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What would happen if the government took away a deduction for interest?

24 March 2021

 

By Ross Barnett - Property Accountant

 

What would happen if Interest deductions were taken away

I think this would be completely crazy and goes against every tax/accounting principal, but the government is getting desperate and could do anything!  This article gives a brief explanation of the effects of such a change.

Currently when you earn rental income, you can offset expenses associated to the rental against the rental income to reduce the taxable profit.  A major expense is interest on the mortgage.

If the residential rental expenses are more than the rental income, the new Ring Fencing laws (from 1/4/19) often take affect and mean the loss can't offset personal or business income, and the loss carries forward to the next year. Or the loss from one property can offset the profit from another, as long as the structure is correct.

If the interest deduction is not allowed, and the interest costs are no longer tax deductible, then rental properties will make significantly more profit, and in many cases have a lot more tax to pay.

This could have a major impact on cashflow for property investors, and could mean that many property investors struggle to hold lower cashflow properties, or properties with high debt.

Current Situation

I recently did a video, reviewing a Christchurch new build, https://fb.watch/4oBNV3kxRN/" data-ogsc="">Click here to watch
Purchase $500,000, borrow 100% or $500,660 including costs to buy less contribution.
Income was $23,205
Expenses was $23,345, which includes $11,465 of interest ($500,660 at 2.29%)
Loss of $140

So even before we get to chattels depreciation, there was already a loss and no tax payable.  If you are not doing chattels
depreciation, I have added a link and information further down this email.

If this property was on Interest only, would have to put in $140 per year (not a great buy!)

If Interest Deductions were not allowed

Income still $23,205
Expenses for tax purposes now $11,880 excluding interest
Surplus before depreciation and  for tax $11,325
Less chattels depreciation $5,000
Taxable Profit $6,325

Tax at 33% $2,087

Overall Cashflow if no interest deductions

So the property would still be losing $140 per year on interest only
But now the property investor would also have to pay $2,087 in tax.

The total loss would now be $2,227 or $43 per week.

In this example the loss isn't that bad, but that is at 2.29% interest rates and with large chattels depreciation.

At 3% interest rates ?

Cash loss would be $3,695 per year, plus still having to pay $2.087 in tax.
So you can see as interest rates go up, this could really hurt!

If no chattels depreciation

At 2.29% interest rates, but without chattels depreciation, tax would go up to $3,737 or an extra $1,650 tax to pay per year in this example.

Shows how important chattels valuations can be.

With a new tax year fast approaching, if you have purchased a new rental, it's really important to consider a chattels valuation from https://www.valuit.co.nz" data-ogsc="">Valuit .   This newsletter with some examples might also be useful https://cswaikato.co.nz/index.php/latest-news-accounting-hamilton/accountants-hamilton-auckland/213" data-ogsc="">Chattels depreciation

Two potential issues for property investors 

A) Interest only - it is worth noting that the government is asking the Reserve Bank questions about Interest Only loans.  What would you do if rental loans have to change to P& I?

I think it is important to have a plan around this as it is already getting harder and harder to have long Interest Only terms.  I don't have a problem with 1-2 years Interest Only, but I think long term it is wise to be able to pay down some Principal, even if it just means splitting the property loan into 2 or 3, and putting one of these parts on Principal and Interest.

B) Could interest rates go up at some time?

Tony Alexander has been suggesting that interest rates could go up, and that looking at some 5 year rates could be a good idea.  NOTE, this doesn't mean it will happen and many experts get property prices and interest rates wrong all the time

Attached is a link to a video that may give you some ideas on interest rates  https://fb.watch/3Uq52LqUt2/" data-ogsc="">Click here to see 7 minute video about current interest rates

If you need some help with property, are stuck and just not sure where to go next, you can always book in a free chat with me for 5-10  minutes, as this discussion can often point you in the right direction to move forward.  https://www.cswaikato.co.nz/services-property-accountants-hamilton/201" data-ogsc="">Click here to book a free chat with me (Ross)

 
 
 
 

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