What interest deductibility changes mean for property?
Property investors are set to benefit from changes to interest deductibility rules which will kick in at the end of this month.
The Government is reversing changes implemented under the previous regime which meant interest costs could no longer be considered an expense come tax return time.
Let’s consider what that might mean for prospective investors, and the wider market.
We don’t have a capital gains tax in New Zealand. Not officially, anyway.
Some would argue the “bright-line test” equates to one, and that’s fair, but the Government intends to reduce the ownership threshold of this test to just two years.
That’ll render it irrelevant for the bulk of property investors, who’ll plan to hold for much longer than this.
In the eyes of the IRD, the annual profit an investment property makes is the total rent it generates, less all the expenses incurred to the owner.
That’s what the investor will pay tax on, at their marginal tax rate. For anyone earning more than $70,000 a year but less than $180,000, that’s 33 per cent.
There are a range of expenses that can be deducted, including rates, insurance, accounting fees and routine maintenance.
However, the biggest expense of all is the interest bill, which dwarves those other costs put together.
In Christchurch, the median house price is $650,000, so if we assume a 20 per cent deposit of $130,000, an investor will have a mortgage of $520,000.
The annual interest bill is going to be $34,580, based on the 6.65 per cent mortgage rate the big banks are offering for the next three years.
Rates, insurance and maintenance will probably add up to about $7500 over the course of a year.
According to Corelogic, rental yields are 3.6 per cent in our second-largest city. That equates to a weekly rent of $450, which makes for an annual rental income of $23,400.
At the moment, the IRD will see an annual taxable profit of $15,900 (the total rent minus the $7500 of non-interest expenses).
On a personal tax rate of 33 per cent, this investor is going to get a bill for $5247 of tax to pay.
That large interest cost of $34,580 has still been paid too, even though the IRD has ignored it.
When all is said and done, this investor has been required to front up with about $460 a week to top up this investment.
Nobody said property investment was a walk in the park.
Having said that, houses typically increase in value (at least over the longterm), and in this example the investor would need to see a capital gain of just under 4 per cent to break even that year. Plus, things are about to get easier. From April 1, 80 per cent of the interest can be included as a tax expense, and next year we’ll be back to 100 per cent, as was the case prior to 2021.
That improves the previous calculations a lot.
If all the interest is deductible, the expenses line balloons to $42,080. With the rent unchanged at $23,400, this venture has no longer made a profit at all — it’s lost $18,680.
No longer would our investor get a bill. They are instead due for a tax refund of $6164.
A weekly top-up of $241 is still required, because the rent still doesn’t cover the mortgage payments and other costs.
The owner remains reliant on rising house prices to make this investment work, although these tax changes will improve their annual cash flow position dramatically.
It’s become a little easier to get rid of troublesome tenants, while strong migration is ensuring demand is high.
These tailwinds are supportive of the housing market, but its fortunes might still come down to interest rates.
The official cash rate is expected to decline over the coming years, but if it settles around the 2.5 per cent level, mortgage rates are still likely to be around the 5 per cent mark.
That’d be much lower than where rates are today, but still above what we saw from 2016 to 2022.
Unemployment is also on the rise, which typically a headwind for the housing market, and affordability is still an issue.
House prices surged 48 per cent during the two years ending November 2021, before declining 18 per cent in the following 18 months.
Even after that correction, prices are still about 25 per cent above pre-covid levels.
The housing market has stabilised and property investors are facing a few less headwinds than they have in recent years.
However, we shouldn’t count on a return to the big capital gains of years gone by.
"Unemployment is also on the rise, which typically a headwind for the housing market, and affordability is still an issue.