Analysis: Property investors to benefit from repeal of interest deductibility rules - but law flawed from outset

By Alison Pavlovich for The Conversation

ANALYSIS - The new coalition government has announced a suite of tax reforms, including reintroducing the ability for property investors to deduct the interest costs on their mortgages against their rental income.

Early criticism of the proposed changes has focused on its retrospective nature (it will be backdated to 1 April, 2023), potential windfalls to landlords (at the expense of tenants), and the fiscal cost of the measure.

Missing from much of the coverage was mention of the previous Labour government's policy being extremely punitive to some landlords, without necessarily bringing the claimed benefit of improving housing affordability. In fact, it is likely to have put upward pressure on rents.

Alongside the reinstatement of interest deductions, National's plan to reduce the applicable period of the brightline test - which requires property owners to pay income tax on property sold within a certain time frame - from ten years back to two years.

While property investors will benefit from the proposed changes, there have been some real issues with Labour's earlier tax reforms. We should be glad to see them gone.

Denying deductions on residential properties

In 2021, the Labour government announced plans to phase out the deduction of interest against income derived by residential landlords.

These changes meant landlords couldn't offset interest payments against their rental income. If the property was later sold, the accumulated interest costs would then become deductible against any taxable gains.

Much like the extension of the brightline test from five to ten years, proponents of this law change said it would address housing affordability by reducing investor demand.

As it happens, investor demand in the property market has reduced significantly since 2021. But whether denial of interest deductibility has caused or even contributed to this will never be known.

During the past two years, the property market has experienced a slowdown due to rising interest rates, stricter lending rules, and a general reduction in economic confidence in New Zealand.

End of a flawed law

Some criticisms of the new government policy are valid. It is retroactive, benefits property investors, and is expensive for the government to implement. But on the flip side, the policy removes a fundamentally flawed law.

When the government proposed the denial of interest deductibility in 2021, Inland Revenue advised against it on the basis that the change was unlikely to improve housing affordability.

According to this analysis, while the measure might put downward pressure on house prices, it was also likely to result in upward pressure on rent. The policy also had the potential to reduce the supply of new housing developments in the longer term.

An incoherent tax system

More broadly, Inland Revenue said it was concerned the measure added to the compliance and administrative burden on affected taxpayers, and eroded the coherence of the tax system overall.

This last point is important.

A good tax system should be coherent and comprehensive. The introduction of the denial of interest deductibility reduced the coherence of the tax system.

There is a fundamental (and long-standing) principle in tax law: the costs associated with producing taxable income can be offset against that income - with employees being the one major exception to this rule. But in most other cases, expenditure incurred in producing taxable income is deductible.

Removing the deduction of interest expenditure, an often substantial and very real cost to property owners, is a significant departure from this principle. It was likely to cause financial hardship for some landlords.

Furthermore, this incoherent measure was introduced, at least in part, to compensate for the obvious hole in the current tax system - the lack of a comprehensive capital gains tax.

The then revenue minister, David Parker, acknowledged the tax system benefits residential landlords by exempting many from tax on any capital gain upon sale of the property.

But rather than introducing a tax on capital gains - widely accepted as part of a comprehensive tax system and supported by the Working Tax Group in 2019 - the government chose to implement a distortionary measure in an attempt to address the problem of tax advantages for residential property investors.

Still no capital gains tax

The government may well be winding back the measures introduced by the previous government to appease its property investor constituents.

And there is no real chance the new government will introduce a comprehensive capital gains tax, which would improve the coherence and comprehensiveness of New Zealand's tax system.

In fact, by reducing the application of the bright line test to two years, quite the opposite is intended.

But the interest deduction denial was unlikely to achieve a great deal more than an increase in rents. It was a bad law, and there are good reasons for it to be gone.

Alison Pavlovich is a senior lecturer in the School of Accounting and Commercial Law, Te Herenga Waka Victoria University of Wellington.

This article is republished from The Conversation under a Creative Commons license. Read the original article here.

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