New Zealanders love our property. When we think about increasing personal wealth, buying our own home then starting a rental portfolio with additional property purchases is a common trajectory.
Rising interest rates coupled with changes to rental regulations particularly gradual removal of interest deductibility on existing rentals are making it harder for rental property owners to continue making money on their investments.
In fact, in many cases rental properties are now costing their owners money.
So, what are these changes, and how will they impact your rental portfolio? Firstly, let’s look at how you should be managing your portfolio now.
Rental property status quo
Just like any business landlords historically have been able to claim their interest expenses as a cost against their rental income. Labour has changed the regulations removing interest deductibility for rental properties meaning that the main expense of owning a rental (loan interest) isn’t tax deductible. This means landlords will be paying much higher tax on their rentals as the main deduction (interest expense) is no longer allowed so the income increases on paper.
For example, look at an interest-only $800,000 home loan on a rental worth $1.2m that earns a weekly income of $750 per week. The annual income is $39,000. Interest on the $800,000 home loan at 2.25% adds up to $18,000. Other costs like rates, maintenance, insurance, or engaging in the services of a property manager or accountant might add up to $10,000 for the year.
In total, expenses add up to $28,000 which makes your total profit for the year $11,000. At a 33% tax rate, your tax bill for that property will equal $3,630, an amount that can easily be covered by your profit (although this amount will vary according to your personal tax rate).
This is why owning rental properties has historically been so attractive. Landlords have been able to increase their personal wealth without having to pay as much tax. When the time comes to free up capital, they can sell a property and realise significant capital gain.
Understanding the new rules
Interest can no longer be claimed as an expense for properties purchased on or after 27th March 2021. For rental properties that were purchased before 27th March 2021, interest deductibility is being phased out over four years, ending on 31st March 2025.
Furthermore, new rules set out by the Credit Contracts and Consumer Finance Act (CCCFA) have made it harder to extend interest-only loans with banks because they’re more likely to take a conservative approach and often require full lending assessments to obtain approval for extensions.
Look at the same interest-only $800,000 home loan on a rental worth $1.2m that earns a weekly income of $750 per week and incurs annual expenses of $10,000. Because the interest amount of $18,000 is no longer deductible, your profit on the property increases from $11,000 to $29,000. At a 33% tax rate, your tax bill for that property will equal $9,570 (although this amount will vary according to your personal tax rate). Subtract interest and tax from your profit and that leaves you with very little – a little over a grand.
As interest rates increase, let’s do the math again. For a $800,000 home loan at 5.5%, you’ll accrue $44,000 on interest. If you continue to earn $39,000 in rent annually and spend $10,000 in maintenance and other rental-related expenses, your profit now reverses to a deficit of $15,000.
It will now cost you $15,000 annually to cover the expenses associated with that property.
On top of this the interest isn’t tax deductible, so for tax, your rental income is $39,000 in rent less just the maintenance expense of $10,000 = $29,000 and you incur a tax bill of $9,570 at 33% tax.
Your total costs to hold the same property are now circa $25,000 per annum. This cost needs to be covered somehow, which could have a significant impact on your financial situation.
6 ways to make home loan changes work for your rental
For property owners with at least one rental, these changes could create a major dent in your property income stream. So, how can you mitigate these changes?
- Apply for an interest-only extension with your bank with a maximum term of five years. While this often requires a full lending assessment, it could help minimise principle payments and reduce outgoings on rental property mortgages while interest rates continue to rise and help avoid the need to chip in personal income to cover mortgage repayments.
- Refinance your mortgage. Refinancing with another bank can be an effective way to get an interest-only loan approved on all loan suffixes, usually for a maximum term of five years. Depending on the size of your loan, you could also receive a cash incentive and competitive rates for refinancing.
- Open a revolving credit facility. A revolving credit account could be useful as a buffer to fund any losses or to provide back-up funds if required.
- Reassess your loan terms. If you don’t qualify for interest-only loan terms, you may be able to reduce your mortgage repayments another way. If you have owned a rental for many years and have been making accelerated repayments or lump sum payments, you could be eligible to push your loan terms out to 30 years again, which could help to reduce repayments.
- Review your personal home loan. While your personal home loan might not have any bearing on your rental property debt, you may be able to free up some cash there too. Temporarily reduce mortgage costs and free up some cash by extending your loan out to 30 years or put lending on interest-only for up to two years.
- Review your rentals. If need be, consider selling a rental property to reduce debt and help with cashflow, or reinvest to new rentals or commercial property where the interest would be deductible. Before going down this path, though, always check with your broker first. Depending on the level of your debt, you may be required to give the bank the full proceeds of any property you sell to meet the bank’s ongoing loan servicing and LVR rules, so do your research thoroughly first.
The changes explained
Interest deductibility changes have been implemented to help soften the housing market and make it easier for first home buyers and lower income-earners to buy property. Property investors may have less incentive to buy more property because tax benefits may no longer apply, so more property will be available for other people to get into the market.
It’s important to note that the new rules don’t apply to the same extent as ‘new builds’ which are defined as property that received its Code of Compliance on or after 27 March 2020. Interest relating to new builds is eligible to be deducted for up to 20 years from the date of the CoC.
These changes will impact property investors. Navigating the rental property market in 2022 is a bit of a minefield, so we recommend seeking help before attempting to do it yourself.
Here at Threefold, our team of advisers understand the ins and outs of home loans and the changes that impact rental properties.
Because we work closely with all the major banks and lenders, we can negotiate the best rates for you, making your rental portfolio easier to manage and more likely to earn you money.
To find out more details on how you can navigate the changing rental property market, request your free consultation below and one of our trusted team will be more than happy to help.