Property and Tax - Brightline and Interest

Property and Tax - Brightline and Interest
If you own residential rental properties, or are looking to buy, then you should be aware of the tax changes recently introduced by the Government for owners of residential rental properties.

The legislation was introduced in draft in September 2021 and is expected to be passed into law early in 2021. However, the proposed changes will be effective from 1 October 2021.

The proposals are complex, however, broadly:
• If you acquire a residential property on or after 27 March 2021, interest incurred from 1 October will no longer be deductible.
• For residential property acquired before 27 March 2021, interest deductions will be phased out over the next four years.
• Residential rental properties include those used for short term rentals.
• There are also changes to the Brightline Rules.

Interest deductibility changes – what do they mean?
Previously, if you borrowed money to purchase a residential rental property, you could offset the interest costs against the profit, so that you only paid tax on the net profit (i.e., rent – interest and other expenses = net profit, pay tax on the net profit).

With the new rules, you may not be able to offset the interest costs, so your profit will be higher. This means you will likely pay more tax.

Phase-in of new rules
The new rules will be phased in for properties acquired before 27 March 2021:

Date interest incurred                           Percentage of the interest that can be claimed
1 April 2020 to 31 March 2021                                                         100%
1 April 2021 to 30 September 2021                                                 100%
1 October 2021 to 31 March 2022                                                     75%
1 April 2022 to 31 March 2023                                                           75%
1 April 2023 to 31 March 2024                                                           50%
1 April 2024 to 31 March 2025                                                           25%

Exemptions
There are a few exemptions to the new interest deductibility rules, including:
• New builds: Interest incurred on loans for “New Builds” will continue to be fully deductible for 20 years from the date of issue of the Code of Compliance Certificate (CCC), irrespective of a change of ownership. A "New Build” is a property with a self-contained residence, where a CCC has been issued on or after 27 March 2020.
• Dealers, builders, and developers: Interest deductions will continue to be available for land dealers, builders and developers who are already taxed on sales.

Can I claim a deduction for the interest once I sell the property?
Interest deductions denied under the proposed new rules may be claimed in the year the property is sold, provided that the sale is taxable, for example, under the Bright-line Rules. However, the interest will only be deductible to the extent of any taxable income, such that you couldn’t claim a loss.

New Brightline Rules - updated
The “Brightline Rules” apply to sales of residential land acquired on and after 1 October 2015. Under the new rules, a sale within ten years of acquisition will be taxed (or five years if the land was acquired before 27 March 2021, or two years if the land was acquired before 29 March 2018). There is an exclusion for the main home.

Under the new rules, New Builds will continue to have a five-year Brightline period. However, the “Main Home Exclusion” has also changed. For residential properties purchased from
27 March 2021, the Main Home Exclusion will only apply whilst the property is used as the owner's main home. If the land not been used as the main home for a period that exceeds 12 months, the exclusion will not apply for that period.

There are a couple of areas to be careful here:
• If you are buying bare land, and there will be a delay in waiting for the title to be issued and to build your new home, you may have a period for which the property will not qualify for the main home exclusion.
• If you are renting your house out temporarily you also need to watch this. If the house is rented out for more than 12 months, you may also have a period for which the property will not qualify for the main home exclusion.
• If you are using your property partially for other purposes, e.g., flatmates, a portion of the sale may be taxed on the Brightline Rules.

New rollover relief
Under the Brightline Rules, you could be taxed on the transfer of a property to a related entity, such as a Trust. The transfer will also re-set the Brightline period, in that you start again. With the new Brightline Rules, this could be for a period of 10 years.

However, the new rules also include a proposed rollover relief. The proposed rollover relief should allow you to change how you own a property without triggering the Brightline property rules. When the legal ownership of a property changes, but the effective (or economic) ownership is the same, the transfer could be ignored if it fits one of the prescribed situations. In theory this means the original owner should not be taxed on the realised gain on the property, and the new owner should be treated as having acquired the land when it was acquired by the original owner. So, using our Trust example, if you transferred your rental property to your family Trust, the Trust may be able to adopt your original purchase date for the purpose of calculating whether a future sale of that property would fall within the Brightline Rules.

As always, the devil is in the detail. The rollover relief will only be available if the transfer value is equal to or less than the original owner’s acquisition cost. No relief will be provided if the amount received is more. We are scratching our heads a little here, as this wording effectively means that there will only be rollover relief when there is no increase in value. This appears contrary to the IRD information sheet that states the original owner will not be taxed on the realised gain on the property.

Also, the transfer must fit the specific criteria. For example, the rules do not consider a transfer from a Trust to a beneficiary, so if you want to wind up your Trust and own the properties yourself, you are unlikely to qualify for this rollover relief.

Unfortunately, this will be a case of wait and see. As the proposed rules are intended to apply to transfers on or after 1 April 2022, you may wish to postpone any relevant transfers until there is greater clarity. The new rules are incredibly complex, it will be critical to get specialist advice for your situation.

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