Capital Gains Tax: Dealing with long-term assets

In the fifth of a series, David Snell shows there are no easy answers to dealing with inflationary capital gains.

In 1963 my parents bought a home for $5,000. My mother still lives there. It's now worth maybe $400,000. So she's rich, right? Not exactly. It's the same house and having to pay tax on the capital gain on sale (say 33 per cent of $395,000, some $130,000) would leave her without enough money to move.

It would be much more sensible to tax only the "real" gain in excess of inflation.

That's an extreme example, but not unrealistic.

New Zealand house prices don't always rise in real terms. The Reserve Bank calculates (using Quotable Value statistics) that house prices dipped by around nine per cent in 2008 during the Global Financial Crisis.

Of course, prices have risen since but by December 2013 were still only 13 per cent higher than in December 2008. Over the same period, inflation was around 15 per cent. That is, the average home owner was worse off.

Let's use these figures as an example. Suppose Ngaire purchases her investment property in January 2009 for $500,000. She sells in January 2014 for $565,000. She's made a real loss - her $65,000 book gain is less than inflation over the period of around $75,000. Yet, at a 33 per cent tax rate, she needs to stump up $21,450 in tax.

This makes no sense.

Capital gains taxes have three options for relieving the unfair tax - indexation, lower tax rates and taper relief. None of them works.

Indexation increases Ngaire's cost base in line with inflation - in this case, to $575,000, so she shows a small loss. This method falls down on complexity grounds - fine in our example, but it runs rapidly into problems around timing and record keeping for home improvements, and exclusions for periods where the investment property's not available.

If Ngaire uses a family trust or company, things get murkier still.

Lower tax rates. Labour, for example, proposes a 15 per cent rate of tax. In Ngaire's example, again, she's paying tax on her loss - the only difference is that it's less tax. Whatever the situation, lower tax rates will always give the wrong answer. And the longer the period of asset ownership, the greater proportion of any book gain will be down to inflation, compounding inequity.

That leads to "taper relief" - that is, the longer an asset is held, the lower the tax rate. The UK tried hard to make this work - after attempting everything else - with the taper dropping down from 40 per cent to 10 per cent depending on the length of ownership.

But taxpayers aren't dumb. They hold onto assets for just long enough to claim the 10 per cent rate. So they avoid most of the tax otherwise due. This "lock in" effect is a natural behaviour. But it distorts investment activity and means not much tax is paid, making the entire exercise pointless.

For me, inflation is the single biggest problem with capital gains taxes.

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Read the first, second, third and fourth columns in this series.

David Snell is an executive director at accounting firm EY. He used to work for Treasury.