Interest Deductibility and New Builds - does the Draft Legislation Stack Up?
On 28 September 2021, the Government released their draft legislation for amendments to interest deductibility legislation and how new builds will be treated for bright-line tax purposes.
The draft legislation proposes that investors’ ability to deduct interest in relation to properties acquired before 27 March 2021, will be phased out between 1 October 2021 and 31 March 2025.
The Government has largely mirrored their proposals in their previous discussion document “Design of the interest limitation rule and additional bright-line rules”. See our previous article for more information on this discussion document: Guidance on Interest Limitation Rules.
Below is a summary of the proposed legislation introduced today.
While interest deductibility will be phased out for properties acquired before 27 March 2021, and is not deductible for properties acquired since that date, there are exemptions for new builds, and for land businesses and property developers. Properties acquired on or after 27 March 2021 may also qualify for deductions if the property was acquired after 27 March 2021 but as a result of an irrevocable offer made on or before 23 March 2021.
Where interest is not deductible, but the sale of the property is subject to tax, previously denied interest deductions may be available although the deduction may be limited to the gain on the sale.
What is a new build?
We now have our first look at what a “new build” might be for tax purposes. A new build is generally defined as a self-contained residence that receives a Code of Compliance Certificate (CCC) to confirm that a residence was added to the land on or after 27 March 2020. It will also include a self-contained residence acquired off the plans that will receive its CCC on or after 27 March 2020 confirming it has been added to the land. A new build can include modular and relocated homes that are not constructed on-site or from new materials. The definition also includes the conversion of one dwelling into multiples, such as a commercial building into individual residential buildings.
Expiry of exemption for new builds for interest deductibility purposes
The exemption for new builds will expire on the earlier of the dates that either the new build ceases to be on the land (i.e. demolishment or removal), or 20 years after the new build receives its CCC. It is pleasing to see that this exemption is proposed to apply to anyone who owns the new build within this 20-year fixed period, which includes subsequent owners.
Where a new build is acquired off the plans and before its CCC is issued, the 20-year fixed period will still run from the date of the CCC. There will be special rules for hotel and motel conversions, and for new builds that receive their CCC after a significant delay.
Interest deductibility exemption for land businesses and other property developments
There is a proposed land business exemption for interest relating to land held as part of a developing, subdividing, or land-dealing business, or a business of erecting buildings on land. Interest relating to remediation work and other expenses from ownership and development of the land will also qualify.
For those who do not qualify for the land business exemption, the development exemption will apply for interest relating to land that they develop, subdivide, or build on to create a new build. However, interest will only be deductible if the existing tax rules allow deductibility. The exemption for land businesses and property development will apply from the time they start developing the land and end when they sell the land or receive a CCC for their new build. Once the new build receives its CCC, the new build exemption will apply instead.
Interest relating to remediation work done to an existing property that is not significant enough to create a new build will not qualify for this exemption.
The interest limitation rules will not apply if the interest relates to income earned in the main home, such as in flatting or boarding situations. The normal apportioned deductions are intended to continue to apply in these circumstances.
Main homes and new builds are not the only types of residential property that are proposed to be exempt from the new interest limitation rules. Other types of residential property that will be excluded include farmland, Māori excepted land, emergency, transitional, social, and council housing, hotels, motels, and hostels, care facilities such as hospitals and nursing homes, retirement villages and rest homes, student accommodation, employee accommodation, and land outside New Zealand. If you meet all of the other requirements for claiming deductions, you will be able to deduct interest against income earned from those properties.
If a piece of land contains both a residential property and one of the excluded or exempt properties, interest will be able to be deducted for the portion of the property which is exempt. A reasonable method must be used to allocate interest between the two.
The proposed rules will not apply to companies where their core business does not involve residential land. Residential land must make up less than half of the total assets of these companies.
Close companies will still have to apply the rules, even where their core business does not involve residential property. Close companies are companies where more than 50% of the company is owned by five or fewer individuals or trustees.
The date that you borrow funds is not relevant to interest deductibility, but rather, it is the date that the property was acquired which is relevant. If you refinance on or after 27 March 2021 and the original loan qualified for the phasing out of interest deductibility, then the refinanced loan will also qualify.
Deductions will also be phased out on variable loans, however, if the amount outstanding on the loan is higher than the amount outstanding on 27 March 2021, the amount outstanding 27 March will be interest deductible whereas the extra amount will not.
Borrowings for business property will not be affected by the interest limitation rules. This may cause issues where a loan is used for residential and business property. In these cases, special transitional rules apply.
We have already written on the many changes to the bright-line tax rules in various articles which you can read here: The Bright-line test and main home exemption what you need to know, The family home can still attract bright-line, Limited guidance on interest limitation rules
We now have some further clarity, especially on what will qualify for the new build bright-line test.
New builds and bright-line property rules
As advised in their discussion document, the Government has also proposed a new build bright-line test. This is a shorter, 5-year bright-line test for new builds acquired on or after 27 March 2021. The definition of new build is the same for both interest deductibility, and the new build bright-line test.
The draft legislation will be considered by the Finance and Expenditure Committee. As part of its process, the Committee will usually call for public submissions on the proposals. Typically there is a six-week submission period. The Committee will then usually make its recommendations to Parliament. The proposals may change as a result of the select committee and parliamentary processes.
Bright-line rules and the main home exclusion
There was a welcome proposed change to the main home exclusion. At present, if more than half of your property is used for your main home, the main home exclusion will safeguard your home from the bright-line rules. However, if less than half of the land is used for a main home (e.g. more than half of your land is used as a rental) then the main home exclusion will not apply and any gain on sale will be taxed.
The proposed law will amend this so that where the main home proportion of the property is smaller than the rental portion, the gain on sale will be apportioned. These new rules will apply to property acquired on or after 27 March 2021.
Rollover relief is proposed to allow changes to how the property is owned after 27 March 2021, while still allowing a deduction of a portion of interest expensed during the interest phase-out period, as well as the original bright-line tax treatment.
Rollover relief will be provided for some transfers to family trusts and transfers to or from look-through companies and partnerships.
Rollover relief is intended to apply to the eligible transfers made from 1 April 2022 onwards.
The above is intended for informational purposes only and should not replace specific tax advice. For personalised advice on all tax issues please contact Julia Johnston at Saunders & Co.