Limited guidance on Interest limitation rules
On 10 June the Government released their discussion document “Design of the interest limitation rule and additional bright-line rules”. The discussion document provides details on the proposed interest limitation and bright-line rules, following the 23 March 2021 announcements. Submissions on the proposed changes close on 12 July 2021.
The proposal is detailed and covers a number of issues. The proposals are mostly positive, but there are a number of issues that still need to be resolved in order to ensure the family home is not taxed inadvertently. The application of the interest limitation rules will be of particular interest to investors of newly built properties. Investors who have built new houses prior to 27 March 2021 will be disappointed to see that there is no recognition of their contribution to the New Zealand housing stock, and will no doubt be disappointed to see the harsh interest limitation rules will to apply to them as they are phased in. We have set out the main points of the discussion document below.
Deductibility of interest
We have already discussed the proposal to limit interest deductions in our article Property investors hit hard by tax reforms but we have summarised the key points again. Restrictions from 1 October 2021 have been proposed on the deductibility of interest expenses that are incurred in relation to residential property.
Interest on debt drawn down before 27 March 2021, relating to residential investment property acquired before 27 March 2021 will be considered ‘grandparented’ interest and it is proposed to be phased out as follows:
|Date interest incurred||Percent of interest you can claim|
1 April 2020–31 March 2021
1 April 2021–31 March 2022
April 2021-30 September 2021=100%
1 October 2021-31 March 2022=75%
1 April 2022–31 March 2023
1 April 2023–31 March 2024
1 April 2024–31 March 2025
From 1 April 2025 onwards
For non-grandparented interest, it is proposed that all deductions will be disallowed from 1 October 2021.
What residential properties are caught by the interest limitation rules?
The discussion document proposes to limit interest deductions for debt used to purchase or operate residential investment property, which is primarily residential property rented to tenants.
The following residential property would be excluded from the interest limitation rules:
- Land outside New Zealand
- Employee accommodation
- Care facilities such as hospitals, convalescent homes, nursing homes, and hospices
- Commercial accommodation such as hotels, motels, and boarding houses
- Retirement villages and rest homes; and
- Main home - the interest limitation proposal would not apply to interest related to any income-earning use of an owner-occupier’s main home such as a flatting situation.
Possible exclusions for certain student accommodation, serviced apartments, and Māori land are being considered.
What interest will be subject to the interest limitation rules?
It is proposed that loans used to fund residential investment property will need to trace the borrowing to determine the purpose of the borrowing. This will determine if the interest is deductible or not (except companies, subject to the proposed company changes set out below). Changes are also proposed for refinancing an existing loan and transitional issues relating to pre-27 March debt.
Most people know that interest is deductible when incurred by a company. The new interest limitation rules would override the current general rule for interest deductibility. The discussion document proposes that close companies and residential investment property-rich companies (companies whose assets are more than 50% residential investment property), will need to trace the use of their borrowed funds. This is so that taxpayers cannot get around the interest limitation proposal by using companies to borrow to acquire residential investment property.
The Government has proposed that property developers should be exempt from the proposed interest limitation rules as they are focused on increasing housing supply through the construction of new builds.
Options are being considered for applying the exemption to one-off developments as well as to professional developers.
The Government is considering whether some remediation work may qualify for the development exemption where it adds to the housing stock, for example by extending the life of older buildings or making a building habitable.
Interest limitation on sale
While interest deductions for residential investment property will be phased out from 1 October 2021, there is still the possibility that those disallowed deductions can be used to offset tax upon the ultimate sale of the property. The discussion document has considered 4 options:
- Deductions disallowed – interest would never be deductible
- Deductions allowed at the point of sale – full interest can be deducted upon sale if the sale is subject to tax
- Deductions allowed at the point of sale but limited to not create a loss – as with 2, but the interest can only reduce the profit to nil, and no loss is allowed
- Deductions allowed subject to an anti-arbitrage restriction – as in 3, but instead of the excess loss being disallowed, it can be ring-fenced and used in the future against other revenue account property sales.
The Government would like submissions on these options. Other than option 1, there will be significant changes in how accounts are prepared, and ongoing additional compliance will be required to ensure any relevant information is available if the property is subsequently sold on revenue account.
It was widely publicised that the Government would consider how new builds would be affected by the new rules. The first point to address is what will be considered a “new build”.
The Government has proposed that “new build” residential properties should be exempted from the proposed new interest limitation rules and will be subject to a “new-build bright-line test” which is effectively a five-year version of the new 10-year bright-line test.
The first point to note is that only properties that receive a code of compliance on or after 27 March 2021 can be a “new-build” unless the property was purchased on or after 27 March 2021 and Code Compliance Certificate (CCC) was issued within 12 months. This means that people who have built property prior to 27 March 2021, and have retained those properties will not be considered a “new-build” for either bright-line tax or interest deductibility rules.
It has been suggested that the following scenarios where a property receives a CCC on or after 27 March 2021 could be a “new build”:
- a dwelling is added to vacant land
- an additional dwelling is added to a property, whether stand-alone or attached to the current dwelling
- a dwelling (or multiple dwellings) replaces an existing dwelling
- renovating an existing dwelling to create two or more \dwellings.
- a dwelling converted from commercial premises such as an office block converted into apartments.
Deductibility exemption from interest limitation may extend to subsequent owners
The Government has proposed that “early owners” (those who acquire a new build no later than 12 months after its CCC is issued, or add a new build to their land) would be eligible for the new build exemption. Subsequent purchasers (those who acquire a new build more than 12 months after the new build’s CCC is issued and within a fixed period such as 10 or 20 years from the date that CCC is issued) may also qualify for the exemption.
New build bright-line test
While it is welcome news that new builds will benefit from a five year bright-line test, there are ongoing issues with people being caught paying tax on the sale of their family home. The proposal to use a new build bright-line test will not resolve these issues. The new build bright-line test apples the same rules under the 10 year bright-line test, but for a shorter period of five years. This means that there is only a 12 month buffer period. If someone agrees to purchase land prior to title issue, they are treated as acquiring the land on the date of the agreement, they then have to wait for title to issue, then have to build. If they do not move into the property within 12 months of acquisition, then they will have to pay tax for the period they did not live at the property if they sell that property within five years of acquisition. Even where someone purchases land, if they do not live at the property within a year of settlement of the land, then they will not benefit from the buffer period so will be left paying some tax on any gains made during the period of ownership if the property is sold within five years of acquisition.
Some welcome limited relief from the interest limitation rule and bright-line test is proposed in relation to transfers to trusts and transfers where there is no significant change in ownership. This relief involves deferring the taxing point until there is future disposal of the property that does not qualify for rollover relief.
It is proposed that if a person disposes of their property to a family trust, that disposal can benefit from rollover relief for both interest limitation rules and the bright-line test where the following conditions are met:
- every settlor of the land is also a beneficiary;
- at least one settlors of the land is a principal settlor of the trust; and
- every beneficiary (excluding the beneficiaries who are also principal settlors) is associated with a principal settlor.
The Government has also proposed a modified set of associated person rules to assist with this.
Under current law, taxpayers are normally allowed to deduct interest on loans used to acquire shares in a company. Interposed entity rules are proposed to ensure that taxpayers cannot claim interest deductions for borrowings used to acquire residential investment property indirectly, through an interposed entity. Whether an entity will be a “residential interposed entity” will be determined by criteria relating to the asset values.
Interaction with the mixed-use asset rules
The focus of the interest limitation rules is on debt relating to residential investment property, but they will also apply to baches and other second homes if used to earn income. Changes to mix used assets are proposed to ensure they work with the proposed changes.
The discussion document is comprehensive and addresses a number of areas that will be impacted by the interest limitation rule and bright-line rules. The Government has many proposals, and has asked for submissions on their various proposals.
If you would like to understand how these proposals might impact you, or you would like assistance with making a submission, please get in touch with our tax team.
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