The Government’s decision to deny interest deductions to residential landlords has generated much heat. A particular focus has been its labelling as "closing a loophole”.

Quite clearly current law says interest is deductible for property investors who derive taxable income. (One Twitter commentator quotes the relevant section of the Act). At a technical level, interest deductions are not a loophole.

However, the outrage misses the point.

Simply, (most) voters see a residential landlord deducting interest and making non-taxable gains. In the language of politics, that is a loophole.

“Loophole” is shorthand to describe the policy problem. Voters understand it at this level. (Equally, in the same property context, “Mum and Dad investors” and “speculators” is the language of politics and not tax policy).

Having spent a little time in Tutukaka recently, I have reflected on the role of the Court of Appeal’s 1986 decision in Pacific Rendezvous. That case was about a motel which borrowed money. It continued to operate as a motel while the owners sought a (non-taxable) sale of the property. The question was whether all the interest should be deductible because the money borrowed would also fund the future sale. (The motel was being renovated prior to sale using the funds raised). The Court said all of the interest was deductible. The dual (taxable and non-taxable) use of the funds was irrelevant as all of the money was borrowed for the income producing business activity.

The decision is at the core of our current interest deduction rules. (For companies, subsequent law changes meant they do not need to trace borrowing to a taxable purpose as long as they carry on a business for the purposes of deriving income).

The policy question is whether that should be the law.

When reported statements from residential property investors are that rent barely covers their costs, a reasonable conclusion is that the borrowing serves two purposes – rental, which is taxable and holding for future gain, which is generally not. If an investor borrows to acquire the property, paying the interest on the mortgage is necessary to making the gain.  But for the interest, no gain could be made. (Investors may be using the term “costs” loosely, including amounts which are capital improvements. I have taken them literally).

This suggests the current law may not be appropriate. Denying interest deductions for assets which have two uses is a policy solution.

The harder part is what is the amount to be denied:

  • A gain is only made in the future. Although the New Zealand housing market has shown incredible resilience, there is no guarantee of future house price gains.
  • A solution would be to apportion interest based on the rental profit to the total return (rental profit plus gain on sale). However, that can’t be done on an annual basis. 
  • An arbitrary allocation is, therefore, necessary. Remembering that the current allocation is 100% to rental and 0% to gain, some other arbitrary allocation percentages could be, 75/25, 50/50, 25/75 or 0/100.

The Government’s proposed solution is to allocate 100% to the future gain, for existing rental housing stock at least. It is a blunt solution as the dual use of the borrowing suggests some apportionment should be made. 

The solution speaks to the politics. From a tax policy perspective, it is less justifiable unless you expect gains to continue which the Government does appear to think is the case. Its estimates of the revenue from the bright-line changes rely on continued growth in property values.

Unfortunately, the Government’s solution isn’t up for debate. It is only its application to particular areas which are being consulted on. That is a pity as a 50/50 apportionment, although still arbitrary, seems to be a fairer solution (especially as the loss ring fencing rules prevent rental loss offsets).

As an aside, some commentators have noted that interest is a deduction allowed to all taxable businesses. They worry this means all interest deductions might be denied in future. That is less of a concern. 

This is because most businesses do not obviously have a dual use to their borrowing, and the prospect of a sale is more remote. The reasons for denying residential property investors a deduction is, therefore, not as present for most businesses. There is less likely to be a dual use.

Also, we should not forget that the current rules for companies are because Inland Revenue’s view required a tracing of borrowing to the specific taxable use. The current rules are a compliance saving measure for companies – interest is assumed to be incurred solely for a taxable use.

While the proposed residential property interest denial rules do not indicate a cause for concern for broader interest deductions, there are other policy concerns that might produce a law change though. The tax difference between equity and debt funding is one of those, particularly when combined with a new 39% top marginal tax rate. 

(The company interest deductibility rules are likely to be modified where a company or its economic group has residential property assets. This is because of the proposed policy rather than a wider view that interest deductions should be denied for companies and other businesses).

What do I take from this analysis?

  • The language of politics and tax policy are different, so take a breath.
  • In our pre-election taxmail analysis, we said promises not to increase taxes lead to arid debates on whether the promise is broken. The real question is whether the policy is right. We also said such promises restrict policy choices, particularly in times of economic and fiscal uncertainty, when all options need to be on the table. Although the politics are obvious, making “no tax increase” promises are not good tax policy. The interest denial solution is not the first best solution as a result.
  • The work for tax policy is in the detail and the nuance. Whether a policy is good or bad or effective in achieving its purpose requires analysis. In this case, nothing has been released to support the decision to deny interest deductions. (New Zealand Treasury’s statement is that there has not been enough time for analysis and, as a result, that it should not proceed). However, it is obvious that more tax will be paid. Less certain is whether the investor or the tenant will end up bearing this cost and the effect on property values. It is likely that we will never have a direct answer on either of these questions. We will be left with only anecdotal evidence as each investor makes their own decisions.
  • As we said in our taxmail, a 50/50 apportionment is a fairer and better tax policy solution. That of course ignores the political and other objectives of the announcement.
  • I also ask why the Government hasn’t provided this analysis, it is their job. This analysis may not persuade everyone, but it would likely have produced a better debate.

Finally, Pacific Rendezvous, the motel, is still operating in Tutukaka. It is on the Pacific coast and has spectacular views. It’s worth a visit for the views, if not because of its place in New Zealand tax history.