Taxing Capital Gain – the IRD is coming for you

So.  In simple terms, people currently pay tax on capital gain if they acquired the property with the intention of resale -ie they are property traders, so profits made on resale are taxable.  Or they sell within 2 years and fall within the “brightline” test.

Most property investors, however, acquire property with two intentions.  Firstly, to hold as an investment property.  Secondly, at some point in the future to sell and take the capital gain tax free.   Maybe you, the reader, intend only to hold property as an investment and never intended selling at any point…that’s fair enough, and in commercial property that is often the case – commercial property operators tend to have a longer term view, and rent on commercial property is usually positive.

But with regard to residential property, it is my experience you would be in a small minority.  The profit in residential property investment comes overwhelmingly in capital gain which at some stage generally has to be realised by selling something, as opposed to borrowing against the capital gain to buy more property.  People look forward to the day they can cash up some of that gain and enjoy the lifestyle that goes with it, and so they should.

However, it has always been a bad idea to admit this.  It is now doubly so, with the release of the IRD’s latest consultation paper: PUB00260: Income tax – land acquired for a purpose or with an intention of disposal.

8. As noted above, an amount that you derive on the disposal of land will be income under s CB 6 if you acquired the land for a purpose or with an intention of disposing of it. But remember that there are exclusions for residential land and business premises that might apply (see [5]).

9. The key things to bear in mind in deciding if s CB 6 applies are:
What matters is your purpose or intention when you acquired the land.

• A purpose or intention of disposing of the land does not need to be the only purpose or intention you had when you acquired the land. It also does not need to be your dominant or main purpose or intention. It is enough if disposal is one of your purposes or intentions.
•  Disposing of the land has to be more than a vague idea or just a possibility or option in the future. You have to have a firm purpose or intention of disposing of the land.
• The test of whether you had a purpose or intention of disposing of the land is subjective. But what you say your purpose or intention was will be assessed against all of the circumstances.
• Evidence of what your purpose or intention was before you acquired the land (eg, during the whole acquisition process) can be taken into account.
• The extent of commitments you make or steps you take shortly after you acquired the land may be relevant in testing what your subjective purpose or intention was.
• The length of time you held the land may also be taken into account, and if you have a pattern of acquiring and disposing of land within relatively short timeframes, that is likely to be relevant.
• The onus is on you to show that you did not acquire the land for a purpose or with an intention of disposing of it.

 

Sure, you need to have a “firm purpose or intention of disposing” of the land….but note that the onus is on you to prove you did not acquire the land with an intention of one day disposing of it, not on the IRD.Then we get to the examples, and Example 5 is also worth reading.

Example 5 – More than one purpose or intention
54. Chris purchased a property in August 2012. The property was marketed as being an attractive investment – ideal as a rental property, and expected to have “great annual capital growth”. Chris decided to buy the property to rent it out for three to five years, by which stage he hoped to be able to realise a capital gain on the property. Chris has paid tax on the rental income. He sold the property in October 2015 for a sizeable profit.

55. The 2-year “bright-line” rule does not apply to the sale of the property, because it was acquired before 1 October 2015. Even if the property had been acquired on or after 1 October 2015, the 2-year “bright-line” rule would not apply because the property was not sold within two years of being acquired. Therefore, in those circumstances it would still be necessary to consider s CB 6.

56. An amount that a person derives on the disposal of land will be income under s CB 6 if they acquired the land for a purpose or with an intention of disposing of it. A purpose or intention of disposing of the land does not need to be the only purpose or intention the person had when they acquired the land. It also does not need to be their dominant or main purpose or intention. It is enough if disposal is one of their purposes or intentions.

57. Chris was attracted to invest in the property in question because it was expected to have great annual capital growth, and could be rented out in the meantime. He purchased the property with the purpose of renting it out in the short-medium term and then selling it to realise the expected capital gain.

58. It does not matter that Chris acquired the property for more than one purpose, and disposal was only one of those purposes. When he acquired the property, Chris had a firm purpose of disposing of it in three to five years to hopefully make a capital gain.

59. Neither the residential exclusion (s CB 16) nor the business exclusion (s CB 19) apply in respect of the property, because Chris did not live in it or carry on a business from it.

60. The proceeds on the sale of the property are therefore income to Chris under s CB 6.

61. It is not relevant that the rental income was subject to tax – the Act taxes rental income as well as the proceeds on the sale of the property.

62. Chris can get a deduction against the sale proceeds for the amount he paid to acquire the property and for any capital improvements he made to the property. In each year he owned the property he will also have been allowed to deduct the interest on the money he borrowed to purchase the property, the cost of insurance on the property, and the cost of any repairs and maintenance on the property that were not capital in nature.

So…you only need to have disposal as one intention, and the onus is on you to prove you didn’t intend to dispose of the property.  There is an arguable case to be made that, in Auckland at least, every purchase of residential property, particularly those that are cashflow negative, is made with an intention of resale.

Ok, this is only a consultation paper.  However I would wager that it already represents IRD policy in practical reality.  It has a short consultation time and I expect will be acted on soon if it isn’t already.

Please note that there is a common misconception that holding a property for 10 years gets you off the hook.  It doesn’t.  That only applies where you are associated with a developer or trader and are “tainted” by that association such that a sale would be taxable.  If you hold the property for ten years, you get past the tainting.  But holding for ten years doesn’t do anything if you purchased a property with intentions that included selling in future.

Best practice, I suggest, will be for you to get your lawyer to record in a File Note that you have come to them about purchasing an investment property for long term holding, and that you intend to hold the property for future generations. Say so to them in an email.  Print and retain the email with your file on the property.  You need something to satisfy your onus to show that on acquisition you did not intend to dispose of the property, and your lawyer producing a record of a conversation where you relayed exactly that will help considerably.  It won’t save you if you’ve purchased twenty properties over the last ten years and sold them all after two years, but it will help the average investor who has built up a housing portfolio and now wants to get some personal reward.

As always, caution is the watchword!