So people investing in housing get both a tax advantage on interest, and an untaxed capital gain.
It seems obvious that we could use a tax mechanism to mitigate this problem.
Ideally, a tax-based response to the housing crisis will affect only speculators, it won't have perverse consequences, and it will be consistent with other tax laws.
One suggested mechanism is a "deemed rate of return".
Instead of calculating the actual income and expenses on a property, investors are deemed to earn a certain percentage of the property's value.
For example, investors might be deemed to earn 5 per cent on the value of their property, and they would be taxed on that amount, no matter how much they had spent on interest.
But this has the perverse consequence that landlords won't be able to deduct other expenses either, such as repairs and maintenance. Landlords could be reluctant to spend any money at all, leaving tenants in miserable houses.
Another approach is to disallow deductions for interest. However, this is inconsistent with how other business expenses are treated. It would also have a highly negative effect on investors all through the country, not just in Auckland where the highest capital gains are being earned.
I think that we should look to the well-established principle of apportionment to devise a tax mechanism for the Auckland property market.
Tax law routinely requires businesses to apportion expenses between private and business activities, between taxed and untaxed activities, and between local and foreign enterprises.
Although investors in the property market claim otherwise, it seems obvious that at least part of their reason for investing is to collect untaxed capital gains. If those gains are untaxed, then it seems unfair for them to be able to deduct the full cost of any interest.
I suggest that we allow a proportional deduction for interest on residential rental properties. If a person's own investment is equal to the amount borrowed for the property, then they could get a full interest deduction.
But if the owner has put in only, say, 25 per cent of the cost price, and the bank is putting the other 75 per cent in, then the investor would only get a partial deduction, of, say, half the interest expense. The lower the owner's investment in the property, the lower their interest deduction would be.
Over time, as the investor reduces the amount owed through mortgage payments, they would be able to claim a higher proportion of the interest expense.
One group of people could be negatively affected by this type of mechanism. Some people who own rental properties are "accidental investors", such as people relocating from one town to another who have been unable to sell their home.
However, these people could be allowed time to rearrange their affairs.
A three-year exemption from the proportional deduction rule for houses that have been a family home should be sufficient to protect them.
A proportional deduction rule for interest has one further advantage.
People who buy multiple rental properties often put their hands on their hearts, and swear that they're doing it for the long-term income stream, not to make a capital gain through buying and selling. This proposal takes them at their word.
• Deborah Russell is a senior lecturer in taxation at Massey University.
