Now that the thunderous reaction to the government’s big property measures announcement last week has abated a little, it’s worth digging a bit more into the proposed tax changes.

It was good to see the government acting boldly. A median house price rise of $50,000 in February alone (and $100,000 in Auckland), coming on top of years of price appreciation, is dangerously unbalanced for social and economic stability. 

The government had to respond, and it did.

It focused on two broad responses, measures to improve supply including the announcement of a $3.8 billion housing acceleration infrastructure fund and an expanded building trades apprenticeship programme, and tax measures intended to reduce the interest of investors in the existing residential property market and instead tilt their interest toward new builds.

It is the tax measures, and in particular, the removal of interest deductibility for investors in existing residential properties that have caused most of the debate.

The level of anxiety and concern stemming from the tax announcements mean that they probably have a reasonable chance of making some difference. 

They will negatively impact investor sentiment for residential property investment and as such may take some pressure off rampant house price growth. That would be a policy win, although there are valid concerns that additional tax costs for investors may find their way into rents in some markets.

But are there other hidden costs and unintended consequences of that policy win?

A loophole

The extension to the brightline test from five years to 10 years was well telegraphed by the government, with the minister of finance noting publicly in early December 2020 that he had sought advice from Treasury on that change. The political argument is whether this is in effect a capital gains tax? 

Well, it will certainly tax some gains that with a five year brightline test would not have been taxed. 

However, it’s not a comprehensive capital gains tax and it’s not well designed. The government (to use its own language) has left a “loophole”; hang on to your property for ten years and you don’t pay it. 

You can expect investors to rationally respond to that signal.

By contrast, the removal of interest deductibility for existing residential property investment caught us all by surprise.

The ability to deduct the interest cost of debt used to finance business or income generating assets has long been a feature of our income tax system. Interest deductibility is a deliberate design choice in our tax system supported by successive governments and is the current law in New Zealand. 

To label it a “loophole” as the government has assiduously done is cynical and unfair to people following the law.

If a government wants to reduce the after-tax return from investing in existing residential rental properties, and therefore reduce the motivation of investors in buying and banks in lending to buy those properties, then denying interest deductions is an available policy choice.

But both the fact that it is a blunt tool, and the unorthodox method of introduction come with the hazard of unintended consequences. 

And we don’t know how significant those hazards are because it seems that this was a very recent decision, and the government did not have time to get full advice from its key ministries; Inland Revenue and Treasury. But here are a few issues that we should worry about.

The denial of interest deductions for one specific class of investment undermines the coherence of the New Zealand tax system by introducing uncertainty and complexity.

There’s no principled reason why interest deductions should be allowed on debt used to fund a share portfolio or the fixed assets of a business, or even a commercial property investment, but disallowed for a residential property investment. 

Investors will wonder which class of investment assets is next at risk of losing an interest deduction? Policy setting uncertainty can alter investment in subtle but damaging ways.

To make this interest denial stick will require introducing more complexity into the tax system. New tracing rules will be required to look through interposed entities to try and determine the purpose of the debt raised. 

Unwelcome new rules

For example, a company borrows $1 million and repays an existing loan from its 100% shareholder and the shareholder buys a residential rental investment for $1m. The interest on the loan is deductible to the company. The economic effect for the shareholder is an interest deduction against a new residential rental stream. Rules designed to stop this and similar structuring will be complex to design, difficult for investors to follow and hard for Inland Revenue to administer.

The way the government has introduced the new rules is unwelcome. The government is rule-making by press release – a process of dubious constitutional merit. Last Tuesday, it released a short fact sheet stating that from Oct 1 2021 no interest deduction will be allowed on debt used to acquire an existing residential rental property if the property acquisition date is March 27  2021 or later. 

Investors who intend to buy a property right now must make that decision based on that press release in anticipation of a law yet to be designed or passed, and on which there has been no consultation and no proper advice from Treasury or Inland Revenue.

This level of uncertainty may be exactly what the government wants to achieve, cooling investor interest in the market, but it will have unintended outcomes. 

Despite the short comment in the fact sheet that new builds will be exempt from the interest denial, there has been uncertainty created. There are reports of pauses on funding 'build to rent' projects and conversion of existing commercial properties into residential apartments until it is clear they will qualify as new builds.

These tax changes are simply the latest in a decade or more of efforts to chip away at the tax settings that have made residential property attractive to investors. The National government removed the ability to depreciate residential rentals in 2010, and in 2015, introduced the two-year brightline test. The Labour-led government extended the brightline test to five years in 2018 and introduced the residential loss ring-fencing rules in 2020.

These measures, together with the latest changes, are all intended to raise the effective tax rate on residential rental investment. This reduces the relative attractiveness of residential property compared to other investments thereby reducing investor demand and the impact of that demand on prices.

For the sake of New Zealanders shut out of the housing market, I hope the overall package announced last week has a positive impact on slowing house price growth, even if it comes with some undesirable costs. But the accumulated tax changes over the years, are a motley bunch of policy tools that undermine the coherence of the tax system. 

Successive governments have been forced to use them because a properly designed comprehensive capital gains tax has never been seen as politically viable.