Taxing Matters

Posted on September 19, 2009
By Frank Newman

Calls for a capital gains tax are gaining momentum, but unfortunately the capital gains debate thus far has been tainted with misinformation and a lack of clarity as to what a capital gains tax would hope to achieve. It is my view that:

• Property investment does not enjoy special tax privileges as widely claimed,
• Property prices are not expensive and not likely to decline significantly, and
• The introduction of a capital gains tax on property will create further imbalances in the allocation of investment capital that may cause house prices to increase not decrease as some claim.

Property tax

Property investors do not enjoy the tax privileges some claim. In 2007 the Deputy Commissioner of Inland Revenue, Robin Oliver, stated as much when he said to a government select committee, “Rules about expenses for deducting costs such as interest, upkeep and maintenance, as well as paying tax on income, are the same for investments in shares or anything else. In fact under the housing case, the capital gains boundary is brought back a bit. There are tighter rules regarding what is a capital gain.”

It may come as a surprise to many that there is in fact a capital gains tax regime in New Zealand; its application is far from clear and therefore not widely understood.

Put very simply, a taxpayer is liable for income tax on capital gains if they are a dealer or trader, or if they bought the investment with the intention of reselling at a profit. If they intend holding the investment to generate income, then capital profits, should any arise, would not be taxed.

For example the investor who pays $200,000 for a petrol station, makes $20,000 a year profit and then sells it some years later for $300,000 would pay income tax on the $20,000 annual profit but not the $100,000 gain on the resale.

The capital gain would be taxable if the investor habitually bought and sold petrol stations as they would be deemed to be in the business of buying and selling petrol stations and the resale gains would be treated as taxable income.

This is no different to the property investor building up passive rental income by owning rental property. In this respect property does not have a tax advantage.

It’s establishing an investors “intention” that causes the difficulty. The IRD as the all-powerful arbiters must look at the circumstances of each case to come to a view on the investor’s intention at the time the purchase was made. With the onus on the taxpayer to prove their intention, that lack of legal clarity puts the taxpayer at risk of an unexpected and potentially ruinous tax liability.

Property investors face further challenges because there are additional and more specific rules that apply to gains on the sale of property (as Robin Oliver refers to in his quote). These include for example a minimum ten year holding rule for a builder’s private home and onerous rules about “tainting”. The tainting rules state that should a long-term property investor with an existing portfolio of properties buy another property with the intention of selling it for a quick profit, then the capital gains on ALL of their properties in their portfolio would become taxable. They all become “tainted” by the one transaction. This is not the case for sharemarket investors who can own shares in a trading account and shares in a portfolio account, without one tainting the other.

It is therefore incorrect to say New Zealand does not have a capital gains regime, (but fair to say it lacks the clarity of capital gains regimes in other countries).

It’s also bogus to claim property is New Zealanders most preferred investment because of tax advantages. While tax undoubtedly plays a part, it is popular for a number of other reasons.

Firstly, property investment has provided better long-run returns than the alternatives! According to the Real Estate Institute housing price index, residential prices have returned 11.8% a year over the last 17 years, compared with a 7% for New Zealand shares. ¹

Secondly, and most critically, people will only invest in things they trust. The Sunday Star Times recently reported the findings of a survey of 1200 people who were asked to rate the level of trust they have in sharebrokers, financial advisers, fund managers, mortgage brokers, insurance advisers, and banks. Only banks scored in positive territory which points to a confidence crisis in the funds management and sharebroking industries.

These issues are never factored into the comments of the central bankers, politicians, fund managers and academics who so frequently scold us for “over-investing” in property, and for these reasons property is likely to remain the most preferred long-term investment for New Zealanders. A capital gains tax is not going to change that.

Capital gains tax

There have been various claims made about the apparent benefits of a universal capital gains tax on property. Some say it will make houses more affordable and put an end to property bubbles. This is simply incorrect and appears to hide an underlying “tax the rich” agenda. There is no evidence from countries that have capital gains taxes that it makes housing more affordable. The biggest housing bubbles in recent years have occurred in countries like Australia, the USA and the UK which do tax capital gains.

Others, including fund managers, say it would shift scarce investment capital into more “productive” areas (like managed funds!). Ironically it is fund managers who have a privileged tax position, not property investors. Since the introduction of the Portfolio Investment Entity (PIE) regime fund managers no longer pay tax on trading profits. They and they alone are able to buy and sell shares with the intention of making a capital profit, and not pay tax on those gains. The truth is money has not flowed into other areas because property has provided the best returns. Fund managers need to up their game before asking the government to penalise others.

In fact, the introduction of a capital gains tax may create capital distortions that make house prices less affordable, especially if the family home were to be exempt as proposed by some. In this case it is highly likely that investors would shift investment capital into bigger and more expensive family homes, with the intention of making a tax free gain when the property is sold. Exempting the family home would also exclude some two-thirds of all property from the regime and substantially diminish the tax base, which is in fact the only rational reason why a capital gains tax would be introduced.

Affordability

Commentators are right to point to houses being less affordable when measured as a multiple of household income than our peer countries like Australia, the USA, Canada and the UK. That measure of course looks at two things: house prices and incomes, but the commentary invariably focuses on house prices, which is the least relevant half the story.

The reality is houses have become less affordable for New Zealanders, but house prices are not expensive when one looks at building costs, land development costs, and house prices internationally.

On average the cost to buy and section and build a small house (145m2) is about $425,000 ². Building costs have risen 6% per year in the last 10 years; significantly more than the rate of inflation.³ It is also highly likely that building costs will rise again once builder registration is introduced in March 2012 and builders become a “restricted” trade.

Land prices too have increased at a rate much faster than the rate of inflation. This is due in part to restrictive planning practices by local authorities and a rapid increase in council costs. For example, a majority of local councils impose development levies. In the case of the Whangarei District Council (on which I was an elected member for six years) those fees add about $20,000 to a new household unit. Although the Whangarei District Council touted this as a means of shifting the cost of new infrastructure from ratepayers to developers, it (conveniently) omitted to reduce the general rate take at the time they introduced the development fees! The effect is a $6m (20%) annual injection into council coffers, at the expense of land developers who must invariably pass that cost on to home buyers. It has also imposed additional compliance costs on homeowners by passing more restrictive resource consent conditions which by necessity require engaging various “professionals”. From what I have seen of others councils, the Whangarei example is not unusual.

We should also remember that the property market operates in the international market place. Property investment capital is internationally mobile, and demand from overseas investors will inflate the prices of homes here, where conditions suit overseas investors to do so (eg favourable exchange rates).

It is therefore illogical to think that our property prices will fall say 30% as some prominent commentators have suggested, when construction and land development costs are rising and will continue to rise faster than the rate of inflation – and when overseas investors can buy our property at will.

The point these commentators miss is that the problem is household incomes are too low and have failed to keep pace internationally over decades of declining economic prosperity, while property costs and values have increased.

I put this down to decades of poor political leadership at central and local levels that have focused on social, cultural and environmental “well-beings” with little regard to the economic health of our community. The result is that households are taxed more and earn less, and homeowners are paying the price.

There are signs that this imbalance has at least been recognised by central government but the cultural shift required to bring about a rise in personal income levels is likely to take decades to achieve. The 2025 Taskforce chaired by Don Brash which is investigating the reasons for the recent decline in New Zealand’s productivity performance, is at least a move in the right direction, but the vested interests that are likely to oppose economic prosperity should not be underestimated and indeed have been given political muscle in our MMP environment.