Could the IRD do a test case on property speculation

A reader e-mails:

I’ve been thinking about the overheated Auckland property market, which must be driven by to some extent by speculation, and the intent of the tax law. I reckon IRD could take a test case along the following lines: 

Mr and Mrs X purchased a two flat property in central Onehunga in 2009 for $480,000 to add to their rental property portfolio. They borrowed 100% of the purchase price so therefore the rent was well short of the required mortgage repayments and the property always made a loss for tax purposes. They had to ‘top up’ the mortgage payments with around $100 a week of their own money (they privately told their friends they were happy to do this because the property was well located and would give a good capital gain). In 2014 they decided to restructure their portfolio and sold the property for $680,000. They declared no taxable capital gain because they considered the property was held for rental purposes and they had no history of buying and subsequently selling rental properties. 

IRD could propose that when they bought the property they did so with the clear knowledge that the rental income was less than even the interest on the mortgage used to fund the purchase, and with rent rises in Auckland averaging about 5% a year they would be required to top up the mortgage repayments from their own money for the foreseeable future. The purchase was therefore only a viable proposition if the property was to be sold at a later date for a substantial capital gain. It therefore must have been purchased with the purpose or one of the purposes being resale. The $200,000 gain on sale should therefore be treated as taxable income.

There are various provisions in the income tax act relating to the sale of land – the one related to the business of dealing in land is CB 7 and the one related to buying land with the intention of resale is CB 6. The tax law does not say landlords have to have the intention of trading in property to get caught. Case law has limited the circumstances in which CB 6 or predecessor section have applied but judges can create new precedent, and judges’ interpretation of tax avoidance provisions has moved to a more purposive approach in the last 10 years or so.

It would be an interesting test case,if the IRD went this way. It could have a big impact, if successful.

My personal preference is for NZ to have a land tax, with reductions in income tax rates to make it overall fiscally neutral.