Capital gains tax lifts its ugly head

July 11, 2008

News — Tags: , , — admin

There is no capital gains tax in New Zealand – but it seems that nobody has told the Government.

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.

1 Comment »

  1. […] is a process called Tainting (Andrew King talks a little about this here) by which you could become classed as a trader and, therefore, have to pay income tax on the […]

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