Over the past couple of weeks, the so-called “bright-line test” that taxes gains on the sale of residential property has been the subject of a lot of media attention. That’s because a recent Inland Revenue draft interpretation statement on the application of the bright-line rules highlighted the potential for the family home to be taxed. This is a risk for anyone who purchased a home on or after 27 March 2021 and spent a continuous period of 12 months or more not living in it, and then sold it within 10 years of purchase.
In such a circumstance, someone could be taxed on a portion of the gain on the sale of the property at their marginal income tax rate (ie, up to 39%). This is irrespective of the reason for the absence from the property and whether or not this was within a person’s control, as we explain.
The bright-line test effectively acts as a capital gains tax on residential properties sold during the “bright-line period”. It was originally enacted by the National government, with application from 1 October 2015 and taxed gains made on the sale of residential properties within a two-year bright-line period.
The bright-line rule was never intended to tax the family home, so gains made on the sale of a person’s main home were excluded from taxation, provided the property was used as a main home for “most” of the time it was owned. Inland Revenue interpreted “most” as requiring the property to have been used as a main home for more than 50% of the period of ownership. It was an “all in or all out” test, meaning that once the property had not been lived in for more than 50% of the ownership period, the entire gain on sale was subject to tax, whereas absences of less than 50% of the ownership period meant no taxation on sale arose.
The main-home exclusion rule never proved controversial, with most people accepting that an absence of more than half of the period of ownership meant a property should not really benefit from an exclusion to the bright-line rules. The bright-line rules have evolved over the years. In 2018, the Labour government extended the bright-line period to five years, but kept the exemption for main homes unchanged (ie, it was still interpreted as a 50% main-homeuse requirement). With effect from 27 March 2021, the bright-line period was extended again to 10 years as part of the enactment of the Taxation (Annual Rates for 2020-21, Feasibility Expenditure, and Remedial Matters) Act 2021. At the same time, the government fundamentally changed the main-home exemption to a 12-month change-of-use rule and an apportionment mechanism.
These two changes to the bright-line rules were a rushed piece of legislation. They were not included in the first version of the 2021 Amending Act released in June 2020, nor in the second-reading version released on 11 March 2021, meaning they never went through a comprehensive select committee process. The bright-line changes were released via a Supplementary Order Paper to the 2021 Amending Act on 23 March 2021. They were accompanied by a fact sheet and commentary, explaining how the new rules would operate with respect to residential properties acquired on or after 27 March 2021.
How the main-home exclusion now works
A person’s main home is excluded from taxation under the bright-line rules if it is used predominantly as a dwelling and as a person’s main home. Importantly, the exclusion does not apply if the property was not used as a main home for more than 365 consecutive days. If this 12-month period is breached, then any gain on sale is taxed on an apportioned basis, meaning the person is taxed based on the proportion of time spent not living in the property as their main home.
The issue with the new test is that the term “main home” has been very broadly defined. Inland Revenue’s statement takes a very strict interpretation of the term and essentially treats any absence from a property as failing the “main home” test. This means those who are required to spend large periods out of the country for work may inadvertently be considered to no longer be living in their “main home”. These New Zealanders may have pursued overseas job opportunities for better pay, only to discover that the financial penalties of being subject to capital gains tax outweigh the benefits of working abroad.
Startling and bizarre consequences
Of particular concern is the Inland Revenue statement’s hypothetical case of “Rebecca” who owns an apartment with her husband and lives there with their two children. Rebecca leaves the country for a two-year work assignment and lives in temporary accommodation offshore provided by her employer. Her family continues to reside in the apartment while she is away, and she visits home twice a year.
Bizarrely, despite not owning a second property and her family living in the property she owns, the family home is not considered to be Rebecca’s main home in this example, with the consequence that she is subject to tax on a proportion of her half-share on the sale of the property after she returns to New Zealand. This is a very harsh interpretation and one that is at odds with Inland Revenue’s stance on what constitutes being a tax resident in New Zealand.
Broadly speaking, a person is tax resident in New Zealand if he or she spends more than 183 days in any 12-month period here or they have a “permanent place of abode” (PPOA) in New Zealand. If a person is tax resident in New Zealand, he or she is subject to New Zealand tax on their worldwide earnings. Inland Revenue Interpretation Statement IS 16/03 on tax residence makes it clear that if a person owns a property in New Zealand and has previously lived here for a substantial period, it will be very difficult for them to establish that they don’t have a PPOA in New Zealand. IS 16/03 states that a property does not have to be vacant or available for use by a person to be a PPOA. A property can be rented out and still be a PPOA. Further, IS 16/03 focuses on a person’s associations and connections with New Zealand, noting that the test is looking to establish the “place where the taxpayer habitually resides from time to time even if they spend periods of time overseas”.
There is no doubt that “Rebecca” in IR’s statement example would have a PPOA in New Zealand and therefore would be subject to New Zealand income tax on her offshore salary. It therefore seems inconsistent that while remaining a New Zealand taxpayer, Rebecca fails the main-home test and becomes subject to taxation on its eventual sale. Inland Revenue is quite simply trying to have its cake and eat it too. Even more concerning is the potential for people who have been forced out of their homes, owing to circumstances entirely beyond their control, to end up facing a tax bill. It would be truly distressing for families already grappling with the aftermath of the Auckland flooding or Cyclone Gabrielle to be burdened with an unforeseen tax liability. But this is a very real possibility. There are people in Auckland who have already been out of their homes for seven months, waiting for central and local government funding issues to be resolved so they can pay for repairs on their properties.
They will likely be outside their homes for more than 12 months as a result. For anyone in this situation who bought after 27 March 2021, any future gain on the sale of their house within 10 years will trigger a tax liability. It is hard to justify how this interpretation and outcome of the law aligns with the bright-line test’s intended focus. This unfairness hit the press recently, resulting in a statement from the Prime Minister’s office on 23 August that the bright-line rules would be clarified to ensure they would not tax the family home and a statement from the Minister of Revenue that where flood- and cyclone-damaged houses are voluntarily sold to local authorities, the bright-line rules will not be triggered. This quick response to provide some assurance to flood and cyclone victims is to be applauded. However, the Revenue Minister’s statement addresses only the sale of properties to local authorities. It does not address the situation of flood and cyclone victims forced out of their properties for more than 12 months while they are being repaired and who later sell the property to a private purchaser a few years down the track.
Our view is that something needs to change and we hope the Prime Minister’s broader promise in this regard will be made good. It is unfair and very poor tax policy to burden family homeowners with a capital gains tax, particularly when these individuals are driven out of their properties through no fault of their own. The imposition of a 12-month test should be reconsidered, especially in cases where individuals cannot live in their homes due to circumstances beyond their control, such as natural disasters.
A fairer solution should also be available for those who spend time abroad, whether for work or for embarking on “the Big OE” after enduring years of travel restrictions during the pandemic. The main-home test could, for example, be aligned with the PPOA test for tax-residence purposes. Another alternative would be to lengthen the 12-month period significantly, noting that in Australia the main-home exemption from capital gains tax allows individuals to reside outside of Australia for up to six years while still benefitting from the exemption. Imposing capital gains tax on the family home is something that almost no country in the world entertains. The recent changes to the bright-line test have brought in too many situations for properties acquired after 27 March 2021 where this may occur. It is a consequence of rushed legislation and an ad hoc approach to the taxation of residential investment property, rather than taking a more measured and principled approach to the broader issue of the taxation of capital gains.
Bruce Bernacchi is a partner and Lucy Tustin is a law graduate at Dentons Kensington Swan