On 26 September 2006, the Cabinet of Ministers adopted a new Regulation on Application of the Law on Personal Income Tax. The Regulation entered in force retroactively as of 1 September 2006 and replaced the previously existing Regulation carrying the same name. Among other things, the new Regulation has brought changes to the taxation regime of real estate transactions by individuals.
An important set of provisions of the new Regulation concerns delimination of non-taxable personal income and taxable business income. Thus, the Regulation puts an end to the long-standing query concerning taxation of capital gains derived by individuals from the sale of real estate used by the individual for business purposes. Prior to the introduction of the Regulation it was argued that any capital gain from the sale of real estate owned by an individual for more than 12 months was non-taxable. Now, the Regulations make a distinction between the sale of real estate used for personal purposes and real estate used for business purposes. While not stating it explicitly, the Regulations seem to imply that the income tax exemption will not be available for capital gains by individuals engaged in the businesses of real estate brokerage or sales, management (which potentially includes also all types of rental and lease transactions) or development. In all other cases the individual will need to pay income tax from the amount of real estate depreciation deducted by the person in all previous taxation years up to the year of sale. The introduction of the new rule will put a further strain on the already hugely inefficient administration of taxation of rental income. The new rule is also likely to increase the number of small-scale apartment rental businesses which elect not to declare these businesses and to avoid taxation of their rental income. The problem may be further aggregated by the distortion of the rental market by the Latvian housing laws which make legal rental transactions risky and unattractive to potential small scale proprietors.
The Regulation intends to make less attractive the widespread tax evasion scheme under which real estate was exchanged by the sale of single purpose entities, each such entity owning a single piece of real estate. These schemes were useful for short term real estate speculation as the capital gains from the sale of shares are tax exempt notwithstanding the duration of the ownership of the securities, while the capital gains from the sale of real estate were only exempt if the seller owned the real estate at least 12 months. According to the Regulation, the transactions whereby real estate is contributed to the capital of a company and thereafter the company is sold, will now be subject to the same tax treatment as an outright sale, and thus any tax gains obtained thereby will be taxable. The Regulation, however, does not go as far as to apply the same rule to the schemes where single purpose companies are created solely for the purpose of acquisition of real estate (other than by way of contribution to capital) and thereafter are being sold. Therefore, the above change may be considered largely a cosmetic device which will affect mainly the relatively small number of individuals which have acquired real estate for speculative purposes in their individual capacity, but will not have any impact on the more sophisticated tax evasion schemes.
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