Terry Baucher says the IRD is keenly targeting cash gains made on property investments - and is likely to get more help from the Government

By Terry Baucher*

Reserve Bank Deputy Governor Grant Spencer certainly put the capital gains tax cat among the pigeons when he suggested “the Reserve Bank would like to see fresh consideration of possible policy measures to address the tax-preferred status of housing, especially investor related housing”.

Finance Minister Bill English was swift to respond, remarking: "It is important that people understand there is an existing capital gains tax on those who trade houses and make gains on it.”

But what is the law and how are Inland Revenue enforcing it?

There are a number of provisions that tax property but the key measure Mr English had in mind is section CB 6 of the Income Tax Act 2007.  This section provides:

“An amount that a person derives from disposing of land is income of the person if they acquired the land -​

• for 1 or more purposes that included the purpose of disposing of it:
• with 1 or more intentions that included the intention of disposing of it.”

At first sight this would appear to potentially tax any gains arising from the sale of property.

In practice the section is much more narrowly applied with the tax charge turning on the intention at the time of purchase.

In Inland Revenue’s own words:

If you’re an investor you buy a property to use it to generate ongoing rental income and not with any firm intent of resale. The property is a capital asset and any later profit or loss from selling the property is capital and isn’t taxable (apart from clawing back any depreciation, which is now recoverable).”

Note the phrase “firm intent of resale” and this must exist at the time of purchase.

Consequently, as one court case ruled, someone who purchased a property with “a vague general hope it would be a good investment” could not be said to have the necessary intention of sale.

Advantage of hindsight

Inland Revenue also has the advantage of hindsight so it can consider a person’s prior actions and check the supposed intention with what actually happened.

As part of this it therefore usually requests copies of relevant documents such as sale and purchase agreements, mortgage applications, council applications, or information provided to other Government Agencies.

This can often turn up some damning evidence.

A specialist unit

A key part of the Inland Revenue’s investigative efforts is its Property Compliance Programme (PCP), which has five investigation teams in eight sites around the country.

The PCP began as a trial programme in 2007 but received additional funding in the 2010 and 2013 Budgets.  On average the PCP gets a return of $6 for every dollar it spends on investigations. 

For obvious reasons exactly how the PCP selects its targets isn’t public knowledge, but what it has revealed is that it monitors newspapers, Trade Me and other sites.

It also pays particular attention to certain subdivisions.

Typically these are where there is a lot of building and development activity such as Botany and Queenstown.

Properties within areas of interest are placed on alert so that the PCP is notified when the property is sold or advertised for sale.

Once notified, usually within a week, the PCP then checks to see that the taxpayers involved have met their obligations. At present some 28,000 properties are currently under alert.

A good example of the type of transaction that would interest the PCP would be the Browns Bay property acquired in November 2013 for $751,000 and sold recently for $1,205,000

Given that the owners apparently did little other than obtain a resource consent to subdivide the property into two sections, the vendors can expect to shortly receive a “Please explain” enquiry from Inland Revenue.

Are very low yields a target clue?

Mr Spencer also noted “rental inflation has remained considerably below house price inflation. Average rental yields in Auckland have fallen from 4.6% in 2010 to 3.7% in 2014”. 

In that context even with borrowing costs at 50 year lows, an astute Inland Revenue investigator might question whether a heavily geared investment property was realistically purchased as a long term investment. If the rental income cannot cover the borrowing costs then arguably the value of the investment could only be realised by sale. 

Odds in IRD's favour

Once an investigation is under way, the onus then falls on the taxpayer to prove the intention behind a transaction. Consequently, the odds are stacked in Inland Revenue’s favour during an investigation. 

If they do come knocking you therefore need to be thoroughly prepared, with every transaction well documented.  In my experience that is often not the case, so, for the advisor, it often comes down to trying to minimise the damage.

Unsurprisingly, the PCP has been a successful initiative, raising over $50 million in additional tax during the year ended 30^th June 2014.

And yet, despite that success, it seems to me that the PCP is only just beginning. About $23 million of the additional tax for the year ended 30^th June 2014 came from taxing speculators or trading.

That seems a little light given that according to the REINZ the total value of residential property sales in the twelve months to 31^st March 2015 was $42.6 billion.  

The sheer volume and value of residential property transactions would therefore seem to represent a target-rich environment for the PCP. 

It appears the Government thinks so too.

At the same time as Bill English reminded everyone about the existing rules, he also remarked that more funding for Inland Revenue to pursue speculators is “a matter that'll be discussed in the run up to the Budget”.

With a red-hot property market, a restive Reserve Bank and a deficit to eliminate, I’d say the discussions are centred on not if but how much extra funding Inland Revenue will receive. Watch this space.

--------------------------

*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »