Confusion still reigns over Capital Gains
With no comprehensive capital gains tax to be implemented and letters from armchair experts filling the local papers, it is timely to familiarise ourselves with the current laws in relation to capital gains on the sale of land. We expect that these rules will be strongly enforced as a result of the Government not introducing a comprehensive capital gains tax.
New Zealand has a body of capital gains tax laws regarding the sale of property. In addition, Inland Revenue operate a “property compliance team” whose job it is to review property transactions to ensure they have been taxed correctly. Gone are the days where you can buy a house, do it up and flick it on “tax free”. You might not return the profit for tax purposes, you might not even get caught straightaway, but it does seem that the chances of getting caught at some stage are rapidly increasing.
For quite some time now, Inland Revenue has been receiving data regarding land transactions in New Zealand. There is now also the added requirement to provide an IRD number with certain property purchases. This means Inland Revenue receives the information even faster. If you have failed to return tax on the sale of a property transaction and it is discovered at a later date, there will be additional penalties and interest to add to the initial tax amount.
There seems to be a lot of misunderstanding about what is and is not taxable in relation to the sale of property, and just because someone else did not pay tax does not mean they were not required to do so, or that they will not be caught at a later date. The land tax rules are extremely complex, and the application is based on the relevant facts of each specific case.
It is important to note that the burden of proof in civil tax matters sits with the taxpayer. This means the taxpayer is required to prove that on the balance of probabilities, they are correct. Inland Revenue does not need to prove anything for civil tax matters. The standard of proof is not a case of just showing that Inland Revenue is wrong, the taxpayer needs to prove the correct tax figure.
So, exactly what sales are subject to tax?
The cornerstone principle is that any property acquired with an intention or purpose of sale will be taxable upon sale. This does NOT need to be the dominant intention or purpose. That intention or purpose does not even need to eventuate. The test is whether there was an intention or purpose of sale at the time of acquisition. Such an intention or purpose will mean the property is held on revenue account and will be taxable upon sale. It is important to note that Inland Revenue has the benefit of hindsight when looking to assess tax. Any property purchased and sold within a reasonably short period of time could be reviewed by Inland Revenue. Inland Revenue will then often start to gather information from third parties before contacting the taxpayer. It is common for Inland Revenue to obtain a copy of the bank’s lending documents which may hold clues as to the taxpayer’s intentions or purpose.
Any “undertaking or scheme to develop or divide land commenced within 10 years of acquisition” may be subject to tax upon sale. In this case, the undertaking or scheme need not be carried on as a “business” but if it involves development of the land or division into lots and the work is more than minor, then it is likely to be subject to tax. The key consideration in this situation is whether or not the work is more than minor. The courts have held that a wide scope of subdivisional activities, including legal and engineering work will be considered when determining whether the work is of a minor nature or not. This will involve an overall assessment of various detail such as time, effort and costs involved, both in absolute terms and in relation to the nature and value of the land where the work is undertaken. Given the rising costs of development and associated work, it seems that more developments and divisions are being captured by this tax rule, meaning any profit is taxable.
For land owned for ten or more years, tax will be imposed on profits if it is disposed of as part of an “undertaking or scheme involving a development activity where there is significant expenditure on channelling, contouring, drainage, earthworks, kerbing, levelling, roading or any other amenity, service or work customarily undertaken or provided in major projects involving the development of land for commercial, industrial or residential purposes”. We have seen Inland Revenue apply this provision to tax small developments of only a few sections where the costs involved in the relevant works were high.
People have been caught out post the Canterbury Earthquakes where a lot of land was rezoned. This is due to the fact that the sale of a property will be taxable where at least 20% of the gain on disposal is attributable to the influence of zoning changes. It is a question of fact as to whether the gain is attributable to the re-zoning, and a valuer should be engaged to advise on this. There is a 10% discount for each full year of ownership, and after the tenth year of ownership this provision will not apply.
There are also provisions within the Income Tax Act which relate to the sale of land to associated parties. If a property is held on revenue account then, if it is transferred to an associated party, it will remain on revenue account regardless of the new owner’s intentions, purpose or use of the property. This often catches people out when they purchase a property in one entity with the intention to transfer it at a later date. This would mean the original purchaser has acquired it with an intention of disposal (to the associated party). The associated party then acquires that property and it will remain on revenue account. While there may not be a gain between the initial purchase and the transfer and, therefore, little tax to pay, the fact that the new owner will then hold that property on revenue account forever is a huge problem.
There are a number of exclusions to the above rules, the main ones being the residential land exclusion and the business premises exclusions. It is important to note that in some circumstances, the family home will not benefit from the exemption where it is owned in either a company or even a family trust.
The above rules set out the “land tax” rules. However, there is a blanket “catch-all” known as the bright-line test. This is essentially a capital gains tax in disguise. Previously, the bright-line test applied to tax all properties disposed of within five years of acquisition. New Rules announced the extension of that test from five to 10 years. See this article for more information on the changes to the bright-line test. The bright-line test provides that any property sold within 10 years of acquisition will be taxable upon sale regardless of the intent when purchased. The bright-line test for properties acquired before 27 March 2021 is five years, not ten. The old, five year rule is also applied if the offer was made on or before 23 March 2021 and the offer could not be revoked before 27 March 2021.
There are some exclusions to the bright-line test such as a transfer pursuant to the relationship property agreement or an inheritance. The main exclusion is known as the main home exemption and this exclusion is not as simple as some might think There are issues when the property is owned by the trust, it does not apply at all when the property is owned by a company, and there are rules about when it will apply to individuals.
The main home exclusion was also changed when the bright-line test was extended to 10 years. Under the previous rules (and the rules that still apply to those properties grand-parented under the five year bright-line test) a property was either treated as a main home with a full exemption to the bright-line tax, or it would not be a main home. The exclusion applies as long as the property was used as the owner’s main home for more than 50 percent of the bright-line period. The new main home exemption that applies to those properties captured under the 10 year bright-line test means that the exemption will no longer apply on an all or nothing basis, but instead will apply for the period the property is used as the owner’s main home. See this article for more information on the main home exemption.
New Zealand does tax the capital gains on property in many circumstances, it is just not well understood and the application is complex. It is, therefore, likely that whatever you hear down at the local pub or at a bbq is inaccurate, and certainly shouldn’t be relied upon. Specific tax advice should be sought to ensure you are aware of your tax obligations in relation to the sale of any property. You might not know your tax position, but Inland Revenue most likely will.
The above is intended for informational purposes only and should not replace specific tax advice. For personalised advice on all tax issues please contact Julia Johnston at Saunders & Co.