What to develop a property? What are the tax implications when you sell?
We are seeing a lot of property development on the Mornington Peninsula whether it be sub-dividing and developing two new houses, or on a larger scale. And property development these days is not just undertaken by full time property development companies, but many trades people or families are undertaking the property development. So what does it all mean for tax?
A recent ruling issued by the Commissioner of Taxation regarding Private Binding has clarified the classification of property developments. In particular, the ruling highlights whether the income resulting from a property development qualifies as regular income or capital gains.
The term “mere realisation of an asset” implies that any profits earned from a property development are liable to capital gains tax with the benefit of a 50% discount. However, property development that doesn’t fall under this term is viewed as an independent enterprise, and subject to tax as a regular income source, at the owner’s full marginal tax rate.
Either way, there are tax issues to consider. Today we examine a couple of case studies to illustrate how such considerations could play out for the property’s owners.
Property development – subdivision
Let’s take the case of a taxpayer who has owned a large rural property for many years during which time, they constructed a principal residence, ran a small farming operation, and divided the land to build a second residence for the family. Years later due to ‘mine subsidence claim’ the owners quit their farming operation and applied to the council for re-zoning permission, allowing them to subdivide their agricultural land into one-acre parcels. What is mine subsidence claim as not all readers will be aware. A mine subsidence is the movement of the ground following the extraction of coal. After coal is extracted beneath the surface, the land above can sink. There are many contributing factors to mine subsidence. Subsidence can cause damage to buildings and other structures. Claims can be made if your property has been impacted. This fact does not specifically impact the outcome of the case, it just triggered the taxpayer to do something.
The owners in question then decided to contract a developer to manage a significant subdivision project. It was agreed that the developer would oversee all project activities from its commencement to the finalising of settlements with the contracted purchasers. Most importantly, it was agreed the developer would undertake the required Development Application, once the land surveys and designs were concluded.
The ATO was then asked to rule on which income classification was applicable based on these facts, namely if the profit from the sale of the one-acre parcels was:
• regular income resulting from conducting a property development business
• regular income resulting from an “isolated transaction” with the purpose of realising a profit, or
• statutory income as determined by the capital gains tax provisions.
The ATO ultimately decided that the sale of the land qualified as statutory income as the developer handled all activities associated with the development project. This meant there was an adequate separation of control making the resulting profits “a mere realisation of an asset” (capital gains)
Property development – an old estate
Whether income qualifies as “realised from an isolated transaction” depends on whether:
- the intention or purpose of entering into the transaction was to generate a profit, and
- the profit was generated by conducting a business or commercial transaction.
In relation to the case cited above, it could be argued that the taxpayers only entered into the property development transaction after the mine subsidence claim and the council re-zoning were complete. And that the decision to level the residences, discontinue the farming operation, subdivide the land into one-acre parcels, and to sell them with pre-approved plans, via an intermediary, was to realise a commercial profit.
Despite this strong argument, the Commissioner of Taxation ruled that the taxpayer’s initial intention (*) was to purchase the land for its principal residence and farming potential, and that a significant factor governing the decision to subdivide – or develop – the land was the subsidence claim and subsequent council re-zoning. While these weren’t the only deciding factors, they were nonetheless factors beyond the taxpayer’s control.
Such re-zoning opens up property development opportunities for the affected landowners. It could even be argued that in this case, the taxpayers took advantage of a change in governmental policy for the mere realisation of an asset. As a lot of land, specifically in larger cities, has recently undergone re-zoning, it could even be said that the resulting property developments qualify as capital gains accounts, rather than as regular income accounts.
(*) When a transaction for the intention of realising a profit involves the sale of property, it is typically, but not always, necessary that such purpose exists at the time the property was acquired.
Further points to consider
In all situations it does come down to the facts and circumstances.
Land holdings if sold as they are, would usually be exempt from tax under conditions like “principal place” or “farm land.” However, in this instance, you most likely wouldn’t realise the full value of the land as you would when putting the land under development.
If the land in question has been owned for some time with no original intention to subdivide, you could potentially benefit from the ATO viewing the subdivision as a capital event rather than regular income.
If a land owner aims to distance themselves from the property development project by formally contracting a developer, the ATO may view the project as an opportunity to realise the full value of the land on a capital account.
Many property developments are sold to developers with or without a development application or permits.
Regardless of how a development project is executed, there are significant accounting, apportionment, and GST Margin Scheme issues to consider when selling newly re-zoned residential land to its ultimate owners.
If you’re planning a property development project – regardless of the driving factors behind your decision – SMART Business Solutions can help you determine if the income resulting from your project qualifies as regular income or capital gains as well as identifying the associated tax implications. It is all about Property Investment, Development & Construction for our director Shannon Smit. Many of our clients have experienced Shannon's absolute passion for everything property? Just mention your looking at a development, investment or building something and you will see her excitement wanting to know all the details! Having built her first home at 21yo, and many others build or investments since, more recently the SMART office, and a large client base of builders, developers and investors it is with excitement we share with you that Shannon has been announced as a Finalist in the Australian Accounting Awards "Property Specialist Accountant of the Year". The winners are announced 1 June 2018.
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