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Avoiding the financial wall

For investors caught badly on the higher rate, higher tax highway, it’s probably best to reach for the brakes now, writes Mark Withers

By: Mark Withers

30 April 2023

This article is a no-frills hard look at the cash flow reality facing heavily leveraged residential property investors holding property that is not new builds, and whether, if you are amongst them, you need to make tough decisions to sell and retire debt.

Many residential investors have a portfolio of disallowed residential property funded by debt that is now subject to the deductibility of its interest being progressively disallowed.

Since the removal of deductibility we have seen interest rates more than double, so we are now seeing rates generally being re-fixed at 6.5 per cent, or more, if you are subject to commercial lending criteria. And we may not have seen the end of interest rate rises.

For the 2024 year we are entering, 50 per cent of the actual interest incurred is non-deductible and, in 2025, 75 per cent of interest will not be deductible. In 2026 none will be deductible.

This means many residential investors, as they roll off fixed rates, are seeing their interest bill double at the same time tax bills rise on a “taxable income” that, in reality, does not exist and in fact probably represents a cash flow deficit.

Bear in mind many investors will also experience their new tax bills as a double hit, finding themselves liable for the previous year’s terminal tax and, for the first time, liable for next year’s provisional tax where they have crossed the provisional tax threshold of $5,000.

These investors are caught in a pincer movement … the impact of interest rates doubling and tax increasing. This is also happening at a time when lending criteria for property investors has never been tougher, with stress testing of income to qualify for debt at unprecedented levels meaning many investors will not qualify again for the debt levels they currently have.

Banks are also more inclined to impose principal repayments on lending which is more money that can’t be found from a portfolio that is trading at a cash deficit after tax. Now, here’s the thing I hear a lot. Don’t worry, the National Party has promised to restore interest deductibility, so all will be well. This promise for many has become the perfect excuse not to focus on making changes to cope with cash flow impacts and the removal of interest deductibility.

But with the departure of Jacinda Ardern, the election result now looks to be anything but a foregone conclusion with coalition possibilities on the left more or less matching those on the right and the prospect of NZ First or the Māori Party potentially holding the balance of power.

So, it would be a brave person who predicted an election outcome right now. Even if National got elected it’s likely that actually repealing the interest deductibility law might take a year or two, and the effective date for the law change would probably be April 1 of the following year. For many investors facing a cash-flow crunch now there is no time to wait and hope things change.

So, what to do? Firstly, don’t assume you can simply increase your rents to cover it. In recessions and with the cost of living as high as it is, it is tenants on fixed incomes who are hit hardest.

VITAL STEPS

Step 1 is to project your interest bill out over the next four to five years based on when your existing low fixed-rate loans mature.
Step 2 is to then estimate your tax bill based on that same interest no longer giving you a tax deduction beyond the 2025 tax year. This exercise will reveal whether you have a portfolio cash-flow deficit. If you do have a deficit you have to consider how to fund it.

If you are reliant on utilising lines of credit associated with the portfolio that is causing the cash-flow deficit you are effectively digging a deeper hole. You are also running the gauntlet of whether a lending review could result in that credit being cancelled by the bank if you can no longer meet their criteria to qualify.

Talk to your broker so you can see the level of finance vulnerability. This may lead to the need to sell property to reduce debt and correct the loss and tax position. The question then becomes what assets are best to offer up in a market such as this?

TAX SETTINGS

It’s going to be hard to find a buyer for multi-income properties that do not meet the new build definition because there are few investment buyers about because of the tax settings.

Run-down rental properties often need money spent on them to achieve a sale in a weak market. So, it’s likely to be a pretty gloomy picture on what can be achieved price-wise. Gaining a sale means meeting the market, as painful as that might be. But calculating your position and retaining control is far better than hitting the financial wall and finding yourself at the mercy of a lender who is only interested in getting a mortgage repaid.

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