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There has been much comment on the Government’s labelling of interest deductions for residential landlords as a “loophole”.

The furore around this language misses the point. Simply, (most) voters see a residential landlord deducting interest and making non-taxable gains. To them, that is a problem - a loophole. Voters understand it at this level. “Loophole”, “Mum and Dad investors” and “speculators” is the language of politics, not tax policy.

The tax policy problem for interest deductibility arises from a 1986 tax case about a motel which borrowed money to fund renovations prior to a sale, (the sale was non-taxable). The court ruled that the borrowed money was used in the motel’s business (which clearly was a taxable activity). This meant that all of the interest was deductible.

This case is the basis of the current tax law. The question is whether this is the right tax policy.

According to some residential property investors, the rent they are charging barely covers their costs. A reasonable conclusion from this is that borrowing to buy an investment property supports two uses: renting it, which is a taxable use, and holding it for future gains, which is generally not a taxable use.

This suggests the 100% deductibility of interest may not be appropriate.

How to split interest between the different uses for the borrowing is the hard part though. Saying the interest is only for the future gains assumes that house prices will continue their upward trajectory; however, that is not a certainty. Practically, interest deductions are claimed each year. Just how much should actually be deductible each year is difficult to answer. The actual gain, if any, will only be known at the time of sale. An arbitrary adjustment for the two uses, (renting versus future gains), is the only workable option.

So how might this split be calculated? The current interest split is 100% to rental use and 0% to holding for future capital gain. An arbitrary split could be: 75/25, 50/50, or 25/75. The Government has decided that a 0/100 split for existing rental property stock is right. This is at the other extreme to the current rule. 

The Government’s answer is about the politics rather the underlying tax policy problem. It is a blunt solution.

The Government’s solution assumes future growth in house prices as the justification for non-deductibility for interest. (It assumes the capital gain must be the sole reason for buying investment properties). In my view, a 50% deduction for interest, although arbitrary, seems to be a fairer solution to the actual problem - particularly as there are already restrictions for landlords, such as preventing rental losses being deducted against other income.

Some commentators have also suggested that all interest deductions might be at risk in future. I think that is less of a concern.

Borrowing by business is different. It is unlikely to have the same dual use for the borrowed funds, that is, to fund both a taxable activity and an activity that creates capital gains. However, denying interest will bring more complexity to the tax system as a whole. For example, companies can usually automatically deduct interest - saving compliance costs.  Under the new rules, companies which own residential property or have bank funding secured against shareholders’ residential property, will likely face more complex rules.

The Government’s housing tax announcements raise the following points for me:

  • The language of politics and tax policy is different. The recent announcements speak to the politics.
  • Promises not to increase taxes lead to debates about whether the promise is broken, when the real question should be whether the policy setting is right. Such promises unnecessarily restrict choices when all options need to be on the table. This is especially important in times of economic and fiscal uncertainty. Tax policy promises do not lead to good tax policy making, despite the promises seeming like good politics at the time. Because of what is not on the table, the interest denial solution is not the best tax policy solution in my view.
  • The role of tax policy is to consider the detail and the nuance. Whether a policy is good, or bad, or effective in achieving its purpose requires robust analysis. This has not happened with the interest denial solution. The Government’s tax policy advisers, the Treasury and Inland Revenue, make that clear. As a result, although logically we can expect more tax to be paid because of the interest change, whether investors or tenants will end up bearing additional costs, and what the effect will be on property values, is unknown. If the Government has alternative analysis supporting its decision, then its release would help inform the debate.

One final question from me. Dual use of borrowing raises the question of why isn’t the gain taxable? But that’s for next time.