28/03/2024·2 mins to read

Full interest deductibility for residential rental properties returns but no change to loss ring-fencing

There has been much discussion and speculation about the restoration of full deductibility of interest incurred by landlords in financing residential rental property (RRP). In part, this is because of wrangling between coalition partners as to the commencement date of the restoration, how much additional interest would become deductible at commencement, and when full deductibility would be reintroduced.  

There has been less attention on what it means in practice for RRP investors, and how pre-existing loss fencing rules will significantly erode the benefits of full interest deductibility for some.

The current interest limitation rules

For RRP acquired before 27 March 2021 and borrowings drawn down before 27 March 2021 (Grandparented Transitional Loans), the previous Government began phasing out interest deductibility from 1 October 2021, with 75% of interest incurred deductible until 31 March 2023.  For the tax year ended/ending 31 March 2024, interest deductibility on Grandparented Transitional Loans reduced to 50%.  

For other RRP acquired on or after 27 March 2021, interest deductions have been denied in full from 1 October 2021.  

The interest limitation rules incorporate some significant carve-outs.  They have never applied to interest incurred on business premises, build-to-rent land, land used for social, emergency, council or transitional housing, and land held by property developers.

So what is changing?

Under a recent amendment paper to a tax bill that is expected to be passed over the next couple of days, the interest limitation rules will be curbed in the first instance, with 80% of interest incurred on RRP loans being deductible for the 2024/25 tax year (1 April 2024 to 31 March 2025), regardless of when the RRP was acquired.  From 1 April 2025, the interest limitation rules introduced in 2021 will be fully repealed.  Here is a summary: 

Interest incurred on …

1 April 2023 –
31 March 2024

1 April 2024 –
31 March 2025

From 1 April 2025

Grandparented transitional loans

50% of interest deductible

80% of interest deductible

100% of interest deductible

Loans for RRP acquired on/after 27/3/21

0% of interest

80% of interest deductible

100% of interest deductible

But ring-fencing remains

A point that has been overlooked in some media discussion is that the Government has not proposed any relaxation of tax rules that “ring-fence” RRP expenditure and losses.

Under the ring-fencing rules, allowable deductions for interest and all other expenditure associated with holding RRP, or for a loss on its disposal (where the disposal is a taxable event, under the bright-line rules or otherwise) can only be taken against rental income derived from RRP, or taxable RRP sale profits (where applicable).  

To the extent that allowable deductions exceed such income, the deductions are suspended and the excess expenditure can only be carried forward to later years to be taken against future RRP income.  They cannot be offset against the owner’s other income, such as income from employment or from other business activity.  

Even with interest deductions fully restored in theory by the removal of the interest limitation rules, in a high interest rate environment ring-fencing is likely to impact many RRP investors who find themselves to be negatively-geared, with interest together with other deductible costs exceeding rental income.  For such investors, deductions for interest and other deductible costs in excess of rental income will remain suspended and carried forward as described above.

For negatively-geared RRP owners, ring-fencing therefore has a very significant impact.  It erodes the benefit of otherwise full interest deductibility by denying a current year cash tax saving on non-RRP income, which saving would otherwise effectively partly compensate the owner for the negative cashflow position on the RRP investment.  To make it rational to retain the investment, an owner in such a position would need to be confident that underlying long-term capital gains will outstrip current and medium-term cash leakage, taking into account the time value of money. 

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