For many investors the impact of phased removal of interest deductibility is still sinking in. In this article we explore some of the consequences of the change that may not have been apparent at first glance.
Firstly, a recap on the government’s announcement. For acquisitions of residential property after 27 march 2021 interest will only be deductible until 1 October 2021.
Interest on debt funding residential property acquired prior to 27 March 2021 will be phased out over 4 years.
Until 30 September 2021 100%
1/10/21 – 31/3/23 75%
1/4/23 – 31/3/24 50%
1/4/24 – 31/3/25 25%
From 1 April 2025 0%
The government also signaled that interest on lending that funds new builds may remain deductible to encourage the private sector to add to housing stock.
Definition not drafted
Unfortunately, the government has not provided a definition of a new build as yet. It has signaled that the definition may include a property acquired within a year of its code of compliance being issued. Subsequent to the announcement, the government has signaled a public consultation process that will include taking input on how a definition of a new build will read.
It is possible that new builds constructed or acquired before the announcement may be included in the definition as to exclude them would create a real injustice for those that debt funded new builds prior to the deductibility change.
Its also too soon to assume that interest deductibility will remain in perpetuity for new builds, it may be that the government imposes some form of time limit on this deductibility. This seems increasingly likely given the alternative will essentially create two different classes of residential property with vastly different tax rules that could impact the price point of existing properties.
By now, most investors will have considered the cashflow impact the removal of interest deductibility will have relative to the additional tax liability it will create.
Those with unacceptable cashflow impacts will need to sell property to deleverage.
Remember to carefully select property for sale relative to each properties Brightline count. Triggering Brightline tax on a sale designed to deleverage non deductible interest would be a bitter blow. Remember bright line day counts generally run from the date a change of title is registered until the date a sale and purchase agreement is entered into for sale.
Provisional tax is required to be paid once a tax liability of $5000 or more is generated. When becoming a provisional taxpayer for the first time the cashflow impact of the tax is magnified due to the need to pay not only last years terminal tax, but next years provisional tax all in the same year.
Many investors use Look Through Companies to hold their property investments. Where a high-income earner was using income to support the investment it is not unusual to see shareholding biased in their favour. This ensured the losses being funded were flowed to the high-income earner. But now with the removal of interest deductibility, these same arrangements could see those on the highest tax rates being streamed the artificial income from look through companies that have had interest deductibility denied. Before considering altering shareholdings investors should appreciate that selling shares in a LTC is a bright line reset event. One solution to this may be altering shareholding pursuant to relationship property agreements, but these will need to be drafted formally and all parties to them will require independent legal advice for them to be valid.
There can be significant tax issues associated with changing shareholdings in QC’s. These include a minimum QC continuity test of 50%. There are also rules that require dividends from QC’s to be distributed to living beneficiaries if trusts are shareholders. Failure to do so or breaches of continuity can cause QC status to be lost. If QC’s pay tax on their new profits, they will also accumulate imputation credits without necessarily having corresponding retained earnings due to interest costs still being met. These imputation credits must be attached and considered taxable dividends even when declared from capital profits.
Debt funding portfolios that that contain both commercial and residential property or properties that are split use properties contain unique challenges. Historically, deductibility was determined by what borrowed money was used for rather than what type of asset provided the security. Over many years though, most investors have changed and refinanced their funding mix and cross collateralised security arrangements making it very difficult in some cases to accurately undertake a track and trace exercise to determine what debt brought what asset. It remains to be seen whether the government will expect these track and trace exercises to be done when considering deductibility of interest in mixed portfolios.
Legitimate restructuring of debt
Investors with businesses may have legitimate debt restructuring opportunities where their trading businesses owe them money. This may even be significant if retained profits were distributed prior to the personal tax rates rising without these dividends being paid in cash. It may now be possible for these businesses to borrow to repay shareholder loans, allowing the shareholders in turn to retire non deductible debt in their property entities.
As with many tax issues, the more you consider the issues the more complex they become. With the consequences of the removal of interest deductibility still filtering through it’s a time to take tax advice as you consider your options. Do this particularly before you change structuring decisions as most restructures are trigger events for Brightline. This includes trust resettlement