How the Government is changing rules for renting out your 'main home' and the bright-line test

ANALYSIS: As it doubles the bright-line test in a bid to take the heat out of the property market the Government has changed the way main homes are excluded from the tax rule.
Instead of the previous system where homes either were or werent considered main homes, based on the length they were rented out to others, the new system allows some periods of a homes ownership to be taxed while others are not.

The complex change has resulted in National crying foul, saying Labour are breaking a promise not to tax the family home.

But the Government argues it is just modifying the exclusion National itself introduced to be fairer given the new 10-year length of the policy.


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How the main home exclusion used to work​


The bright-line test is not a tax itself its a method of applying income tax.

It applies income tax on the profits of any houses sold that meet specific criteria. It was introduced as, technically, you were always supposed to be taxed if you were intentionally buying homes to flip them for a profit but proving that you had this intent was basically impossible.

The test works by saying if you sell this house within this time period you were clearly intending to profit from selling it when you bought it. The last National government introduced it with a two-year period, meaning it would only net homes sold within two years of purchase. Labour extended it to five years in 2018 and is extending it to 10 years now.

ROBERT KITCHIN/Stuff
Revenue Minister David Parker with Prime Minister Jacinda Ardern.

But there is a large exclusion for anyones main home so people could still use the profit from selling the house they were actually living in to upgrade to a larger home, without facing a tax bill. This puts the aim squarely on people with multiple properties, not someone who just owns the house they live in.

When it was introduced there were some limits placed around the "main home exclusion in order to stop it being abused by people living for a few weeks in a house and saying it was their main home. That limit was 50 per cent. That meant if the home was rented out for more than 50 per cent of the two-year period, it didn't count as your main home, and the tax would apply if you sold it.

When Labour first extended the test to five years in 2018 it replicated that formula for the new five-year period: If you rented it out for more than 50 per cent of the five years lets say three of the five years you would be taxed on the sale.

123RF
Renting our your main home could result in a tax bill.

How the main home exclusion will work now​


As the Labour government has moved to extend it to ten years, it is changing the formula.

The basic argument around is that keeping it at 50 per cent would be unfair in two ways.

It would be unfair to those who rented out a property for five years and one month and then sold within ten years, because they would face a very hefty tax bill even if they lived in that home for many years.

And it would be a bit unfair to allow people to rent a home for four years and 11 months (just below 50 per cent) without taxing part of that gain if it was sold within 10 years.

So instead of just having that blanket 50 per cent rule, things are getting far more complicated - by splitting up your potential tax bill into each of the years you rent it out.

This is worked out by splitting the total gain at the end of the period into year-long chunks and taxing you for the years when you were renting it out.

If you rent out the property for less than one year, nothing happens no taxes apply.

If you rent it out for more than one year the tax does apply to a proportion of the gain equal to how long you rented it out.

This means the tax bill would be far lower than if it applied to the total gain, but could still be substantial.

Judith Collins says Jacinda Ardern has broken a promise by introducing a 'capital gains tax' after the Government announced a series of housing policy changes.

How this could work in practice​


This is super complicated, so lets use an example with some nice round numbers.

You buy a house in 2022 (the rule only apply to homes bought after Saturday) for $1 million.

The house gains in value to $1.6m when you sell it six years late in 2028, even without you making any improvements so you net a $600,000 profit.

If you didnt live anywhere else you have no tax bill. That $600,000 is yours.

But lets say you rented it out for two years because you were living overseas.

You dont have to pay tax on the full $600,000 profit, but you do have to pay it on the two years you werent there. The gain for those two years is calculated by looking at the proportion of the time it wasnt your main home and splitting the profit into that proportion. Its easy in this example: 2/6ths of $600,000 is $200,000.

Now we can take that profit and work out how much tax you would have to pay. Remember the way the tax works is that the profit is added to your income for that year.

If we assume you are earning $80,000 from your salary, the profit takes your taxable income for that year to $280,000.

Because income tax rates are progressive, the first $100,000 of that profit is taxed at 33 per cent, the second $100,000 is taxed at 39 per cent. That brings you a total tax bill of $33,000 + $39,000 or $72,000 on your profits of $600,000.

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