Tax-free capital gain, or taxable land sale?
Tax Alert - May 2017
By Ian Fay and Fraser Chapman
Did you know the sale of your main home may be subject to tax?
Taxpayers who have bought and sold their personal residence a number of times should be aware that their activity has the potential to be subject to the land sale provisions. This will be the case regardless of whether they had an intention to make a profit. Inland Revenue commentary released late last year will help taxpayers understand if that activity will be caught within the rules.
As part of Inland Revenue’s continued compliance focus on land transactions, QB 16/07: Income tax land sale rules – main home and residential exclusions (QB 16/07) was released late last year. This commentary will help taxpayers to decide if they are able to rely on the “main home” exemption from the bright line rule, or the residual exemption from the general land transaction provisions.
Where a taxpayer is caught by the bright line rule, if the relevant property is their main home they will generally not be taxed on the capital gain. Similarly, if a taxpayer is caught by the general land transaction provisions, they will generally not be taxed on any gain if the relevant property is their personal residence. However, taxpayers need to be aware that if they have established a “regular pattern” of land transactions, they will be unable to rely on these exclusions.
QB 16/07: Income tax land sale rules – main home and residential exclusions
Legislation does not define “regular pattern” for the purposes of the land transaction rules. Given this, it can be difficult for a taxpayer to understand when their activity will mean that they will no longer be able to rely on the main home or residential exemption.
QB 16/07 provides further detail on what the Commissioner considers to be relevant when assessing if a “regular pattern” arises. The commentary also lists useful examples that illustrate when a pattern of transactions will become regular. This provides taxpayers with a useful benchmark to assess their activity.
While there is no hard and fast rule on the number of transactions that will amount to a “regular pattern”, it is accepted by Inland Revenue that generally at least three prior transactions will be required.
Establishing a pattern
In order for a pattern to emerge from a taxpayer’s activity, there must be similarity or likeness between the transactions. The relevant factors to consider when assessing this similarity include:
- the type and location of each of the sections of land;
- the type of dwelling houses;
- the method of erection;
- the use to which the dwelling houses were put; and
- any other relevant characteristics of the transactions.
It is important to remember that the reason or purpose for each transaction should be disregarded when looking at these factors. It will be irrelevant that a taxpayer is forced to sell their personal residence a number of times because of events that are outside their control. In these instances, it is plausible that taxpayers may not give the land sales provisions a second thought as the potential to make a capital gain played no part in the decision to sell the property.
There is no set number of transactions that are required for a pattern to occur. However, the greater the number of similar transactions, the more likely there is a pattern.
Taxpayers should be aware that Inland Revenue has recently placed an increased compliance focus on land transactions. In this regard, Inland Revenue’s property compliance budget has increased to $62 million for the 2015 -2020 period. In addition, increased information sharing between LINZ and Inland Revenue will assist Inland Revenue to identify those taxpayers engaging in regular land transactions. The ‘land transfer tax statement’ prepared alongside the registration of a land transfer asks specific questions around seller identity and the nature of the property being sold. It is now easier for Inland Revenue to identify when a pattern begins to arise and we expect to see increased audit activity in this area.
For a pattern of transactions to be regular they must occur at consistent intervals. The factors that help to establish regularity include both the number of similar transactions and the intervals of time between them.
Inland Revenue has provided a useful benchmark for taxpayers by indicating that generally at least three prior transactions would be needed for there to be a regular pattern. Taxpayers should bear in mind that this is only a guideline as there may be some instances where two prior transactions are enough to establish regularity. Again, this assessment is one of “fact and degree”.
What land transactions are relevant?
The pattern for consideration must relate to the taxpayer’s “main home” or personal residence.
This clarifies the position for those taxpayers who are engaging in land transactions that do not involve their own residential property. For example, if a taxpayer has a pattern of speculative buying and selling of land they do not live on or do so as part of their business, these transactions are taxed under a different rule.
When deciding if the main home exemption from the 2 year bright-line rule is able to be used, taxpayers should remember that the regular pattern of land transactions is not the only hurdle. If the main home exemption has been used twice in the last two years, it is unable to be used again. Therefore, this should be considered before under-going an analysis of whether a “regular pattern” has been established.
Example of a regular pattern
Given the fact that there is no hard and fast rule, taxpayers should refer to the various examples set out in QB 16/07. These provide insight into how Inland Revenue would apply the test in practice. The example below is a direct extract from QB 16/07.
Melody and David are keen house renovators and have purchased a number of properties to improve and sell at a profit. These purchases and sales are shown in the table below:
Melody and David purchased the properties for a purpose and with an intention of selling them after they had completed some improvements. Their aim was to renovate the properties while they lived in them and sell them at a profit, enabling them to move up the property ladder. As such, the proceeds from the sales may be subject to tax under s CB 6 – the purpose or intention provision. This depends on whether Melody and David can rely on the residential exclusion in s CB 16.
Melody and David acquired the properties with houses on them, and it is assumed that they occupied the houses mainly as their residences. It is also assumed that the area of each property was 4,500 square metres or less. Therefore, the only issue is whether Melody and David are precluded from using the residential exclusion, which they will be if they have engaged in a regular pattern of acquiring and disposing of houses that they occupied mainly as residences.
When the first three properties (N Road, P Street and E Place) were sold, Melody and David did not yet have a regular pattern of acquiring and disposing of houses. A regular pattern has to exist independently of the transaction being considered. By the time E Place was sold, there had only been two prior acquisitions and sales. The Commissioner accepts that generally at least three transactions would be needed for there to be a regular pattern.
By the time the J Avenue property was sold, Melody and David had previously acquired and disposed of three houses that they had lived in. The question is whether those three transactions amount to a regular pattern of acquiring and disposing of houses that were occupied by the couple mainly as residences. If they do amount to such a regular pattern, Melody and David will not be able to rely on the residential exclusion for the sale of the J Avenue property.
For there to be a pattern, there has to be a similarity or likeness between the transactions. In this case, there is. The N Road, P Street and E Place properties were all residential properties in Wellington acquired, occupied, renovated and sold by Melody and David. It does not matter that the nature of the renovations done to each property was different. The pattern only needs to involve acquiring and disposing of houses that have been occupied mainly as residences.
For a pattern of acquisition and disposal to be regular, the transactions need to occur at sufficiently uniform or consistent intervals. In this case, the properties were held for 1 year 11 months, 2 years 2 months, and 7 months, respectively. Three properties were acquired and disposed of in a period of 4 years 8 months. The Commissioner considers that the intervals between the transactions are consistent enough for this to be a regular pattern. The intervals between the transactions do not need to be identical.
Because Melody and David have engaged in a regular pattern of acquiring and disposing of houses that they occupied mainly as residences, they cannot use the residential exclusion in s CB 16. Therefore, the proceeds from the sale of the J Avenue property will be income to Melody and David under s CB 6. Melody and David can deduct the costs of the property and the redecorating, to the extent that those costs are not private in nature.
The ability of taxpayer to rely on the ‘main home’ and residential exemption does not solely rely on whether the taxpayer has occupied the relevant property. Careful consideration of the rules is required when a pattern of transactions begins to emerge. For more information on the application of these rules please contact your usual Deloitte advisor.
May 2017 Tax Alert contents