Bright-Line Tax Dangers
Matthew Gilligan explains the complexities of the new five-year bright-line test.
30 June 2018
You are likely aware of the bright-line tax rule. Initially brought in as a two-year rule, the Labour Government extended it to five years, effective March 29, 2018. On the face of it, the regime is relatively simple – you either sell a residential property within the brightline period, or you do not. However, like most things in tax, if you scratch beyond the surface there is complexity and real dangers for investors and their professional advisers. Here are three scenarios to illustrate:
Scenario One: Restructuring Ownership Of An Existing Rental
In 2017, Donald purchased a residential rental property in Auckland for $800,000. Fortunately for Donald, the vendor failed to appreciate the development potential of the property and it has a current market value of $1.25 million. Donald is looking to buy a new home and to protect his equity accumulated in that rental. His accountant and mortgage broker recommend that a look-through company (LTC) is established and the rental sold to the LTC at $1.25 million. The LTC takes up borrowing of $1.25 million, which Donald then utilises to repay the rental bank debt (in his own name), and the surplus to buy the home. This structure is extremely effective in terms of the deductibility of interest for tax purposes and allows his home (with all of the equity) to be gifted to a trust.
Unfortunately, Donald’s advisers have not realised the sale of the property from Donald into the LTC is a disposal subject to the bright-line rule. Thus, Donald has triggered a taxable gain of $450,000 and has a massive, unwelcome tax bill. Liability could arise to his taxation and legal advisers for failure to advise in such circumstances (but this is a grey area).
Scenario Two: Transfer Of A Bach To A Trust
Kim owns a coastal property that is used solely for private purposes as a holiday home. Kim wants to protect the property and so approaches her lawyer to assist. The lawyer establishes a family trust and the property is transferred into it in June 2018. Three years later, Kim decides to sell it. The trust sells the property, which has grown significantly in value. Kim then gets the shocking news that the gain is taxable.
As this property was moved into trust ownership after the extension of the bright-line period from two to five years, any disposal by the trust within five years is taxable. As the holiday home is not Kim’s “main home” she does not get the main home exemption. Unfortunately, her lawyer failed to advise her that the transfer of the property into the trust triggers a reset of ownership for brightline purposes. Had Kim continued to hold the property personally, she could have disposed of it without any tax issue.
Scenario Three: Significance Of Nomination
Bob and Sue enter into a contract to buy a residential rental property in their names “or nominee” on March 1, 2018. Settlement is set for June 30, 2018. In early June they ask their lawyer for advice. The lawyer recommends that a trust be established and a deed of nomination is prepared on June 5, 2018 to nominate the trust to settle the purchase..
Three years later the trustees decide to sell. They had anticipated that any sale within two years would be taxable, but as Bob and Sue signed up to buy the property on March 1, 2018 they believed that the five-year rule would not apply (because that applies only to properties where the purchase agreement is entered into on or after March 29, 2018). To their dismay, they discover that the nomination of the family trust as purchaser on June 5, 2018 represents the acquisition date as far as the trust is concerned. Accordingly, the trust is subject to the five-year bright-line period.
The bright-line rule poses significant risks for investors and their advisers. We urge you to seek advice when acquiring property, restructuring ownership, or entering into nomination agreements.