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10 March 2022

Market Impacts of Brightline & Interest deductibility changes

It’s been a long wait since the announcement back in March that the Brightline would be extended to ten years for existing residential stock and that interest deductibility on residential lending would be phased out.


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The legislation heralding these changes was finally released on the eve of the deductibility of interest being removed [on 1 October] on existing residential stock purchased in the wake of the announcement. Perhaps one reason for the delay has been the difficulties the Government has faced defining a ‘new build property’, given this category of acquisition retains a five-year Brightline status and the right to deduct interest against rental income.

Much of the detail was as anticipated, with a couple of minor surprises...

— The first is that the definition of a ‘new build’ will include anything gaining a CCC after 27 March 2020 rather than 2021, effectively backdating this a year. This is good news for people who finished a project after this date but still leave properties finished before this with no interest deductibility. — Another interesting quirk is the 20-year timeline for deductibility passed from property owner to property owner. This will create the need to track yet another day- count and will no doubt need to feature as a warranty in the sale-and-purchase agreement regarding how much time a buyer has left in the 20-year deductibility window, which is not reset as property passes from owner to owner.

While the bill will still go through a final consultation process, we now have a degree of certainty around how the rules will work. Based on this, it’s possible to consider what some of the market impacts might be and think about the opportunities and challenges investors can now respond to. Whilst my own crystal ball is no clearer than anyone else’s, here are a few thoughts and suggestions on what I think the impacts will be, along with some strategies.

Firstly, let’s face facts. Nobody should accept a taxing outcome where they pay tax on an income that doesn’t actually exist without considering making a change.

Selling and de-leveraging should at least be considered.

The combined impact of rising interest rates and the removal of the deductibility of that interest on existing stock properties will have a significant cash flow impact on investors, many of who seem remarkably slow to react to the changes before us.

Consider this example:

Until recently, we have enjoyed interest rates as low as 2.5 Percent. Take an existing stock rental property purchased for $1m, with borrowed money at 2.5% that yields a net 3%. Net rent is $30,000, and interest costs are $25,000, producing a taxable profit of $5,000. Tax is $1,650.

Now consider what happens if interest rates double to 5%, as predicted, and interest deductibility is removed.

Rent remains at $30,000. Interest costs climb to $50,000, creating an actual loss of $20,000. This loss is already ring-fenced by existing legislation. But without deductibility of interest, the investor must pay a tax of $16,500 on the rental without the benefit of the tax deduction.

This pushes the cash deficit from the property to $36,500. In addition, for the opportunity to sell at a capital gain, this regime needs to be sustained for ten years.

For many, this scenario will prove untenable.

I believe the risk of rising interest rates and the certainty that deductibility on existing residential stock is being removed should be used as a motivator to review the actual yields you are getting on your properties relative to their values – and consider the upside of de- leveraging by selling low yielding properties.

Not only will this strategy improve your actual cash flow, but it will also reduce the impact of the removal of interest deductibility.

Right now, there is a lack of listings and plenty of buyer demand, so gaining a positive outcome that will make a material difference to your cash flow is there for the taking for many investors willing to contemplate a sale.

Perhaps this is step one of a strategy to then re-borrow for a new build. Remember, a new build is not just a brand-new acquisition. It includes converting one dwelling into two flats. It also includes subdividing an existing property and adding a new minor dwelling. Subdividing comes with the added benefit of no Brightline reset.

So, the message here is, consider polishing some of the gold nuggets you are already holding with projects that don’t trigger Brightline complications and are supported by continued deductibility of interest.

If you are considering a new build, pause and think. Yes, the five-year Brightline and deductibility are great, but are you paying a premium for the property compared to an existing one?

There are also a lot of inexperienced developers entering the fray and warnings from the construction industry about shortcuts being taken.

Consider the supply chain and labour shortages and consider whether construction contracts can be re-priced if prices rise. There are already suggestions from the construction industry that it will become impossible to get fixed priced contracts in this climate. On the finance front, remember you can’t lock in an interest rate on a building project until completion and rates are set to rise between now and then.

Also, think of the artificiality that these tax changes are going to create in the market. There will be vast numbers of infill terrace houses built in response to the tax incentives. However, current projections are that the current population growth does not demand this level of building, meaning we could quickly end up with an oversupply.

I worry that should that happen, the Government may not repeal their tax policy because it might be viewed as a political change of heart. So, the lever thrown today to distort the market will almost certainly have an unintended consequence tomorrow if it’s left in gear too long.

The mere fact that the tax system is being used as a tool to impact house prices is a risk in and of itself. Once tax law is altered unfairly to create winners and losers, you have the flow-on problem of turning the winners back into losers if the rules are changed back by a different government.

Do we really believe the current setting to allow interest deductibility on new builds to carry forward over 20 years won’t be altered by politicians over that time? You only have to look at the fact that the Brightline has been moved from two years to five years, and now to ten years, to see that nothing lasts when politicians look to the tax system to drive their own agenda.

Lastly, pause to consider investing in commercial property. No-loss ring-fencing, no Brightline, no limit on the deductibility of interest, and, would you believe, even a tax deduction for depreciation on the building and an extensive list of fit-outs.

Sound like the good old days? Well, that is still the tax reality of commercial property, which, at an entry-level, could be as simple as an $80,000 carpark.

Yes, the prices have risen as yields have fallen, but they are still typically better than residential, combined with the advantage that the tenant pays the outgoings with net leases.

Could now be the time to roll up your sleeves and sell some of those low-yielding residential properties currently funded with debt, which are soon to become non- deductible, and buy some higher-yielding commercial property that has none of the associated complications with tax?

 

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