If you’re confused by the compliance details behind the government’s rules to phase out deductibility of residential investment loans, you’re not alone.
In an attempt to shed some light on interest deductibility for investors, we’re going to run through a few scenarios and recap the fundamentals of the new rules.
Firstly, deductibility of interest is determined by what borrowed money is used for, not by the security that’s provided. So, for example, if a residential rental property is mortgaged to provide finance to purchase a commercial property, the interest remains deductible. The fact that a residential property is providing security is irrelevant to the deductibility.
While this is straightforward in principle, there are a number of issues that can crop up over time. Through their life, loans across a property portfolio are typically, repaid, refinanced, re-borrowed, cross collateralised and re-documented. Property values will change, and opportunities will arise to add or remove assets from a portfolio.
This makes it difficult to trace what debt has been used for over its lifetime, and whether it is or isn’t deductible.
Tracking and tracing debt
There’s a lot of variation between tax practitioners when it comes to how diligent they are at tracking and tracing what debts have been used for over the years.
Some have simply taken the approach that ‘all debt that isn’t private must be deductible’. These practitioners are now finding themselves unable to determine whether debts have gone on to fund disallowed residential property or not.
This is an issue for any portfolio that contains a mix of disallowed residential property and other properties like commercial, boarding houses and student accommodation. It has forced the government to address the thorny matter of how to deal with ‘non-traceable lending’.
The government’s ‘solution’ offers us an unexpected concession.
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You can treat an untraceable loan as being used to acquire non-disallowed residential property first, based on the market value of the allowable property as at 26 March 2021. This means only the balance is applied to disallowed residential property.
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If the balance of untraceable lending on 26 March 2021 is less than the value of the other income generating property, none of the interest is subject to limitation!
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If the balance of untraceable lending exceeds the value of the other income generating property, only the excess (above the market value of the allowable property) is treated as being used to acquire disallowed residential property. This means only this excess interest is subject to the phasing out and limitation rules.
These concessions are surprising for two reasons. Firstly, there is essentially an assumption that all commercial property was acquired with debt before the residential. Secondly, that market value is used to determine the deductible quantum of the debt, rather than the cost of the commercial properties.
It will be lost on nobody that this rewards a taxpayer who has been tardy in their historic tracking and tracing of debt. They receive more deductibility and incentives than those who have kept better records.
One can only wonder how an IRD auditor might go about determining whether a loan deemed ‘untraceable’ really had such a confusing and mysterious past.
Investors with mixed portfolios and untraceable lending should certainly start determining how they can establish market value of their non-residential investment properties as at 26 March 2021.
Variable balance line of credit lending
Variable balance line of credit type lending is also throwing up challenges, especially where private money is paid down against deductible debt then redrawn for private purposes.
Determining where the business/private line in the sand can be drawn has never been easy. Now we must also consider the extent to which these loans funded disallowed residential property, and how to deal with them over time as balances alter.
The best approach here is to adopt a ‘High Water Mark’ mechanism.
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If the loan was only used to fund residential property, the interest will be subject to phase out based on the loan balance as it stood at 26 March 2021.
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If the loan was used to fund a mixture of business and private assets, the interest calculation is based on the lessor of the affected loan balance (the actual loan balance that applied to residential assets) or the initial loan balance as at 26 March 2021.
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If the affected loan balance is lower than the initial loan balance, all interest will be deductible subject to phase out. If it’s higher, only the interest up to the initial loan balance is deductible after applying the phase out percentage.
For the government, the elephant in the room is the fact that life was simple in the past. Interest was either deductible or it was not. This was auditable.
Now, with the layers and layers of complexity these rules heap onto taxpayers, along with ever increasing compliance costs, it will be extremely resource intensive for the IRD to successfully undertake its monitoring of compliance role.
Whether they have the resource to monitor compliance of rules that impact so many taxpayers in such a complex way remains unclear.