When a rebuild interests the IRD

Last updated 10:02 15/02/2014

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Cantabrians rebuilding lost houses could face tax implications, writes tax accountant MARK LODDER .

Unless I'm very much mistaken, the fundamental principle behind insurance is that it puts you back in the same position as you would have been but for the event. It should maintain the status quo.

But take the following as a common scenario in Christchurch. Say John had a family house which was destroyed in the earthquake and his land was sold to the Crown. The insurers offered either an indemnity payout of $500,000, or to replace the house (which John knows would cost around $750,000 plus GST). That's all pretty straightforward so far and there are no tax consequences.

Let's take it a step further. John wants to unlock replacement value but isn't sure where he wants to live, although the family will stay in Christchurch. He does know that he'd prefer to settle with the insurer sooner rather than later.

As a solution he purchases a bare section of land in Christchurch for $200,000 plus GST, and agrees with the insurer to replace a family home on that site. He's now almost back to where was pre-earthquake.

What you don't know yet is that it is John's plan to sell the house as soon as it is completed. He has no intention of shifting his family in there. Economically, and I am not a financial adviser, it doesn't look like a bad plan to me. He either accepts $500,000 indemnity value today, or he gets $750,000 a few months later.

OK, we can acknowledge that there is some risk of the market falling, but it would have to fall $250,000 (ignoring the time value of money) before John would be at a loss economically overall.

Can John keep ignoring tax? The answer is no. Even though overall insurance has put him back or close to the same position as he was before the earthquake, his tax position has changed. From a tax perspective, he has effectively sold one property (the one which was destroyed) and bought another for sale. And driving his tax position is the objective of acquiring the new property - he bought it for resale.

For income-tax purposes, any increase in value between the cost of the new bare section ($200,000) plus the cost of development ($750,000) will be taxable. For example, if he sells the property for $1 million, he'll be required to return the $50,000 profit as income.

It doesn't stop here. The development would mean being required to register for GST. This means that, while he can claim GST on the expenses incurred in developing the property, he'll also be required to pay GST from the subsequent sale.

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This is the best bit: an anomaly can arise where the finished property is sold for less than the combined cost of construction and land. If we follow the same logic as above, while economically you might be better off overall, you could arguably end up with an income tax loss and a GST refund.

Who said status quo would be maintained?

Mark Lodder is a tax partner with BDO based in Christchurch. Any views expressed in this article are of a general nature only.

- © Fairfax NZ News

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