Which is worse – a rental income tax or an interest rate hike?

COMMENT: For a long time, pre-2013, the Government and the Reserve Bank only really used one lever to control the heat of the property market: interest rates. You don’t have to be very old to remember the days of 11% rates. In fact, many Kiwis will still remember rates of 20% or more in the 1980s.

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Increasing interest rates is a slow burn, though. An instant increase of one percentage point on interest rates - which would be one of the larger one-step increases in New Zealand’s history - could take mortgage rates from 2.3% to 3.3%. Would that stop people buying? My guess is no, and that the general enthusiasm currently in the market would continue.

Which brings us to the Government’s decision to implement a tax on rental income. Most market commentators agree that the new rule will put the brakes on the market, but is that because the tax will hit investors harder than an interest rate hike?

Let run some numbers. Take, for example, an $800,000 property where the full purchase amount has been borrowed - a common scenario for investors where 60% is borrowed against the new property and the remaining 40% is borrowed against existing properties.

On an $800,000 loan, an increase in interest rates of one percentage point would mean an extra $8000 in interest payments the following year.

However, let’s say that same property had a 3% rental yield - common in Auckland and increasingly common in other cities. This equates to rental income of $24,000 a year and, assuming a tax rate of 33%, a tax bill of $7,920. For the sake of simple maths, let’s say there were no other deductions and prior to the tax change, the property broke even. That’s near enough the same as the extra costs incurred by a one percentage point increase in interest rates.

So, why bring in this new tax rule and not just raise interest rates? Well, tax just seems to have a larger psychological effect on people, and is more polarising than an increase in interest rates. And the heat of the market right now is largely a psychological phenomenon. Buyers have been worried about missing out, no matter the cost of a property.

Secondly, this tax targets investors and not first home buyers. Raising interest rates would affect all buyers equally.

Thirdly, in the future the Reserve Bank can still increase interest rates. If the recent announcements don’t take enough heat out of the market, then an interest rate hike would be a double whammy for investors.

My view (and bear in mind I’m not an accountant by any stretch of the imagination) is that the tax change is psychologically effective because it seems unfair. Interest on a mortgage that has been raised for investment purposes should, in the minds of most investors, be deductible. That’s how it works in other businesses so taking that deductibility away seems like a major blow. Whereas interest paid on a mortgage is just a cost of doing business and an extra percentage point is just an additional cost that is more easily swallowed. Even the brightline test was an easier pill to swallow because tax on profit is how it all usually works.

The next effect of the tax changes will be how the banks change their affordability calculations. Not only will the announcement therefore take some enthusiasm away from investors, it will also make finance slightly trickier for the remaining investment buyers. Time will tell if it’s enough to affect the market.

- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.