Recent changes to the bright-line test and mortgage interest deductibility in New Zealand (NZ) have created some consternation. As expected, we’ve heard commentary from various sides of the political debate, from investors and homeowners, expressing different viewpoints. Predictably also these viewpoints tend to align with the motivations and agenda of the speaker.

Policy changes of this nature are an effort to tame runaway house prices for the benefit of owner-occupiers. Understandably that is the Government’s motive given NZ has some of the most unaffordable housing in the developed world. But there is always another side of the story. Landlords and Property investors have argued that following the changes, being a residential landlord is now the only commercial activity in NZ which is unable to deduct interest from expenses. Is it really fair to make an exception for landlords relative to every other commercial enterprise?

The answer is probably yes - residential housing is different from other forms of property investing, and other forms of commercial activity. On this basis, differential tax treatment can perhaps be justified.

Not to argue that removing interest deductibility of mortgages is strictly the right approach, mind you. Simply that treating residential investment differently from other commercial activities from a tax perspective, perhaps has a sensible theoretical underpinning.

Would-be landlords compete in a market where non-commercial factors are particularly relevant

Owner-occupiers (people who live in and buy their own homes) are influenced heavily by non-commercial factors e.g. availability of good schooling, lifestyle, or proximity to family. Not to say commercial considerations (likelihood and magnitude of profit) are not relevant, but these are typically of lesser concern for an owner-occupier than would be the case for a landlord. Owner-occupiers also do not benefit from interest deductibility themselves - who gets to take mortgage payments off their personal tax bill? Nobody

In this context, one could argue that an exception is made for residential property landlords, relative to other commercial activities. After all, most other commercial investment is undertaken in the context of a market which itself is profit-driven and commercially dominated. To illustrate – if one restaurant opens up next to another, it can be reasonably assumed that both restaurant owners are commercial and looking to maximise their profits (within personal moral, and legal constraints). The same cannot be said for residential housing.

Do residential property investors create value?

Residential property investment is a commercial activity, but the definition is a struggle. “Investment” which involves the purchase of Existing Housing Stock, often isn’t really about value creation, so much as it is a levered attempt at profiting from the value created by others. Contrast the following:

1. Property investor purchases an existing property for $1 million. Over the next ten years, the property owner benefits significantly from new public investment in infrastructure, private investment in amenities, and changes in zoning restrictions making the land more valuable. The investor does little to add to the value of the property itself and sells the property after ten years for $2 million.
2. Restauranteur starts a restaurant that after 10 years employs four additional staff and generates profits (after all expenses and tax) of $100,000 per annum. Over the preceding 10 years, the restaurant owner is required to undertake a wide range of activities in order to execute effectively on the restaurant business, including marketing, compliance, HR management, accounting (not to mention cooking good food that people want to pay for time and time again). At the end of ten years, the restaurant owner decides to do something different and sells the business for $1 million.

Both enterprises in the hypothetical scenarios above have made a capital gain of $1 million, but one would be hard-pressed to argue the property investor has done as much to “earn” their profit as the restaurant owner. Both activities are commercial, but the former has done little to create value, compared to the latter. In fact, it is wider society (including in no small part the taxpayer) that may have created value in the case of the former scenario e.g. through motorway development.

Property is an asset where the value is often endowed externally, rather than being created by the owners and employees. So why should society tax property the same as other commercial enterprises when a large proportion of the returns to investment property are created by society, rather than the landlord? Not to say that landlords do nothing to earn an investment return. There is work and risk involved in owning an investment property. But it's not the same as other commercial activities.

When is sympathy warranted?

Nonetheless, there are situations for landlords that warrant sympathy too, and that’s when landlords/investors themselves create value. This is usually done in the form of capital expenditure, e.g. renovating a house to make it more liveable. Landlords may also take on a role more akin to that of property developers - extensively renovating or rebuilding existing housing stock to accommodate additional people or simply demolishing existing housing stock to make way for more.

In these situations, Residential Property Investors should be treated more like commercial businesses. Hopefully, adequate provision exists under the new regime to allow commercial property investors who engage in material and sustained value creation to deduct interest, take capital gains, and be treated comparably to other commercial enterprises.

It's not the same...

Landlords do provide a service to society, investing and risking their capital to provide housing to those who choose not to purchase, or can’t afford to. But just because this activity is commercially minded doesn’t mean it has to be taxed like any other commercial activity. The nature of the market in which residential property investors operate needs to be considered, as does the question of who is creating what value.

Residential properties are homes, these are the places New Zealanders live, underpinning the wider health and wellbeing of our whole society. Accordingly, their affordability is crucial. It's good to see this better reflected in the tax system.

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