How Will The Government's Tax Deductibility Changes Impact My Property Portfolio?

Last Updated 13/10/2021

Ed McKnight

Ed McKnight

Economist, property investor and host of the Property Academy Podcast
Introduction

How Will The Government's Interest Deductibility Changes Impact My Property Portfolio?

The news is in. As of now, most property investors will begin paying more tax following a recent government change to how interest deductibility is calculated.

Why? Because this change means the IRD will view investment properties as more profitable than they actually are in practice.

Because the properties will be viewed as more profitable, investors will then pay more tax.

The newly-announced rules took effect from October 1, assuming they are passed into law by Parliament next year.

But it’s not all doom and gloom. The plan includes some workarounds that make the changes less painful than they could have been, particularly in regards to the bright-line test and for investors of New Build developments.

This article will focus specifically on what the interest deductibility changes are and how they are likely to impact you as a property investor.

What The Changes Are

What Are The Interest Deductibility Changes And How Are They Different From How Tax Was Calculated Previously?

Before the changes came in, calculating your investment property’s taxable profit would include your interest costs as a taxable expense.

Here is an example of how an investor would make their calculations pre-October 2021:

Interest Tax Deductibility Calculation Before and After

After subtracting your operating expenses (e.g. rates and insurance) and interest costs from your rent, you get your taxable profit. You then multiply that taxable profit by your tax rate, e.g. 33% – and that’s the amount of tax you have to pay.

We’re ignoring some eligible tax deductions like depreciation, just to keep things really simple.

But what happens after this change?

Your interest costs no longer come into this equation. So your property looks more profitable and you pay more tax.

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

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

And in some cases that will push properties from being positively geared to being negatively geared.

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.

Cash Flow Example

The $100,700 Difference These Changes Make to some Property Investors. Here’s Why

To give you an example of how the changes will impact property investors here is an example of a property investor purchasing a $800,000 townhouse in Auckland, which earns $675 a week in rent.

And let’s say that property was purchased just before the government introduced the tax changes – so that the deductibility is phased out (rather than being taken off straight away).

Based on the usual assumptions we use here at Opes Partners the property would require the investor to tip in $9,700 over the 15-year period of ownership – before the tax changes come in. This is because we forecast interest rates to rise in the future.

But after the tax changes come in the same property would require the investor to tip $110,400 into the property so that the bank account doesn’t tip into the red.

So that’s a $100,700 difference paid by the investor over time – just going towards tax.

Who The Tax Applies To

Who Does This New Tax Apply To?

The new tax changes don’t affect all property investors equally.

New Builds”, for instance, get to stick with the old rules for 20 years and so will pay the same amount of tax as before. (More on what constitutes a New Build below).

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

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

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

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

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If you qualify for the phased-out approach, then from October 1 2021 you can still deduct 75% of your interest costs on any properties. 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 (unless exempt).

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
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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 cashflow
  • People who invest in higher-yielding properties
  • People who manage their interest rate risk
  • People who rent their properties out via social and community housing agencies

These lists are not exhaustive; there are some other specifics in the legislation where some people will not be as impacted. So not every exemption is listed, but these cover the bulk of cases.

It’s also important to note that as an investor your properties are likely to have features from both lists. The true test is to run a 15-year projection to understand how your property may perform over time.

You can download our Return on Investment spreadsheet for free to do this at home.

New Build Definition

What's The Definition Of A “New Build”?

Many property investors are asking: “What will be considered a New Build?”

It’s a hot topic question, considering these tax changes have significant tax incentives to purchase New Builds.

Up until the most recent announcements, we did not know what the definition of a New Build was or how long it might carry the tax incentive for. Thankfully, we now have clarity about these:

The definition of a New Build

  • A self-contained residence that receives a Code Compliance Certificate (CCC) confirming the residence was added to the land on or after March 27 2020. This includes New Builds bought off the plans from a developer
  • To clarify, if you convert an existing dwelling into multiple new dwellings, this can also qualify as new

One change that came out as part of the government’s September announcement is that the cut-off date for what is considered a New Build has been moved back.

Initially, the cut-off date for a property to be considered a New Build was CCC issued on or after March 27 2021.

2 Definition of New Build kain

That date has now been moved back to March 27 2020.

This change, while seemingly small, was a big win for us here at Opes Partners. We lobbied the government hard to have this date moved back in time.

We estimate that around 550 more of our investors’ properties – at Opes Partners – will now be considered New Builds. And based on our modelling, each of these investors will save $60k - $75k worth of tax over 15 years.

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That’s over $37 million worth of tax that Opes investors won’t have to pay, and we are thrilled for you.


How Long is a New Build a New Build?

New Builds will carry this exemption and pay less tax for 20 years from the time CCC is issued.

If you are buying a property off the plans, then you might sign up to buy a property 2 years before the CCC is issued. Any interest before this date is also deductible.

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Strategies That Still Make Sense

What Can I Do To Respond To These Tax Changes With My Existing Portfolio?

These changes will cause many property investors to think about selling their properties. While that might be the end decision – before doing so, there are 5 steps you can take to respond effectively. We call them the 5 R’s.


#1 – Review your property portfolio

As we mentioned, not all rental property owners are affected equally by the tax changes. People with large mortgages will notice the changes more than people who hold less debt against their portfolios.

Because of this it’s important to run the numbers of your investment property to see how your properties will specifically be impacted.

To do this, Opes has created a spreadsheet – which you can download for free – to create this analysis. Download the spreadsheet here.

Some investors may not need to sell. Others will find they will need to make a change.

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#2 – Rent, make sure you are charging the market value for your property

If your property will have poor cashflow after the changes come in, then it’s time to review your rent.

The rental market is currently moving quickly as some investors are passing on a portion of the potential tax cost to their tenants.

The latest data showed that rents have risen 7.8% in the last year (August 2020 – August 2021), according to the Trade Me rental index.

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This suggests there may be the opportunity for some rental property owners to increase their rent to market level to counter the effect of the higher taxes.

This is where our property managers at Venture Management can help reassess your rent to make sure you’re getting the right amount of money coming in each week.


#3 – Restructure the property’s lending or tax structure

This gets a bit nerdy, but there are ways to decrease the costs associated with your rental property by restructuring how you own your rental property.

Under the new rules you will soon be able to move your rental properties between trusts and look-through companies without having to worry about the bright-line test (which taxes your capital gains).

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Speak to your property accountant – because you may be able to move your properties to better protect your assets and move to a lower tax rate. This could potentially save you thousands on your tax bill once the new rules come in.


#4 – Renovate the property to increase rental return

If you’re still going to be left out of pocket from the tax changes, it’s time to renovate the property to increase the rent.

Some properties only require a cheap and cheerful renovation to increase the rent the investor can charge.

A couple of classic investment strategies include adding an additional bedroom within the internal floor plan, and updating the fixtures and fittings.

We here at Opes Partners call this Cashflow Hacking, and you can learn more about it by listening to this episode of the Property Academy Podcast.

 




#5 – Recycle – sell the property and purchase a more suitable investment

If your property is still looking shaky after taking these first 4 steps, then it may be time to recycle your equity. That means selling your property and purchasing a different investment.

In some instances you may be able to sell one property and buy two – given that New Builds are exempt from the changes and require lower deposits.

If you’re going to do this the most important aspect is choosing a property that works under the new tax regime. This is where speaking with a financial adviser may be a good idea.

The key message here is if you’re worried about the new tax changes … there are options and strategies you can use to counteract them.

Silver Linings

Are There Any Silver Linings Within The Announcements?

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

  • 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
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  • Active investors will have significantly more options within the market as the demand for existing properties drops away. This means renovators will have more options and opportunity
  • Restructuring the entities that your properties are owned within won’t trigger the bright line test. So you can now move your properties between entities that you control without worrying about paying tax on your capital gains
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 are 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 your properties in light of these changes.

Related Articles

Want To Learn More About Property Taxes?

If you're keen to learn more about property tax, then check out these articles: Top Property Accountants in NZ; Will We See a Capital Gains Tax in NZ?; Beginner's Guide to the Bright-Line Test; and Where Are The Cheapest Local Council Rates For Property Investors?.

Ed McKnight

Ed McKnight

Ed McKnight is the host of the Property Academy Podcast – NZ's #1 business podcast. He is an economist, having studied at the University of Auckland and the University of Waikato. He's a frequent writer for Informed Investor Magazine and has contributed to NewsHub, Stuff, OneRoof and Property Investor Magazine.