Explainer: Why is interest deductibility a hot election issue?

Friday, 5 May 2023

ANALYSIS: Landlords remain outraged by the government’s new interest deductibility rules, and it could be a vote deciding issue for many of them.

With most political parties pitching the upcoming election as being all about the cost of living crisis, there is a growing focus on taxes that could be introduced, or repealed.

New interest deductibility rules mean investors’ tax bills are on the rise, and National and ACT say the policy is not fair, and part of a “war on landlords”.

But there is another side to the policy, and its proponents say it is important to help rebalance the housing market.

What is interest deductibility anyway?

Until recently, landlords had the ability to claim back all the interest cost of a home loan against the rental income received on a property.

That meant if a landlord earned $20,000 a year in rent from a property but paid $12,000 in interest on the loan, only $8000 of the rental income would be subject to tax.

How have the new rules changed that?

In March 2021, the Government announced a suite of new policies to rein in the housing market. They included the removal of the ability to deduct mortgage interest on rental properties from taxes.

The policy means deductions on existing properties bought after March 27 2021 are not allowed, while deductions for existing properties bought before that date are being phased out over a four-year period.

By March 31, 2025, when the new rules are fully phased in, the whole $20,000 earned by the landlord in the earlier example will be subject to tax.

Are there any exceptions to the new rules?

There are some exceptions to the new rules, with newly built properties which received their code of compliance certificate after March 27, 2020 able to deduct interest for 20 years from when the certificate was issued.

Build-to-rent developments are also exempt, as are rental properties leased to Kāinga Ora, a registered community housing provider, or specific government departments for social housing.

Why do the changes matter to landlords?

Property accountant Anthony Appleton-Tattersall says a core principle of most tax systems is that people are only taxed on their profit.

A loan to buy a taxable income stream such as a share portfolio, rental property, or a profitable business, is directly related to the earning of that income, so the interest on the loan should be deductible against the income to determine taxable profit, he says.

“And it is. Unless the income earning activity is residential rental property built before March 2020. It means a group of investors now effectively pays tax on their top-line income.”

Landlords say providing rental properties is a business, and the policy means they are being treated differently to other businesses.

How are the changes affecting landlords?

The new rules also mean the cost of owning a typical rental property is increasing by thousands of dollars each year for many landlords.

Cam Hadfield, who owns two rental properties, one of which is a new build, will have to pay $6000 more in tax this year, for example. Once the rules are fully phased in he will pay about $12,000 more tax annually on the existing property.

Wellington investor Brian Main has a larger portfolio which incorporates 12 tenancies. He says the rules do not affect him that much as he has been investing for a long time, and does not have a lot of debt.

But they make a huge difference to newer landlords, who are being hit by them and rising interest rates, and are faced with the prospect of having to sell at a loss, he says.

“The extra money for those costs has to come from somewhere which means having to raise the rent and also reduce repair and maintenance costs, and that is not in anyone's interest.”

He would not have been able to expand his portfolio to provide housing to 17 people, if he had not been able to deduct interest costs from his rental income, he says.

Nick Gentle, who runs a Facebook group for fellow property investors, says how much the rules impact on people depends on when they bought, how much they paid and how much debt they have.

Well-established landlords with larger portfolios, less debt and more equity are better able to carry the extra costs, or make adjustments, such as selling a property to pay down debt, to address them, he says.

“That is not the case for less experienced investors who bought more recently, and are highly leveraged. For them, the additional costs they now face can be just too much, and may mean they have to sell.”

Are landlords selling up as a result?

Not at this point. Economist Tony Alexander, who conducts a regular survey of landlords, says there is no evidence of a wave of landlords looking to sell, and that has been the case since the tax changes were announced.

The reason most landlords give for planning to sell is retirement, with 40% on average picking it, while 22% cite the new interest deductibility rules, he says.

“When asked their biggest concerns, the loss of interest deductibility comes in at around 16%, and they can pick as many concerns as they want, so it is not the be all and end all for most.”

But the policy is putting some landlords off buying. The latest CoreLogic buyer classification figures show the percentage of sales going to mortgaged investors was 21% in the first quarter of this year.

That is down from the 29% market share they had in the first quarter of 2021, before the new rules were announced, and is close to all-time lows.

CoreLogic head of research Nick Goodall says the decline in market share has tended to be bigger for those with fewer properties.

The figures also show cash investors’ share of sales has increased to a record 15% this year, from 11% throughout 2021. That suggests some investors are still finding value and bargains in the market, he says.

Gentle says many landlords will try to hang on to the properties they own because they have an end goal, such as a nest egg for retirement, or they realise they may struggle to buy again in future.

But many will move them into social housing, if they can, or switch them into the Airbnb market, which affects the supply of long-term rental housing, he says.

“And while there are some active, cashed-up buyers out there, many people can’t make the numbers work when buying a property, so they won’t buy because they don’t want to be running at a loss.”

So why did the Government introduce the new rules?

Housing Minister Megan Woods says the intention of the changes was two-fold, as Government wanted to rebalance the market back to first-home buyers, and also to encourage development of new supply.

“We didn’t want to continue seeing mum and dad investors competing with their kids in the suburbs over existing houses, and those houses just being shuffled back and forth, which was what was happening.

“So we incentivised buying new builds, and build-to-rent developments that offer long-term rentals, by exempting them from the interest deductibility changes. This also supports new construction.”

The plan is working, with a big upswing in the construction of new homes, and first-home buyers making up a larger percentage of sales, she says.

What do Opposition parties say they will do?

National and ACT are staunchly opposed to the interest deductibility rules.

They say the policy is leading to higher rents and putting pressure on the state house waiting list and emergency housing, which makes it a tenant’s tax.

If elected, both parties say they will reverse the changes to interest deductibility.