Reasons to take a dim view of house sale ‘bright lines’

It has been a year whereby our vocabulary is now quite different from where we started; words like bubbles, social distancing, contact tracing and recently bright line have seeped into our vernacular.

So where does bright line fit in? First, some scene setting.

Residential house prices are a highly politicised topic, which is quite problematic for any government.

On one hand there is an equity issue that entry into the market becomes more challenging and it is both reasonable that those directly affected feel aggrieved, and great virtue signalling for others to get up in arms about it.

However, on the other hand, a very large proportion of voters own their own house, so increasing values is both good for them and their confidence (boosting spending in the economy post-Covid). Throw into the mix real challenges around expanding the housing stock (the RMA, cost and availability of materials, lack of tradies etc), low interest rates (making borrowing cheaper and house ownership an attractive investment for cashed-up New Zealanders, who would otherwise be getting 0.5% at the bank), plus some population growth (at present not the biggest factor), and you start to get a perfect storm; not of anyone in particular’s making.

The challenge for the Government is that falling house prices are an economic and political disaster, but the current rate of growth in value is unsustainable politically, equitably and economically.

So like Goldilocks, it wants just the right amount of value accretion, but that is pretty hard to manage with its limited toolbox, noting that we already know the government building houses doesn’t seem to be a silver bullet (e.g. KiwiBuild).

The next best thing is creating a spectre or a political "fall guy" on whom you can put the blame — the vilified "speculator", which has unfortunately become synonymous with "investor".

Consequently, investors have been "punished" with changes to tenancy rules and successive unreasonable Tenancy Tribunal rulings, quality-homes rules (that seems fair), loss ring fencing, bright-line rules and vilification in the media.

There was a period that ma and pa landlords exited the market aggressively, creating new problems like raising rents due to shortages and de-intensification of occupancy (e.g. four renters replaced by two home occupiers, meaning the need for another half a rental house in the market).

This trend is reversing again because, despite all of the downsides of being a landlord, it is a significantly appreciating asset class. Here we go again.

So what is the difference between someone who is buying residential property (holiday home or rental property) for a "quick flick" versus long-term hold? Ultimately, it is about their intention at the time they acquired the property.

The tax system has always sought to tax those who are so-called traders/dealers/speculators in property, and anyone who has bought with the intention of resale were always caught by the tax provisions.

But how do you prove intention? What about patterns? Such is quite an esoteric concept, and the IRD certainly struggled to apply the provision to good effect.

Perhaps it could be criticised for not trying hard enough or not being visible enough in doing so but, either way, there was some acceptance by the government in 2015 something must be done.

And it introduced the bright-line test of two years.

To steal someone else’s definition: "a bright-line rule refers to a clearly defined rule or standard. It is a rule with clear interpretation and very little wiggle room. It establishes a bright line for what the rule is saying, and what it is not saying."

In other words, the taxing of residential land transactions via a bright-line test has substituted a less clear rule (did you have intent to sell, or not?) with a simple (?) line in the sand, whereby people are simply deemed to be speculators in land if they hold the property for less than two years.

That seemed reasonable enough. Two years is a relatively short period of time, so isn’t it fair to say that if you only hold a property for less than two years, it is a reasonable assumption that you bought with an intention of resale?

But this was not perfect. "Life happens" and numerous people were caught by this rule whereby they had no intention of resale but did sell due to marriage break-ups, changing towns/jobs, illness etc; but in the wider context, these minority of "bad" outcomes were considered an acceptable overreach by the government.

Another down side of the two-year rule was the potential lock-in of properties, whereby some owners may have held them back from the market until the two years was up, diminishing market supply.

In 2018, the new government, wanting to be seen to be doing something around the rising housing market, extended the bright line to a five-year ownership period.

The revenue minister at the time was quite specific as to the intent: "this proposal will ensure that residential property speculators pay income tax on their gains and makes property speculation less attractive ... This measure will bring fairness back into the tax system." Critics, including yours truly in this column, were concerned that five years was too long, as more "life happens" in five years, and more people who are NOT speculators, but just ordinary Kiwis for whom circumstances have changed, would be caught as "speculators", when they are clearly not such. Even IRD policy advice to the government raised this concern.

To be clear, if you accept that the bright-line test was designed to buttress the original taxing provisions around intent to resale by speculators (as was clearly stated by two governments), then every situation whereby there is collateral damage and it captures an "innocent" taxpayer, that is effectively a targeted capital gains tax.

As unfair as one could argue the housing market is for some, how is that building a fairer tax system?

And now there is some debate whether five years is too short, and that maybe the bright-line test should be extended up to even 10 years.

Again, this just creates a greater chance of an effective capital gains tax on innocent Kiwis who are not speculators.

If New Zealand wants to apply a CGT, despite the fact such has been ruled out during the tenure of the current PM, then let’s have a mature debate (without the politics) and implement a broad-base, fair and fully integrated CGT into the tax system. Extending the bright line, and bringing in a CGT by stealth for a subset of taxpayers, is not the right way to do this, in my opinion.

And on that note, I leave you for 2020. I hope you have found Sharp As Tax occasionally interesting, or at least a little distraction, and trust you will have a very Merry Christmas and safe New Year.

 - Scott Mason is a tax specialist and managing partner at Findex in Dunedin.