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Capital Gains Tax and Monkeys – what’s the link?

Posted 22/6/2018

There has been much said this week about the potential about a Capital Gains Tax on property in New Zealand.

A study out this week by Westpac says that the introduction of a capital gains tax would reduce house prices by 11%, increase rents by 5%, but would help increase owner occupied homes (people owning their own homes).

New Zealand is a bit of a different country in that we don’t have a universal capital gains tax on property. Currently, someone can own a property in New Zealand and benefit by rising house prices and earn income tax-free. This has been the case in the main centres (especially Auckland) where house prices over the last ten years have risen quite dramatically. There are some situations where this gain is now taxed.

One of those tools introduced is called the bright-line test. The rules for this test applied to any house is purchased that is not your own family home (so any investment property). If you sell the property within a set timeframe and make a gain, then that gain is now taxable. The timeframe was initially set to two years, but has recently this year been increased to five years. The bright-line test is a form of capital gains tax, just it doesn’t apply to every property - only to a small number of investment properties.

There are a few other situations where a gain on a property can be taxable. We cover those in one of our units in the Rental Coach course.

An argument for a capital gains tax is made here on the New Zealand Herald, where if you look at the total returns of various forms of investment, the effective tax rate on rental property investment and owner-occupied property are much lower than other investments like bank accounts and superannuation funds. However, some argue that it is political suicide as owners of property would then choose to vote for another political party. We won’t get into this part!

Why are we so incensed when a new tax is proposed? Part of this comes down to human psychology as shown in a study done on monkeys.

Yale University in America wanted to study monkeys and see if they could understand simple economic concepts by using coins as a form of currency. The monkeys would hand over a coin and they could choose different options.  The monkeys had to weigh up the different options and use their coins to purchase food. The parameters they gave the monkeys would change (such as do discounts on a particular day) to reflect some of the patterns in the modern world economy.

One of the most interesting points is this setup where they were presented with two sellers. Seller A would hand over just 1 piece of food. Seller B would hand over 2 pieces of food, but take one piece of food back. The monkeys strongly preferred buying off Seller A.

Why is this? In both situations, the monkey would have ended up with one piece of fruit from either seller. The difference is the sense of loss that is experience when something is taken away. That is called loss aversion and that is something that we as humans experience as well.

 

Consider when you work as an employee and get paid your fortnightly pay. The fortnightly pay goes into your bank account. The tax has already been taken out so that deduction is hidden from your mind. Now compare it to a business person who runs their own business and makes a profit. They are then told by their accountant that they will have to pay to the government 20% of that profit in tax. The feelings of unfairness and unjustness rise up - “How dare they take that much!”

 

However, in dollar terms, the two situations are the same. The employee never saw that tax in the first place, while the business owner saw that tax money, got to use it, but then had to return it back at a later date. (Note - I know this is a very simplified scenario – it is not meant to go into all the tax deductions that business people have. It is just to illustrate the psychology of not having something compared to having more and then paying part of it back).

So, how does this apply to a Capital Gains Tax? Well, you need to focus on what is kept. If you make a capital gain on a house and have to pay a 20% tax on the profit, then you are still left with the 80%. You are still in a much better position that if you hadn’t owned the property at all. However, people get hung up about the 20% that they have to pay and forget about the 80% they still get to keep.  80% of something is better than 100% of nothing!

 

At this point in time, you can keep 100% of the gain and that is quite different from if you were to earn that money from a salary or an investment. Don’t be surprised when the government wants a piece of your pie!

 

Will a capital gains tax be introduced? Probably. New Zealand does have low taxes on properties when compared to other countries in the world as argued by Paul Drum of CPA Australia. It is more a question of when it is introduced and what it will look like. The current tax working group may recommend some changes which may impact not only your investment in a rental property, but your own family home investment. Whatever changes happen, we will keep the Rental Coach course material updated so you will know what the current rules are and how they apply to you.

Remember - just like the monkey, we are loss averse. But sometimes need to be reminded of what we have gained.

 

Rental Coach is a unique e-learning course that helps equip landlords to understand the numbers of their rental property and help answer all the questions you have related to your rental property. For more about the course, visit our website. For linking to this article, please read our website terms and conditions.