You may have heard about the two-year bright line rule which taxes gains on residential property sales, where the property is sold within two years of purchasing the property. The bright line rule applies to residential properties bought on or after 1 October 2015.
Even if this rule does not apply to you, there are other sections in the Income Tax legislation which can tax your property transactions.
This post will look at depreciation recovery. Some vendors of investment properties have been unaware of depreciation recovery, only to be hit with a substantial tax bill after they sold their property.
Just a note, from 1 April 2011, you can no longer claim depreciation on the building as an expense. This 0% depreciation rule applies to buildings with an estimated useful life of 50 years of more.
However, prior to 1 April 2011, you were allowed to claimed depreciation on your building. If you bought your investment property before 1 April 2011 and claimed depreciation, then when you sell the property you will have to add up all the depreciation expense you claimed in your previous tax returns. The total depreciation expense you claimed would be treated as income and you would have to pay tax on it. This is known as depreciation recovery. IRD treats depreciation recovery as a form of taxable income.
For example, if you bought a property on 1 April 2010 for $700,000 (land value $400,000 and building value of $300,000). The depreciation rate for buildings was 2% straight line in 2010. So for the income year from 1 April 2010 to 31 March 2011, the depreciation claimed would be $300,000 x 2/100 = $6000.
From 1 April 2011, you could not claim depreciation on the building as an expense.
On 1 April 2016, if you sold the property for $1 million, you have to include as income the depreciation recovery of $6000 in your income tax return.
If your tax rate is 30%, then the tax you have to pay in relation to the sale is 6,000 x 30% = $1,800.