Tax rules tabled in Parliament recently will affect many property investors and, once enacted, will widen the net that taxes capital gains on the sale of rental properties in some circumstances. Are capital gains from properties taxable?

New Zealanders love rental property, and it is well known that no tax is payable on capital gains made on the sale of rentals in most circumstances.

But there are longstanding rules that tax profits on the sale of properties where a taxpayer is in the business of developing, dealing in, or building properties. These rules are necessary because they tax business income rather than capital profits from long-term investments.

There are many entrepreneurial New Zealanders involved in both types of activity – they earn regular income from taxable property activities (development, for example), and also hold rental properties for long-term investment. There are rules which generally tax capital gains made by these investors on the sale of their rental properties.

The capital gains are taxed if the person or entity (a company or trust, for example) selling the rental property is “associated with” the person or entity operating the taxable property activities. This is commonly referred to as “tainting” of the rental properties for tax purposes.

It can be illustrated through a simple example. Bob has a building business. He also owns a company which holds rental properties for long-term investment. Because of Bob’s common ownership, the rental properties are “tainted” by the building business. This means capital gains on the sale of the rental properties will generally be taxable to the company.

Under current rules, taxpayers like Bob could have legitimately structured their affairs to ensure rental properties are not tainted. Many taxpayers do this.

Such a structure often involves the use of one or more trust and/or company to ensure rental properties are not “associated with” the taxable property activities.

These taxpayers can therefore ensure that (like other New Zealanders) they do not pay tax on the sale of their rentals and so they are not disadvantaged merely by the fact that they carry out other property activities. So what is changing?

The Government is cracking down on taxpayers who have structured their affairs to ensure rental properties are not tainted.

They are doing this by widening the rules that determine whether one person or entity is associated with another, making many existing structures ineffective from a tax perspective for future property purchases. What should you do now?

If you think you may be affected by the changes, your first step is to understand how.

There are limitations in current and proposed rules which may mean it’s not time to write that cheque to the IRD just yet.

First, if you have rental properties that are tainted, tax will generally be payable only on the sale of a property if it is sold within 10 years of purchase. Capital gains on rental properties held for longer are generally still tax-free.

Second, your existing property portfolio will not be affected by the new rules. If you have a structure that means your current rental properties are not tainted, the new rules will not affect them.

The new rules will apply only to property purchases from April 1, 2009 onward (or, in the case of builders, to property improvements made after that date). This gives you the opportunity to talk to your accountant to understand the impact of the changes. Why have the changes been made?

The Government’s press release stated that the changes were intended “to close gaps in the definition relating to land sales that allow land dealers, developers and builders to circumvent the rules by operating through connected persons”.

In our view, the changes will not be well received.

Land dealers, developers and builders have previously been allowed to structure their affairs to avoid tainting of rental properties so that they are not placed at a disadvantage to other taxpayers.

The controversial draft legislation is a fundamental shift in tax policy that will be seen by many as another step closer to a capital gains tax.

* Chris Leatham is a director at PricewaterhouseCoopers in Wellington, specialising in the taxation of property transactions.

Revenue Minister Peter Dunne and IRD officials appeared before the finance select committee today and were quizzed about why people had the impression that there was some tax advantage in investments in rental housing.

Deputy Commissioner Robin Oliver was blunt: “The short answer there is none.”

Rules about expenses for deducting costs such as interest, upkeep and maintenance, as well as paying tax on income were the same for investments in shares or anything else.

Mr Oliver said the rules were tougher for housing investment than other types.

“In fact under the housing case, the capital gains boundary is brought back a bit. There are tighter rules to what is a capital gain,” Mr Oliver said.

Mr Oliver said the concern appeared to be that housing was easier to get and it was easier to get loans from the bank to invest in property.

“The concern is the level of (debt) gearing that is possible in the house market which… is a matter of the willingness of banks to be laid.

Mr English said Finance Minister Michael Cullen and Reserve Bank Governor Alan Bollard had given the impression that one of the problems fueling inflation were favourable tax laws for investment housing.

Officials and Mr Dunne hinted that people seemed more likely to abuse tax rule in housing investments saying it was an area where they picked up greater non-compliance and clawed more tax back.

The budget had allowed for $14.6 million more in spending by the IRD to crack down on housing tax laws.

“Why is there a widespread view that… housing has a tax advantage,” Mr English asked.

Mr Dunne replied that it seemed to him the belief was part of the national psyche of home ownership and it had been decided by Government to enforce current tax law and not impose new taxes on housing.

Committee chairman Shane Jones said the clear inference from Dr Bollard that part of his “woes” with housing was due to a vagueness with tax law or the way it was enforced.

“What you have told us today is that it is not true,” Mr Jones said.

NZPA

Finance Minister Michael Cullen said Inland Revenue would get an extra $14.6 million over the next three years to strengthen property transaction audits. Speculative activity was driving up house prices and household debt levels, he said. So giving IRD more money would help it enforce the law.

Property auditing gathered $100 million between 2004 and 2006, he said and it was important for IRD to have the resources it needed.

Of the country’s 1.4 million houses, around 400,000 are owned by investors. If a landlord buys with the intention of selling, tax must be paid on any financial windfalls.

Sharon Cuzens from Inland Revenue in Wellington yesterday welcomed the boost.

“It will enable us to pursue further, in-depth investigations and education on a risk area we have been actively targeting for some years,” she said.

IRD would improve information so people were more aware of their liability, monitor major developments to ensure accurate return of sales or profits, boost research and analysis of risk areas and increase audit activity in areas of identified risk, she said.

One housing investment expert also welcomed the Budget package. Andrew King, Property Investors’ Federation vice-president, said speculators who evaded tax were taking high risks. He encouraged those people who were eligible to come clean, declare their profits and pay tax.

“It’s like playing Russian roulette if you don’t,” Mr King said. But he also criticised existing tax law, saying it had too many grey areas.

Matthew Gilligan, an Auckland chartered accountant and specialist tax and legal structures consultant, also welcomed the package, saying IRD was too poor to do its job properly and the money would help.

“They’re grossly under-resourced,” he said, citing long waiting lists for taxpayers seeking rulings and waiting for investigations to be concluded.

Mr Gilligan, whose firm has 4500 property clients investing in residential housing, called for clearer rules on housing investment tax liability. Many IRD staff were excellent but it was not uncommon for staff to change so fast that some taxpayers were dealing with three IRD staff members over one issue, he said.

“That’s not uncommon on an audit.” Nor was it unusual for a taxpayer to be given conflicting advice by various IRD staff members, Mr Gilligan said.

Greg Haddon, a Deloitte tax partner, said the $14.6 million was not nearly enough to tackle the issue.

“This extra money won’t make a big impact,” he said, and failed to address the reasons for so many people investing in housing, because they regarded it as a surer bet than other forms of investment.

IRD has already announced the success of previous crackdowns.

Two years ago, it netted just under $11 million from a campaign in the Queenstown/Otago region. Its concentrated audit blitz on developers and speculators started in March 2004 and by November 2005, it had 120 cases either under investigation or heading for prosecution.

Auckland was also a target two years ago, when IRD said it was increasing resources to hunt down speculators and developers who had kept their profits a secret.

Senior Auckland department official Richard Philp said in January 2005 that an extra $106.6 million was gathered nationally within two years on property transactions, including $52.9 million from Auckland.

The rules

• If you invest for the long term, there is no tax on money when you sell the rental property.
• But if you buy with the main aim of selling for a profit, any money you make is taxable.

First-home buyers wait for Government handout

Prospective first-home buyers hoping for help through a Government-run shared-equity scheme will have to wait a little longer.

Housing Minister Chris Carter said $1.4 million had been allocated in the Budget for work on the potential design of a such a scheme, but a pilot would not be funded until at least next year.

Mr Carter has said the most likely location for a pilot scheme is Auckland and it could involve the Government paying for a 25 per cent or 30 per cent stake in a house, effectively reducing the purchase price of a $400,000 property to about $300,000.

If the house was sold, the Government would take back its percentage share. The scheme is expected to be aimed at the lowest quartile of the housing market.

Mr Carter said the Government was keen to explore how much demand there was for a shared-equity scheme.

If the scheme “flew”, it would be introduced as part of a suite of new measures including a possible Housing Affordability Bill. “Shared equity will also be introduced at the same time as the Government seeks to increase the number of houses in the price bracket affordable to first-home buyers.”

Mr Carter yesterday also announced $43.6 million over four years for other housing initiatives.

That included $23.8 million to increase the life of the Healthy Housing programme and extend it into the Wellington region for the first time.

The programme targets overcrowded households and assists them into more appropriate housing.

The Housing Innovation Fund, which provides government assistance to local authorities and community groups to develop affordable housing, would also receive a boost of $19.8 million.