Investors pay $66 million more tax as mortgage interest deductibility phased out

Thursday, 18 May 2023

Deloitte partner Robyn Walker says property investors will really start to feel the true impact of deductibility changes this year.

Property investors paid an additional $66 million in tax during the 2021/22 tax year as a result of the phase-out of mortgage interest deductibility, according to Inland Revenue (IR).

The tax-take resulted from investors being denied the ability to deduct $247 million in interest payments from their rental earnings.

The amount of additional tax-take from the rule changes is likely to increase substantially for the 2022/23 tax year, because the change only came into effect midway through the 2021/22 tax year.

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Investors will progressively lose 25% of their ability to deduct interest each year, and currently have lost 50% of their ability.

Despite losing the ability to deduct almost a quarter of a billion dollars in mortgage interest, tax consultant Terry Baucher said he thought investors might be more leveraged than appeared in the IR figures.

“We don’t have much data here, so it’s good to get a clearer idea of what’s going on,” he said.

He said the amount of mortgage interest being paid by investors during the period was likely reduced by the fact that interest rates were substantially lower at the time.

He also expected the tax take to rise, possibly as high as $75m, because some tax agents did not file returns until later in the year.

Investors with existing homes are set to lose their ability to deduct interest in 25% increments over the next three years, and by then Baucher expected investors to be shouldering at least $1 billion in interest payments that they could no longer deduct.

Baucher previously ran the numbers and found in recent years investors were gambling on large tax-free capital gains to make their investments worthwhile, and relying on their ability to deduct mortgage interest from rental revenue.

Baucher said the changes also had the advantage of driving more investor money into newly built housing, for which interest costs could still be deducted.

This was one of the Government’s stated intentions at the time of the rule change, and according to CoreLogic data, it is working.

CoreLogic head of research Nick Goodall said during the first quarter of this year, 34% of settled new builds (or almost 800 purchases) went to mortgaged investors, while only 19% of existing properties (more than 2200 purchases) went to the same group.

Property investors paid an additional $66 million in tax during the 2021/22 tax year as a result of the phase-out of mortgage interest deductibility, according to Inland Revenue.

Previously, investors had been equally inclined to buy new-builds and existing properties, so a shift in behaviour had occurred, he said.

Goodall said investors were paying more mortgage interest than he expected, but in the context of how much debt the group was carrying, it made sense.

”There’s $347b in outstanding mortgage debt so that does dwarf the $247m somewhat,” he said.

He said the IR data backed up his expectation that interest deductibility changes were “pretty significant when it comes to property investment profitability”.

“For any investor that isn’t already factoring it in, they should be, especially with expectations of lower capital growth for the foreseeable future too.”

How the rule changes work

Prior to October 1 2021, investors could deduct mortgage interest expenses from their rental earnings for tax purposes, reducing the amount of tax they had to pay, in the same way that other businesses deduct costs from revenue to decide profit.

The Government changed the rules, describing this ability as a “loophole”, because it allowed investors to leverage themselves more heavily and take on more debt than home-buyers – allowing them to outbid owner-occupiers.

Investor groups argued the ability to deduct interest was a valid business expense, and said the expenses would be passed on as higher rent, although that did not appear to be happening.

Deloitte partner Robyn Walker said an estimate provided by IR in its September 2021 Regulatory Impact Statement suggested there would be a revenue gain of $1.22b over the forecast period ending March 31, 2025.

In Budget 2022 it was predicted that the additional revenue in 2021/22 would be $80m.

Walker said the fact $66m was taken indicated the revenue forecasts may have been overstated.

“That said, it does need to be borne in mind that not all tax returns will have been filed yet, so that amount may still increase to closer to the $80m forecast,” she said.

“The fiscal impact of tax changes can often be a little uncertain, particularly if there is an underlying intended behavioural change from the law change – i.e. the change will have a lower fiscal impact if it resulted in landlords selling properties to first-home buyers.”

Walker said the amount of additional tax revenue collected was not forecast to increase in direct correlation to the level of interest deductions denied.

“This will likely be reflecting potential behaviour changes; for example, landlords may have taken the decision when these rules were introduced to sell existing properties and to invest in new build properties which are not subject to these rules,” she said.

Walker previously calculated the rate at which investment properties would become loss-making with the rules changes, and said rising interest rates were likely to push more into being negatively geared.

“We’re currently in the first year where there is a material denial of interest deductions (50% for grand-parented property), which is also coinciding with more property owners needing to reset mortgages and commit to higher interest rates,” she said.

“To a certain extent, some landlords may be planning to just sit tight to see what happens in election 2023, with both the National and Act parties committing to repealing these rules.”