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Interest deduction limitation rules: update
In our June newsletter I wrote an article that ‘attempted’ to explain the Government’s proposed new interest deduction limitation rules, which were to have an effective commencement date of October 1st, 2021. In this respect, my drafting of this commentary was only a week or so post the release of the Government’s own 143-page discussion document titled “Design of the interest limitation rule and additional bright-line rules.”
Well, quite a bit of water has certainly passed under the bridge since that discussion document was released, not least being the relatively significant event of the Covid Delta strain breaking Auckland’s border defences and finding its way back into the community. Basically, overnight the country was in lockdown once again, and as I write this article still imprisoned within the closed Auckland boundary, 84 days post the initial lockdown impost, I reflect on various submissions made in the early days of level four, that the Government should drop, if not defer, the proposals. These submissions were on the basis that Auckland investors (let’s face it, the intended target of the rules) were already going to be negatively financially impacted by the Delta outbreak, and that situation should not be worsened by the Government of the day introducing new tax rules.
However, clearly those submissions fell upon deaf ears, as the “Taxation (Annual Rates for 2021–22, GST, and Remedial Matters) Bill” introduced into Parliament last month reflected, with the inclusion of the new rules in its drafting. Subsequent to the Bill’s introduction, IR has issued a commentary on the proposed amendments, and noting a number of changes from the original discussion document, I thought it would be useful to now provide an update.
Firstly, some useful definitions to start off, which will hopefully aide somewhat in understanding my subsequent babble:
- Disallowed residential property (DRP) – covers any land in New Zealand to the extent to which it has a place configured as a residence or abode, the owner has an arrangement to erect such a place, or it is bare land on which such a place could be erected.
- New build – land to the extent to which it has a place (or for which there is an agreement that a place will be added to the land) configured as a self-contained residence/abode, where a code compliance certificate (CCC) has been (or will be) issued on or after 27 March 2020, evidencing that the new build has been added to the land. Includes land exclusively used by the residents of the new build, plus a reasonable proportion of any shared areas (for example, a reasonable proportion of a driveway shared with the residents of an older building also on the land). Also land where hotel/motel was converted into self-contained residences or abodes, provided the conversion was completed on or after 27 March 2020, and the conversion is recorded by a local authority or building consent authority. (Note this definition of a new build has changed since the initial discussion document, which required the CCC in most cases was issued post 27th March 2021).
- Old build – clearly land not satisfying the new build definition.
Since traffic lights appear to be the flavour of the month, I thought I would use a similar format in my article.
- Well unfortunately for those of you who own ‘old builds’ as at 27th March 2021, your days are numbered with respect to claiming interest costs incurred on borrowings to acquire your residential rental property. Commencing 1st October 2021, a phase out period will apply, reducing your interest deduction claims by 25% per income year (with the exception of an 18-month window for the first reduction), until your final claim of 25% of the costs incurred will be in the income year ended 31st March 2025.
- Also red is making a decision to acquire ‘old build’ land post 27th March 2021. The interest incurred on any borrowings to finance this purchase, becomes non-deductible from October 1st, 2021.
- Interestingly, red is the choice by the Government to make any interest incurred on any foreign denominated debt non-deductible from October 1st 2021, regardless of whether or not those borrowings were already in place as at 27th March 2021.
- And not only do you get stung with no interest deductions for your ‘old build’ purchased post 27th March 2021, but equally you will be locked into the new ten-year bright-line period.
However, is there a glow of orange light towards the end of the dark red tunnel?
Now when I was a lad and went to school, a traffic light had an amber light not orange, although I am often told that I am no good with my colours! So, under the orange classification, things don’t look too good for you at the outset (usually red-light scenarios), but then a certain event happens which opens a door of opportunity for you.
- You own an ‘old build’ which has now become DRP and have consequently either had your interest deductions progressively reduced under the phase out rules, or having purchased post 27th March 2021, your interest deduction entitlement expired on October 1st 2021. However, you have now sold your land, which for one reason or another (say a bright-line application) has resulted in a taxable gain on disposal for you. Under this scenario, the previously denied interest deductions would become deductible in the income year of disposal – although depending on the relevant taxing provision, potentially then subject to either the bright-line loss ring-fencing, or the standard residential rental excess deduction ring-fencing rules.
- Once again you own an ‘old build’, but you then decide to commence an undertaking or scheme involving development, subdivision, or building to create new build land. Under this scenario, in the income year that you are deemed to have commenced your project, the interest costs become deductible again – this is referred to as the ‘development exemption’. Note that only the portion of land subject to the new build, would qualify for the interest deductions. Any remaining ‘old build’ land would retain its DRP classification, to the extent that any interest deductions relating to this portion of the land would remain non-deductible. Once the CCC for the new build was issued, you would likely then qualify for the new build exemption.
- And finally, you’ve acquired DRP since 27th March 2021, which has the consequence that you are now faced with a ten-year bright-line period. Well, if you decide to erect a new build on your land, and that new build still exists on the land when you sell it, then your bright-line period reduces to five years (for the portion of new build land).
Now if you want the best of both worlds from the outset, in terms of retaining full interest deductibility and only having a five-year bright-line period, then go for green.
- You only buy new build land which then qualifies you for the ‘new build exemption’ – so a CCC must have been issued since 27th March 2020 and you are acquiring the land within 12 months of the CCC issue date. Now note, that the need to buy within the first 12 months of CCC issue, is simply to obtain the best of both worlds, as only a person who acquires the new build land within 12 months of the CCC issue qualifies for the reduced five-year bright-line test. However, any person who acquires new build land within 20 years of the CCC issue, qualifies for the new build exemption and retains full interest deductibility for the remainder of the 20-year new build period.
- You’re in the business of land dealing, developing, subdividing, or erecting buildings and acquire the land for the purpose of this business. Under this scenario, a ‘land business exemption’ will apply and all interest incurred on borrowings in relation to this land will remain fully tax deductible. Note that land acquired by a person not for the business being carried on, is likely to be subject to the interest deduction limitations, unless either the development exemption or new build exemption applied to that land. Additionally, interest that is initially non-deductible, could subsequently qualify for deduction if the land disposal was ultimately taxable – say it was sold within 10 years and therefore taxable under the tainting rules these businesses trigger for non-business land.
- You only buy offshore land. Since such land has no impact on the supply of New Zealand residential land for first home buyers, this land is not caught by the new interest deduction limitation rules. Do not forget however, that for a New Zealand tax resident, the bright-line rules apply to residential land owned anywhere in the world.
As a final point to make, both the interest deduction limitation rules and the amended bright-line periods do have apportionment rules. So, if your land contains both an old build and a new build, then the old build land will trigger no interest deductibility and a 10-year bright-line period for that portion of the land, while the new build portion will retain interest deductibility and have a reduced five-year bright-line period.
The rules are quite complicated, so please reach out if you need help understanding their potential application to your own scenario.