Chapter 9 – Real Estate Transactions

9.1 OVERVIEW (ITA Subpart CB)

This chapter distinguishes between taxable and non-taxable property transactions.

A 2019 law change requires all buyers and sellers of land to supply their IRD numbers. A gain on the sale of any property (not just real estate) is likely to be taxable if:

• the property is purchased with the intention of resale at a profit (ITA ss CB 3, CB 4, CB 6), or

• the seller has established a regular pattern of similar transactions (ss CA 1, CB 5, CB 16, CB 19); or

• dealing in the property is part of a business activity (ss CB1, CB 5, CB 7);

Special rules apply to the purchase and sale of real estate and there have been recent changes in this area, with more expected under the current government as they aim to reign in the inflated housing market.

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9.1 - Overview  (ITA Subpart CB)

9.2 - Application

9.2.1 - Transactions Involving Land  (ss CB 6 - CB 25)
9.2.2 - Purpose or intention   (ITA ss CB 6)
9.2.3 - Bright-line Test  (ITA CB 6A, CB 16A, CB 18 A)
9.2.4 - Associated Persons Rules (ITA ss CB 11, CB 15, EE 40, Subpart YB)
9.2.5 - Ring-fencing Losses on Residential Property
9.2.6 - Dealers, Developers and Subdividers (ITA s CB 7, CB 9, CB 10, YA 1)
9.2.7 - Builders (ITA s CB 7, CB 11, YA 1)
9.2.8 - Zoning and Related Changes in Conditions (ITA s CB 7, CB 14, YA 1)
9.2.9 - Development or Division of Land within 10 years (ITA s CB 7, CB 10, YA 1)
9.2.10 - Major Development (ITA s CB 7, CB 12, YA 1)
9.2.11 - Exempt Transactions  (ITA ss CB 16 - CB 23)

9.3 - Practical Hints

9.3.1 - Protecting Genuine Long Term Investment Gains
9.3.2 - Documentation
9.3.3 - Property Investment
9.3.4 - Lease Inducement Payments (ITA ss CC 1B, CC 1C, DB 20B, DB 20C, EI 4B)

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9.2 - Application

9.2.1 - Transactions Involving Land  (ss CB 6 - CB 25)

A person who is in the business of building, developing or dealing in land is exposed to tax on all real estate which they sell within 10 years of purchase. Dwelling houses and business premises are exempt unless a pattern of buying and selling these has emerged. (ss CB 16, 19). Associated persons are affected by the same rules.

The Income Tax Act contains specific rules (and a number of related exemptions) that operate to tax certain land transaction receipts. In some cases, these rules go beyond ordinary income taxation and tax genuine long- term capital gains. This is a specialist area and specialist tax advice should be sought for significant transactions. For GST implications see 20.3.16.

9.2.2 - Purpose or intention   (ITA ss CB 6)

Where Inland Revenue believes that a taxpayer’s purpose or intention in buying the land was to then resell all, or part of it, the gain will be taxable.

Example

Maggie Nates takes out a loan to acquire a life-style block in the country. In her loan application, Maggie describes her intention to subdivide and sell half of the property while retaining the balance. Based on this evidence, Inland Revenue would tax Maggie on the gain on the half share sold.

9.2.3 - Bright-line Test  (ITA CB 6A, CB 16A, CB 18 A)

For those who are not in the business of building, developing or dealing in land or otherwise tainted so as to be taxed on your real estate transactions, the general rule relating to intention at the time purchase could be subjective or difficult to prove.

The bright-line test taxes residential property sold within a period from the date of purchase as follows: If you entered into an agreement to purchase residential property on or after 29 March 2018 and sell it within five years, you will be taxed on the capital gain unless the property was your main home, an inherited asset or received in a relationship property settlement.

You cannot use the main home exclusion if you:

• already used it two or more times in the previous two years, or

• have engaged in a regular pattern of acquiring and disposing of residential land.

Residential property purchased from 1 October 2015 until 28 March 2018 is similarly taxable if sold within two years of purchase. Any loss on the sale is ring-fenced and available to set off against a future profit under the bright-line rule.

Residential properties held in trust can qualify for the main home exception if:

• it was the main home of the principal settlor of the trust, or

• the principal settlor does not have a main home and it was the main home of a beneficiary of the trust.

9.2.4 - Associated Persons Rules (ITA ss CB 11, CB 15, EE 40, Subpart YB)

The associated persons rules in the Income Tax Act 2007 are designed to ensure the tax treatment of transactions involving associated persons don’t:

• create a tax benefit

• use the tax system to subsidise the cost of private transactions

• disguise the nature of a business or private transaction

• disguise the person(s) involved in the transaction.

“Persons” includes individuals, companies, trusts and partnerships. The rules have a major impact on property developers, builders and dealers and also affect other areas of tax such as dividends and FBT.

Special association rules apply for transactions involving land: People (YB 4)

For transactions involving land, two people are associated if they are:

• married, in a civil union, or in a de facto relationship

• a parent and a child under the age of 20

• a partner and a partnership

• associated through the tripartite test (See below).

Trusts

Associations with trusts are established through their settlors and trustees. The following are associated for land dealings:

• trustees of separate trusts with the same settlor (YB 7)

• a trustee and a settlor (YB 8)

• a trustee and a person with power to appoint or remove a trustee (YB 11)

The land provisions exclude the association tests for person and trustee for relative (section YB 5), trustee and beneficiary (section YB 6), settlor and beneficiary (section YB 9). So a beneficiary does not become tainted with dealer or developer status through association with a trustee or settlor.

Companies (YB 2, YB 3)

A person may be associated with a company by virtue of the shareholding or voting interest or both. These interests are aggregated with other associated persons.

A company and a person other than another company are associated if the person owns at least 25 % of the voting or market value interest in the company. Two companies are associated with one another if the same group of persons:

• control both companies; or

• own 50% or more of the voting interests in both companies

EXAMPLE

Mr Glum and Ms Dull are de facto partners. He owns 20% and she owns 40% of the shares in Glee Ltd. The holdings of Mr Glum and Ms Dull are aggregated due to their association with one another, so each is deemed to hold 60% of Glee Ltd’s shares. If either of them alone or both of them together hold more than 50% in Joy Ltd, then Joy Ltd and Glee Ltd will also be associated with one another.

The aggregation rule treats each person as holding anything that is held by an associated person. It is applied separately to each person, whether or not that person holds any shares at all in his, her or its own name.

Example

Sonny Chip holds 100% of the shares in Pan Ltd in his own name. His twin, Sissy Chip owns no shares at all. Applying the aggregation rule, Sissy Chip is deemed to own 100% of the shares herself due to her association with Sonny.

Two companies are associated if a group of persons and those with whom they are associated hold more than 50% of the voting interest of both companies.

Partnerships

Partners and associates of partners are associated with a partnership. Limited partners (and their associates) must have a 25% share to be associated with the partnership.

Tripartite Test

Furthermore, two persons A and B are associated with one another if they are both associated with a third person, C. This new “tripartite” test applies even if A and B have never heard of each other and are not connected in any other way.

Effect on Property Transactions

The rules target property dealers, builders and developers who can no longer prevent this activity from “tainting” their investment properties. To be tainted, the association to the property dealer, builder or developer has to exist on the day that the investment property is acquired. In most cases therefore, property acquired by dealers, builders and developers after 6 October 2009 will be tainted. The rules apply to builders for any improvements started on or after 6 October 2009.

If a property is tainted, a gain on disposal is taxable if the sale takes place within 10 years of acquisition. For those in the business of erecting buildings, tainting only applies to improvements made to a rental property, and then to sale within 10 years of completing the improvements. To break the “tainting” the property must be held longer than the 10-year period.

Any attempt to circumvent the rules is likely to be treated by the IRD as tax avoidance.

9.2.5 - Ring-fencing Losses on Residential Property

From the start of the 2019-20 tax year you can no longer offset tax losses from residential properties against your other income. Losses from residential properties (including land, but not mixed-use properties) can now only be offset against other income from your residential property portfolio. Any remaining losses would stay ring- fenced and be carried forward to set off against future residential property income. Shareholder continuity provisions apply to these losses (See 12.2.8) and wholly owned companies within the same group may be able to set off each other’s losses against residential property portfolio income within that group.

9.2.6 - Dealers, Developers and Subdividers (ITA s CB 7, CB 9, CB 10, YA 1)

Where a taxpayer who is a dealer, developer or subdivider buys land for purposes that have nothing to do with their business, any sale of that land within ten years will still be taxable. Likewise, if a person who is associated with a dealer, developer or subdivider purchases land (again, for investment purposes) that person will also be liable to taxation on any sale of that land within ten years of purchase.

Some limited exemptions are available for a taxpayer’s principal residence and/or business premises in some cases.

9.2.7 - Builders (ITA s CB 7, CB 11, YA 1)

There is an extensive rule that operates to tax sales of land made by builders and persons associated to builders. These tax liabilities can arise even where the land was not acquired for reasons to do with the builder’s business.

The rules apply where land is sold within ten years of any improvement being made to that land.

Example

Sam Cash is in the business of building. His wife purchased a holiday home in Pauanui. Ten years later, she added another room to the property (an improvement). She eventually sells the property after a further 5 years for a significant capital gain. Mrs Cash will be taxed on that gain by virtue of the association unless the property constitutes a principal residence or business premises.

What happens in a situation where a builder buys land and builds a family home and after a period of time sells the family home and then repeats this exercise? The Income Tax Act contains an exemption where builders buy land and build a dwelling house primarily and principally as a residence for themselves and any member of the family. This exemption does not apply however where the builder has engaged in this activity to the extent that a regular pattern of such transactions has emerged.

Example

Bob the Builder is in the business of building homes. Bob purchases land and builds a family home, which is then on sold after one year and eight months. Bob purchases a second piece of land and builds a home, which is used for family purposes for six years. Finally, Bob purchases land and builds a home for family purposes and this is sold after nine months. Inland Revenue would be likely to assess Bob for the profit on these sales. Bob may be able to successfully argue that due to the periods involved (particularly the six year period) that a regular pattern has not emerged in this case. Specialist advice would need to be taken.

9.2.8 - Zoning and Related Changes in Conditions (ITA s CB 7, CB 14, YA 1)

This rule taxes profit on land that has been sold within ten years of purchase and at least 20% of the gain in property value is due to a zoning change or consents granted under the Resource Management Act. The rule also catches likely changes that could cause the value of land to rise.

9.2.9 - Development or Division of Land within 10 years (ITA s CB 7, CB 10, YA 1)

In practice, this is a rule that potentially applies to many taxpayers. The taxpayer need not be in the business of dealing, developing, or building, but applies to any taxpayer. Under this rule, tax will be imposed where a taxpayer has, within ten years of acquisition, done some development or division work on their land, being work of “more than a minor nature”.

Example

Sam Cash purchases a one-hectare property with an old barn on the outskirts of a small rural settlement. For seven years Sam leaves the land bare and then knocks down the barn and divides the property into three new titles.

Any future gain on the sale of the titles (whenever those sales occur) will be taxable to Sam under this rule. It is unlikely that the exemptions relating to a residence, business premises or rental property will apply in this case.

9.2.10 - Major Development (ITA s CB 7, CB 12, YA 1)

This final rule applies where a major development or subdivision work has occurred on the land, being work that involves significant expenditure on earthworks, contouring, levelling, drainage, roading, kerbing, or channelling or related work. Under this rule, the proceeds of land sales will be taxable and a deduction will be allowed for the value of the land at the commencement of the scheme.

Example

Sam purchased ten acres of land as a hobby farm and residential home. Fifteen years later, Sam incurs $180,000 in creating drainage and related services and proceeds to subdivide the property into twenty sections. It is likely that Inland Revenue will seek to tax the proceeds from sale after allowing a deduction for the value of the land at the commencement of the development scheme. The exemptions for residential land under 4,500 square meters and farms will not apply in this case.

9.2.11 - Exempt Transactions  (ITA ss CB 16 - CB 23)

Some profits from sub-divisions and developments are excluded from tax on the basis that the sub-divided or developed land is a dwelling house used by the taxpayer principally as residential land or primarily for their business premises. The residential exemption applies if the land does not exceed 4,500 square metres (or a larger area as the Department may allow). A similar exemption is available for developments and divisions of farmland occupied immediately before division principally for farming purposes. In addition the farmland sold must be capable of operation as an economic unit.

9.3 - Practical Hints

9.3.1 - Protecting Genuine Long Term Investment Gains

If you are a land dealer, developer, builder or similar, it can be difficult to protect your genuine long-term property investments from taxation. For example, a long-term investment property held by a property developer must be held for 10 years before any capital gain is tax exempt (there are a number of other exemptions). For this reason, taxpayers involved in property-based businesses should take considerable care in structuring the purchase of long- term investment assets. A number of structures (frequently involving trusts) can be put in place to protect genuine long-term investments, however these could be caught by the associated persons rules. Ensure you obtain specialist tax assistance before implementing any such structures.

9.3.2 - Documentation

If you are acquiring a significant item of property for residential/ business or investment purposes you should ensure that your correspondence with solicitors, bankers and other advisors records your intention at the date of acquisition. This can be particularly important in an investigation situation some years later.

9.3.3 - Property Investment

The tax rules affecting land transactions are highly detailed and specialised, the comments in this book are of an introductory nature only. Having used this chapter to identify likely issues, you should seek professional advice.

9.3.4 - Lease Inducement Payments (ITA ss CC 1B, CC 1C, DB 20B, DB 20C, EI 4B)

Commercial (but not residential) lease inducement and lease surrender payments are treated as taxable income to the recipient and deductible to the payer. Inducement payments are spread over the life of the lease while surrender payments are allocated to the income year in which they arise.