Clearing The Fog Around Deductibility
Mark Withers attempts to shine a light on the ever more complex rules surrounding the phasing out of residential investment loan deductibility.
1 October 2022
Investors can be forgiven for being confused by the detail associated with complying with the government’s rules to phase out deductibility of residential investment loans. This article attempts to shed light on some of the scenarios and recap some of the fundamentals.
Firstly, deductibility of interest is determined by what borrowed money is used for, not the security provided. If a residential rental property is mortgaged to provide finance to purchase a commercial property the interest remains deductible, but the fact that residential property provides security is irrelevant to the deductibility.
While straightforward in principle, all sorts of issues crop up with the passage of time. Loans across a property portfolio are typically repaid, refinanced, re-borrowed, cross-collateralised and redocumented as opportunities to add and remove a mix of assets comes up and the value of the properties change. There is variation between tax practitioners with respect to how diligent they are at tracking and tracing what various debts have been used for over the years.
Practitioners who have taken the approach that “all debt that isn’t private must be deductible” now find themselves unable to determine what debt funded disallowed residential property and what did not. This is an issue with any portfolio that contains a mix of disallowed residential property and other properties like commercial and student accommodation. This has forced the government to address the thorny matter of how to deal with “non-traceable lending” and it offers us an unexpected concession. Under the transition rule, untraceable loans can be treated as being used to acquire nondisallowed residential property first based on the market value of the allowable property as at March 26, 2021, and then only the balance is applied to disallowed residential property.
If the balance of untraceable lending on March 26, 2021 is less than the value of other income generating property held, none of the interest is subject to limitation. If the balance of untraceable loans exceeds the value of other income generating property only the excess above the market value of the allowable property is treated as used to acquire the disallowed residential property. Only this excess interest is then subject to the phasing out and limitation rules.
These concessions are surprising for two reasons. Firstly, there is an assumption that all commercial property was acquired with debt before the residential and, 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 no-one that this rewards a taxpayer who has been tardy in their historic tracking and tracing of debt with more deductibility and incentivises those with better records to join their ranks.
High Water Mark
Those with mixed portfolios and untraceable lending should certainly begin determining how they will establish market value of their nonresidential investment properties as at March 26, 2021.
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 is 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 the balances alter.
The approach here is to adopt a “high water mark” mechanism.
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 March 26, 2021.
If the loan is 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 March 26, 2021.
If the affected loan balance is lower than the initial loan balance all interest will be deductible subject to phase out. If its higher, only the interest up to the initial loan balance is deductible after applying the phase-out percentage.
The elephant in the room is the reality that in the past life was simple. Interest was either deductible or it was not. Now, with the layers of complexity these rules heap onto taxpayers with ever increasing compliance costs it will be extremely resource intensive for IRD to successfully undertake its monitoring of compliance role.
Whether they have the resources to monitor compliance of rules that affect so many taxpayers in such a complex way remains unclear.