in the IRD's eyes. So, you'll have to pay more tax.

But … of course, you still have to pay your interest costs.

The effect is that you'll receive a significantly higher tax bill each year.

The changes are so sizeable, they can turn a property with positive cash flow into one that is now negatively geared.

Cash Flow Example

Give me an example of how much money the property makes before and after

Here's how the cash flow on an investor's property will look once interest deductibility hits 0%.

Let's say the investor has just bought a $500k property, which they borrowed all the money to fund the purchase.

It rents for $500 a week, so will earn $25k in its first year (taking into account 2 weeks of vacancy). The property also has operating costs of $10k per year.

And because the mortgage is interest-only and fixed at 2.5%, it attracts interest costs of $12.5k.

Let's ignore chattel depreciation to keep things simple for now.

Under the previous rules, the property has a taxable profit of $2.5k.

Using a 33% tax rate, the investor will pay $825 to the IRD.

The property owner then takes home $32 a week ($1,625 per year).

The numbers look drastically different under the new rules.

Once interest deductibility is removed, the IRD will say the property has a taxable profit of $15k ($25k of rent – $10k of operating costs). Not $2.5k.

Therefore, the investor's tax bill will shoot up 500% from $825 to $4950 per year.

After paying operating costs and tax, the investor has $10,050 left to pay their interest costs.

These costs haven't changed. So they have $10.05k leftover and still have to pay the bank $12.5k.

That means the property needs topping up by $2,450 per year ($47 per week).

So what's changed?

The rent is the same, the operating costs are the same, and the interest costs are the same. What's changed is the tax bill. And that has pushed this property from being positively geared to being negatively geared.

The investor in this scenario is worse off by $79 per week ($4,125 per year).

Scary stuff. But you also need to remember that property investors will not all be impacted equally. Some properties will be exempt from these tax changes.

Who The Tax Applies To

Who has to pay the tax?

The new tax changes do not apply to all property investors equally. “New Builds”, for instance, get to stick with the old rules and will pay the same amount of tax as before. (More on what constitutes a new build below).

Here’s who will be most impacted by the changes.

Interest Cost Deductibility Flow Chart

Any properties considered 'existing' – and were not bought directly from a developer – will be caught under these new changes. Though how your properties are impacted depends on when you purchased them.

If you acquired the investment before 27th March 2021, the changes will be phased in over 4 years.

If you purchased it after 27th March, you won’t have the ability to claim interest expenses after 1st October 2021.

Here's a table that breaks down how the changes will be phased in.

Interest Tax Deductibility ChangesTable Phases

From 1st October 2021, you can still deduct 75% of your interest costs on any properties you owned before 27th March. This drops to 50% from April 2023, then to 25% in April 2024. From April 2025, no existing properties will be able to claim this deduction.

New Build Definition

What's the definition of a "New Build"?

Many property investors are asking: "what will be considered a new build?"

The exact definition has not been set. The government will spend the next 6 months consulting with the property investment industry to define this term.

However, we expect that it will include:

  • any property bought directly from a developer that also
  • received its code of compliance certificate no more than 12 months before your purchase.

This is a similar definition to what is used in other government policies, e.g. First Home Grant.

Though we expect the final wording to be similar to other government policies, the consultation process is still essential. We still need to answer questions like:

  • If I bought a property directly from a developer 10 years ago, is it still a new build?
  • How long does a new build stay a new build for?
  • If I bought a property directly from a developer in my own name and then moved it into my trust, does that still count as a new build, or is it now existing?

We here at Opes Partners will be very active within this consultation as we work with investors who have purchased new builds over the last 8 years. Their contribution to increasing the housing supply must be recognised and rewarded.

If you're reading more about this online, the exemption is not currently in the IRD guidance yet. That's because the legislation is still to be drafted.

However, the government has been unequivocal that an exemption for new builds will come in. Check out the clip below.

Investors Most Impacted

Who will be most impacted by these changes?

There are five groups of people who will be impacted most harshly by the changes:

  • People who invest in existing properties (not new builds)
  • People who are on higher interest rates
  • People who are highly leveraged and invest with 100% borrowing
  • People who buy an existing property and don't conduct significant renovations
  • People who purchase lower yield but higher growth properties.

On the other side, some investors will be less impacted:

  • People who invest in new builds
  • People who use a cash deposit (20%+) when purchasing investment properties
  • People who purchase existing properties to renovate, increasing the property's value and cash flow
  • People who invest in higher-yielding properties
  • People who manage their interest rate risk

As an investor, your properties feature in both lists. The true test is to run a 15-year projection to understand how your property may perform over time.

The below three examples all give a 15-year cash flow, including chattel depreciation, inflation, and rental increases over time.

1) New Builds vs Existing

1) “New Builds” vs Existing Properties at current interest rates

Here's a comparison of the same $525k property, which earns $450 per week in rent. Both properties are assumed to be bought from 1st April 2021.

The only difference is that the first property is a New Build – where interest expenses are tax-deductible. The second is existing and can't deduct its interest costs after October 2021.

The investor in the new build will need to top up their property by $4 a week in the first year. But after that is expected to have positive cashflow. The investor will top up the property by $200 over the 15 years.

Compare that to the existing property, where the investor will have to top-up the property by $5,773.97. The property won’t break even until year 8.

Government Announcement Changes Interest Tax Deductions Example

That’s probably not as scary as many investors would initially think.

But, this example uses a constant interest rate of 2.5% over the whole 15 years. That’s probably not realistic, so let's consider what would happen with higher interest rates being introduced.

2) Higher vs Lower Interest Rates

2) “New Builds” vs Existing Properties at higher interest rates

The tax deductibility changes have the same effect as increasing the interest rate that investor’s pay by 50%.

You used to be able to decrease your tax by 1/3rd of your interest costs.

So removing that deduction increases the interest costs you had to pay from 67% to 100% (100 / 67 = ~50% increase)

In simple terms, if you were paying a 3% interest rate before, you’re effectively paying 4.5% in interest now.

That starts to have a larger and larger impact as interest rates climb.

Now, let’s take the same properties as above and consider what would happen if interest rates climbed from 2.5% to 4% from year 6.

Government Announcement Changes Interest Tax Deductions Example

You can see that the new build property's cash flow loss in year 6 is just over $3.5k ($68 per week).

In comparison, the property that can't deduct any interest costs has negative cashflows of almost $8k ($153 per week).

Because these changes have the same effect as a higher interest rate, investors will need to manage their interest rate risk. In other words, there is more incentive to fix your rates as low and as long as possible.

3) Cash Deposit vs 100% Borrowing

3) Using a Cash Deposit vs Using 100% Borrowing

The final group of people who will be heavily impacted are those borrowing 100% of the money to purchase investments. People who use a cash deposit will be better off than those who don't.

In the below example, you have the same set up as above:

  • a $525k property
  • renting for $450 a week
  • with interest rates rising to 4% from year 6 onwards
  • identical operating costs and assumptions

But, here both properties are existing, and both bought after 27th March. That means you wouldn’t be able to claim any interest deductions after October 2021.

The only difference is that the first property has a 40% cash deposit, and the second doesn't.

Government Announcement Changes Interest Tax Deductions Example

You can see that the investor who uses a large cash deposit will have lower interest costs. The property will generally be profitable enough to absorb the higher tax bill.

Because of this, even when interest rates rise, their properties are projected to only be momentarily negatively geared before reverting back to positive cash flow.

Those who are highly leveraged, on the other hand, will pay the price. Any increase in the interest rate will make their properties more negatively geared.

An investor who renovates properties to increase their value and cash flow will see the same effect as an investor using a cash deposit. Their interest costs will be relatively lower and their properties, while less profitable, are less likely to become negatively geared.

Silver Linings

Are there any silver linings within the announcements?

While the announcements are heavy-handed for investors, there are a few silver linings:

  • The risk that the Reserve Bank would increase interest rates to cool the housing market has decreased. Interest rates are likely to be lower for longer
  • Property prices are unlikely to fall. Minister Megan Woods specifically talked about first home buyers purchasing with a 5% deposit at the press conference.
    • Even a tiny drop in house prices could push the people who Labour wants to help into negative equity. Falling house values would wipe out the deposits these first home buyers had struggled to save.
    • The government can't allow that to happen, so the worst-case scenario is that property prices stabilise.
  • Active investors will have significantly more options within the market as the demand for existing properties will drop away. This will mean renovators will have more options and opportunity
Conclusion

What are the main things I need to be thinking about?

The critical message for property investors is not to panic. You have 4 years before the entire interest-deductibility changes will be implemented on your current properties.

You need to take time to assess your portfolio to figure out what changes are required if any at all. With enough changes, your properties might remain positively geared.

Similarly, it's important to take anything you read on Stuff or the NZ Herald with a grain of salt. The new rules and the impacts are technical and individual.

We've already seen well-intentioned journalists representing something as fact when really the facts have been accidentally misreported.

If you want help examining your portfolio, we have recently launched a service to review the properties you own in light of these changes. Click here to learn more. The first 15 investors will work directly with Opes Managing Director Andrew Nicol.