Capital gains tax: Some examples of how it could work in practice

There's a lot to your head around in the Tax Working Group's recommendations on capital gains.

Here's some interesting examples of how the system works now, what the proposed changes are and what it would look if implemented.

They're all taken from the Tax Working Group's final report volume I and II and in some cases have been edited for brevity.

The way things are taxed now vs capital gains

Example one

This year, Oliver earned $50,000 in wages and will pay $8020 in tax. Judy, on the other hand, earned $25,000 from part-time work. She also sold shares in a business and got a nontaxable capital gain of $25,000.

Judy has also earned $50,000 but under current law would pay $3395 in tax.

Example two

Paul earns a salary that roughly corresponds to the median New Zealand wage. Over the last 10 years, he has earned about $450,000 of income from his job. He paid about $70,000 tax on that income.

Paul's friend Art purchased some residential property 10 years ago. He has been managing the property on a break-even basis by renting it to tenants and claiming deductions for maintenance, mortgage payments and rates.

Art recently sold this property, making a gain of $195,000. (This gain roughly corresponds to the difference in median New Zealand house prices across the 10-year period.) He is not subject to any taxon this gain under current tax rules.

Wait, what even is a capital gains tax, and to what will it apply?

A capital gains tax is a tax on the profit from the sale of an asset. The group has proposed this should apply to land, farms and most shares and business assets - including the bach - but in most cases will not touch the family home.

How much will the capital gains tax rate be?

It'll be whatever your marginal tax rate is now.

An example

Moana earns $48,000 in wages in a tax year. In the same year, Moana sells some shares and receives a capital gain of $10,000. Her total income is $58,000. Moana's tax liability will be calculated as follows:

• $14,000 at 10.5 percent = $1470
• $34,000 at 17.5 percent = $5950
• $10,000 at 30 percent = $3000
• Total tax = $10,420

However, money spent buying and improving an asset will be deducted at the time of sale and not subject to a capital gain tax.

An example

Midori owns a holiday home that she bought for $350,000. After purchasing the home, Midori spent $5000 doing up the bathroom. Five years later Midori sells it for $500,000. In the year that Midori sells the holiday home she will have income of $500,000 and will be allowed a deduction for the acquisition and improvement costs of $355,000, giving her net income of $145,000.

The 'deemed return method' - another way to tax

The deemed return method is another option for how to structure a capital gains tax. Although it's not the group's preferred method it has sketched out how it could work. It's best suited to residential rental investment property, and would replace any existing taxation on rental income.

An example:

Tina owns a residential rental investment property worth $1,000,000. The property is funded with $300,000 of debt, implying equity of $700,000. Tina is on the top marginal tax rate. The deemed rate of return is 3.5 percent. Tina would owe tax for the year of $8085 (i.e. $700,000 x 3.5 percent x 33 percent).

What's 'valuation day'?

Working out the tax gains and losses would start after the implementation date of a capital gains tax, it would be called 'valuation day'. Taxpayers would have five years from this day to establish a market price (via valuation such as QV) for each asset, rather than how much it cost to originally buy. This would represent the new cost base against which future gains and losses would be measured.

Tax would be paid when the asset was sold, and set at the person's marginal tax rate.

What happens to your parent's bach when they die (a realisation event)

An example

Alison buys a holiday home for $500,000. When she dies she leaves the holiday home, worth $700,000, to her children. The children sell it five years later for $950,000.

If the transfer of the holiday home to Alison's children is treated as a realisation event that is not eligible for rollover treatment (a situation when it's fairer to postpone applying a capital gains tax):

• Alison will have $200,000 of taxable income at the time of her death, which will be returned by her executor/administrator
• Alison's children will have taxable income of $250,000 when they sell the holiday home 5 years later.

If the transfer is eligible for rollover treatment:

• Alison will be treated as having no taxable income from the holiday home on her death
• Alison's children will have taxable income of $450,000 when they sell the holiday home five years later.