In March 2021, the government announced three changes to property tax rules that are likely to affect anyone with residential property investments. The changes include extending the bright-line period from five years to 10 years, changing the main home exemption ‘test’ and removing the ability to deduct mortgage interest from rental income.
Changes to the bright-line regime
The bright-line test was established in 2015 to classify as income the profit made from buying property and selling the same property within a set period. Once captured as income, tax must be paid on that income at your marginal tax rate.
Initially the bright-line period was two years from the date that you acquired the residential property. This was extended to five years from 29 March 2018. From 27 March 2021 onwards, if you purchase residential property and you sell it within 10 years, any profit from that sale will be subject to income tax.
The government has indicated, however, that for new build investment properties, the five-year period still applies, rather than the longer 10-year period.
The government has stated that a new build investment property will be a self-contained dwelling with its own kitchen and bathroom, which has received a code of compliance certificate. The government is consulting with interested parties until 12 July and it is proposed that any agreed measures will apply from 1 October 2021.
Main home exemption
There are, of course, some exemptions to the bright-line test.
If you are selling your main home and you don’t have a pattern of buying and selling properties (generally selling your main home two or more times within two years), the sale may not be captured under the bright-line rules.
Previously, if your property was your main home for most of the time that you owned it, the exemption would apply. For example, you buy a property to live in; over a four-year period you spend 18 months working overseas, during which time you let the property out to cover expenses. Under the old rules the property would still be your main home and you wouldn’t have to pay bright-line tax on any profit from the sale.
This test has now changed; a property can be your main home for periods of time and not others. The new rule takes into account that you may be called to work in other regions or countries and, in this respect, you are permitted to live somewhere else continuously for up to 12 months. If you live elsewhere for more than 12 months, however, and want to sell your home within the applicable bright-line period (10 years for any older property purchased after 27 March 2021), bright-line tax will apply to the period (over 12 months) you spent living elsewhere.
Using the same example from above, you acquire your property on 1 April 2021 and live in it for six months. On 1 October 2021 you work overseas for 18 months before moving back into your property on 1 April 2023; two years later you decide to sell it.
Inland Revenue will calculate how much the property increased in value and you will need to pay tax for the six months that the property was not your main home.
The final change affects interest deductibility. Previously, if you had a mortgage secured against your rental property, you could treat the interest paid as a loss. This could be offset against the income earned by way of rent or sale profit. From 1 October 2021, this will no longer be the case.
Initially the change will only apply to properties purchased after 27 March 2021. Over the next four years, however, the ability to deduct your interest as an expense and offset this against your property income for all properties, including those purchased prior to 27 March 2021, will be phased out completely.
You will be able to claim back 75% of interest paid for the 2022-23 tax year; 50% for the 2023–24 tax year; 25% for the 2024–25 tax year; and from 1 April 2025, you will not be able to treat any interest as a loss.
You should also note that if you borrow money after 27 March 2021 and secure that loan over a property purchased before that date, the interest deductibility rule will be applied as if the property was also purchased after 27 March 2021 and you will not be able to claim back the interest.
These changes make it more important than ever to get legal and accounting advice before you decide to purchase or sell your rental investments.
If you’re thinking of a change, or you want more advice on how the changes will affect you, don’t hesitate to talk with us.