Bright-line test for sale of residential property - issues paper released

By Jenny Liu and John Wang

On 17 May 2015 the Government announced as part of the Budget 2015, proposals to bolster the existing tax rules and improve compliance in respect of property transactions.  Amongst the compliance measures announced is a “bright-line” test which will tax residential property sold within two years of purchase.

On 29 June 2015 Inland Revenue released a consultation paper detailing the design proposals for the new “bright-line” test.  

The consultation paper seeks public feedback on the suggested details of the bright-line test.  Once Ministers have considered public feedback on the proposed changes, the new rules will be included in a tax bill to be introduced in September this year.  The closing date for submissions is 24 July 2015.

The new rules will apply to residential properties for which an agreement to purchase was entered into on or after 1 October 2015.  The critical date for the application of the new rules is the agreement date rather than settlement date.  Where a property is acquired other than by way of sale, the rules will apply if the registration of title occurs after 1 October 2015.

Property gains that are subject to the new rules will need to be included in an income tax return and will be taxed at ordinary marginal tax rates.

Why is the bright-line test introduced?

The purpose of the bright-line test is to supplement the “intention test” in the current land sale rules that makes gains from the sale of property purchased with the intention of resale, taxable.  Due to its inherent subjectivity the intention test can be difficult for Inland Revenue to enforce in practice.  The bright-line test supplements the intention test with an unambiguous objective test.

When is the start and end of the two year period?

The two-year period will run from the date of acquisition to the date of disposal, however the date of acquisition and the date of disposal are proposed to be defined differently to minimise opportunities to avoid the new rules.

It is proposed that the date of acquisition will generally be the date the title is registered with Land Information New Zealand (LINZ), whereas the date of disposal is proposed to be the date a sale and purchase agreement is entered into.  Although the date of disposal is the date an agreement for sale is entered into, it is likely that Inland Revenue will use the LINZ system to identify properties transferred within 2 years, or just outside the 2 year period, for further investigation.

Where there is a sale of the right to buy a property,including sales “off the plan”, the bright-line period will run from the day that a person enters into an agreement to purchase the property, to the date that a person enters into an agreement for the sale of the right to buy the property.

What type of properties will the bright-line test cover?

The bright-line test will only apply to “residential land”.

Under the suggested changes, residential land will mean:

• Land that has a dwelling on it; or
• Land for which there is an arrangement to build a dwelling on it;
• But does not include land that is used predominantly as business premises or as farmland.

The definition of dwelling means that hotels, motels, rest home or retirement villages will not be considered residential land but amendments will be made to the definition to ensure that serviced apartments will be caught within the new rules other than where operated as a business.

Farmland is land where the area and nature of the land disposed of means that it is then capable of being worked as an economic unit as a farming or agricultural business.  Capable of being worked as an economic unit as a farming or agricultural business means land capable of producing revenue sufficient to cover all costs of holding and operating the land, including the cost of capital employed and a reasonable recompense for the proprietor’s labour.   This is likely to rule out lifestyle blocks from any exception. Further, small farms with dwellings may therefore still be subject to the bright-line test even if they are leased to farmers and are used for farming activities.

Are there any exceptions to the bright-line test?

The primary exception to the proposed bright-line test is the main home exception.  This exception will apply when:

• The land has a dwelling on it;
• The dwelling is occupied mainly as a residence by the owner; and
• The dwelling is the main home of the owner.

If the property is owned by a trust, then the exception will apply when the dwelling is occupied mainly as a residence by, and is the main home of, a beneficiary of the trust.  If a settlor of a trust has a main home that is not owned by the trust, the main home exception cannot apply to any property owned by the trust.

The requirement that the dwelling is occupied mainly as a residence is the key test for the residential exclusion in the current land sale rules and is intended to ensure that properties used mainly for investment or other purposes are not covered by the exception.  It is determined based on actual use rather than intention.  The requirement that the dwelling is the main home of the owner is intended to ensure that the main home exception can only be used for one property at a time.  This is determined by the degree of use and the personal connection.

Other proposed exceptions include inherited property, which is not subject to the bright-line test.  The transfer of property under a relationship property agreement would also not be subject to tax under the bright-line test.  However, any subsequent sale of property transferred under a relationship property agreement may be subject to the bright-line test if the disposal is within two years of the original acquisition and the property was not the transferee’s main home.

Officials are seeking submissions on how the bright-line test should apply to disposals as result of individual or corporate insolvency.  

Are taxpayers allowed a deduction of expenditure?

Under the proposed rules, taxpayers would be allowed deductions for property subject to the bright-line test according to ordinary tax rules.  A deduction will be allowed for the cost of the property which includes:

• The initial acquisition price of the property;
• Any expenditure related to the acquisition, e.g.  costs to lawyers, valuers, surveyors and real estate agents;
• Incidental costs of disposing of the property;
• Any capital improvements to the property made after acquisition, such as renovations.

Certain holding costs such as interest, insurance, rates and repairs and maintenance may also be deductible subject to normal deductibility requirements (e.g. sufficient nexus to income, not being capital or private in nature, etc).

It may therefore be prudent to retain documentation in relation to the various expenses incurred in relation to a property such that deductions can be supported in the event that a property is ultimately caught within the rules.   

What if you sell a property at a loss?

Losses arising only as a result of a sale of property being caught by the bright-line test are proposed to be ring-fenced so that they can only be used to offset taxable gains arising under the land sale rules.

A person would not be able to recognise a loss under the bright-line test arising from a transfer of property to an associated person. 

Any other relevant rules you should be aware?

Inland Revenue is proposing a specific anti-avoidance rule for land rich companies and trusts to prevent people from avoiding the bright-line test through the use of trusts and companies rather than direct transfers of residential property.

What about any GST implications?

The current issues paper is silent on GST implications.  We would welcome further clarification on this matter especially where subdivision is involved.

How strictly will these rules be enforced?

Inland Revenue has been provided an extra $29 million in Budget 2015 to chase property investors.  The extra $29 million of spending brings the department's total spending on chasing property investors over the next five years to $62 million and is forecast to generate about $420 million of extra tax in that period.

To support its efforts, Inland Revenue currently uses a sophisticated computer software that identifies and ‘tags’ individuals and properties that have been involved in regular buying and selling activities.  Inland Revenue will likely utilise similar software for identifying taxpayers that are subject to the bright-line test.

Compliance measures

Further to the above, also announced in Budget 2015 the Government also introduced a bill to Parliament last week to enable Inland Revenue to collect more information about people who are dealing in land.  The Taxation (Land Information and Offshore Persons Information) Bill will see LINZ and Inland Revenue collaborating on information collection.  Broadly:

• All parties to a property transaction will be required to obtain an IRD number and provide that number to LINZ as part of the transaction process.  Those who are tax residents in another country will also have to provide their Tax Identification Number from their home jurisdiction.  There will be an exemption for New Zealand residents’ main home (which is consistent with the issues paper).
• Overseas buyers and sellers will need to have a New Zealand bank account to get a New Zealand IRD number.  This rule will also apply to New Zealanders who have been out of the country for three or more years.

This Bill had its first reading last week and has been referred to the select committee.  The government proposes the legislation will take effect from 1 October 2015.  These measures alone may prove a deterrent to some offshore investors.

The Government has toughened up its approach on this issue such that it will soon become much harder for those that buy and sell property in the hope of making quick gains to avoid being identified and taxed appropriately.