The bright-line test is what IRD uses to determine whether income derived from the sale of residential land will incur taxation. This test recently changed to become more expansive. This means the bright-line test will be applicable to many more people, therefore understanding how the bright-line test works is incredibly important for home owners considering whether to sell.
Any residential land bought from 29 March 2018 and sold within 5 years, may have its sale revenue taxed. If the land was purchased before this date then the test for taxation is whether it was sold within 2 years of its purchase.
The bright-line test only applies to the sale of residential land. The Income Tax Act 2007 defines ‘residential land’ as follows:
- land that has a dwelling on it;
- land for which the owner has an arrangement that relates to erecting a dwelling; and
- bare land that may be used for erecting a dwelling under rules in the relevant operative district plan.
The last option makes the term ‘residential land’ very broad, as it would include most land in urban areas. There are two categories that are not ‘residential land’, they are farmland and land that is used predominantly as business premises.
If the sale of the property is captured by the bright-line test, the seller can claim deductions (as revenue account property) for all costs incurred in the business of making capital gains.
If the trustees of a trust own residential land which makes up 50% or more of the trust assets and the trust deed is changed with the effect of defeating the bright-line test, then the trustees are treated as disposing of the land, and may be taxed under the bright-line test. This means trustees need to be very careful about trust variation. It is also important to be aware that transferring residential land to a trust resets the acquisition date that is used for calculating the bright-line test.
There are exemptions to the bright-line test; they are as follows:
- it is the main home of the seller;
- it is transferred as part of an inheritance;
- it is transferred as part of a role as an executor/administrator of a deceased estate; or
- it is transferred pursuant to a relationship property agreement.
The inheritance and executor exemptions are straightforward, however the other two exemptions have limitations on them and need to be carefully considered by a prospective seller.
It is critical to check that the sale of the property isn’t captured under one of the other provisions of the Income Tax Act 2007, as the bright-line test only applies if no other tax mechanism applies to the sale. There is a ‘property tax decision tree’ on the IRD website that works out if the property being bought or sold is taxable under any property tax rules. The new obligations under the Overseas Investment Amendment Act 2018 should also be considered.
Most importantly, if the purchaser’s intention when buying the ‘residential land’ is to resell it for profit, then this will lead to tax obligations.