Introduction More and more people have become involved in property development over the years to seek access in the value of their land or they recognise and wish to take advantage of the possible opportunities associated with their land. This of course has increased the Tax Office’s concern and they are keen to ensure that taxpayer(s) meet their tax obligations, including income tax, CGT and GST.

Property Development Property development can involve different activities depending on the people involved (from mums and dads to experienced builders and property developers), and can range from simply subdividing a residential block of land to building hundreds of units.

Case study        

Mum & Dad employed and working outside the building & construction industry. Thinking of doing a 3 unit development on a property they own. The whole project is predominately funded by borrowed funds. Their involvement in the development process is limited to engaging professionals. Buildings will be erected on the land. Purpose is to sell two of the 3 units to fund future developments. There is intention to do more developments subsequent to the current. One of the units will be kept as a principle place of residence.

What Type of Development is it? How are sale proceeds treated for tax purposes? This will depend on whether or not the property developer is carrying on a business of property development, or simply undertaking the development as a “once off” opportunity. Depending on the scale and nature of the development, the developed property, including the process from any eventual sales, may be treated differently for tax purposes. The profits or loss will be assessable as ordinary income, a capital gain or both.

A. On revenue account as trading stock. When a property developer is carrying on a business, the house, unit or land will be treated as trading stock with the costs of the development being included in the value of the trading stock and any proceeds from their sale included as assessable income under section 6-5 of the ITAA 1997. The Federal Court in Gasparin v FCT (1994) also confirmed that the income is only assessable at the time of settlement.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

B. On revenue account as an isolated transaction. If the property developer is not carrying on a business, but merely undertaking an isolated transaction, the house or unit will not be treated as trading stock, but the net profit from the sale of any property may nonetheless be included in your ordinary assessable income under section 6-5 of the ITAA 1997, as well as a possible capital gain or loss on the disposal of the property. So it appears that if a one off transactions was entered into with a profit-making purpose any profit derived will be assessable under section 6-5. Broadly the net profit is the difference between the proceeds from the sale of the developed property, and the costs of developing the property. Alternatively, a loss incurred in relation to an isolated transaction will be deductible under section 8-1 of the ITAA 1997 Refer also to TR 92/4. Furthermore, in addition to the net profit (or loss), a capital gain (or capital loss) will also usually arise in relation to an isolated transaction. The reason is that, whilst the transaction is on revenue account, it is still involves the sale of a capital gains tax asset, being the land. However, to avoid double counting, the capital gain will be reduced to the extent the net profit is included in the assessable income as per section 118-20.

C. On capital account as a mere realisation of an asset. If the property developer is merely realising a capital asset in the most effective manner, then the entire transaction will be on capital account. This means that the amount received for the sale of any house or unit will be considered capital proceeds and any profit or loss is assessed under the capital gains tax rules and the taxpayer is subject to the potential application of the 50% general discount and the small business concessions if applicable. Alternatively if the sale proceeds are less than the reduced cost base, the taxpayer will incur a capital loss on the sale. Section 104-10 of the ITAA 1997 also states that the capital profit or loss is included in the year that the sale contract was signed not the settlement date.

Checklist to determine a mere realisation v’s isolated transaction It is clear that the ultimate tax treatment will depend on the underlying purpose and activity of the property development. There have been many tax cases that have helped determine the purpose of the transaction in particular those listed in TR 92/3, The High Court’s decision in FCT v Myer Emporium Ltd (1987) and MT 2006/1. The following check list can help in the process of identifying the purpose. The check list assumes that the property developer is not carrying on a business and the existence of any one of the key factors will not of itself mean that a particular sale is a mere realisation or an isolated transaction, although a combination of several of these factors will give an indication about the character of the activity. It is important to examine the facts of each particular situation, together with the check list and any other relevant information available.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

1. The purpose for which you originally acquired the land. If it was for the purpose of farming or some other non-sale related purpose (such as to rent) this indicates capital (i.e. mere realisation). If one of the purposes at the time of acquisition was to subdivide and sell in the future, then this would indicate a profit-making purpose (i.e. an isolated transaction). Furthermore, a change in purpose could also be indicative of an isolated transaction entered into for a profit-making purpose. 2. The length of time the land has been owned. The greater the time of ownership the more weight there may be that it will be on capital account. 3. The magnitude of the development. The larger the area of land subdivided and the greater number of lots, the more likely it will be treated as an isolated transaction and be on revenue account. This is not a decisive factor, just one of a number of factors to be considered. 4. Why are you selling the land? If it is simply to profit from the sale then is an isolated transaction, whereas a non-profit making reason indicates capital. For example a non-profit purpose would include say the local council just recently rezoned the land or tax increased and it became too expensive to hold the land. 5. Have you subdivided and developed other properties in the past? If so this indicates an isolated transaction. 6. Your occupation. If it is in some way connected with the land development, such as a real estate agent or a builder, then this would be more indicative of an isolated transaction. 7. The amount of borrowings used to finance the development. The greater the borrowing the more likely it will be an isolated transaction. 8. Do you have a business plan? If there is a coherent business plan for the subdivision of the land, this could indicate an isolated transaction. 9. The number of stages in the development. The development should be done in a few stages as possible. Multiple stages in a development are more indicative of an isolated transaction. 10. The level of the development. Limited clearing and earth works indicates capital. 11. Your involvement in the development. The more involvement you have in the development, the more it indicates it is an isolated transaction. Statham Case. 12. The nature of the business operation. If there is no business organisation, no manager, no office, no secretary and no letterhead, this indicates it is not an isolated transaction. 13. Did you take time off from your normal occupation to work on the development? If so this indicates an isolated transaction. 14. What other land developments have you undertaken subsequent to the development? The tax commissioner has the benefit of hindsight – so if you have subsequently entered into other similar land developments, it indicates an isolated transaction. However merely subdividing more land of the same land should not be a decisive factor. 15. The overall nature, scale and complexity of the development. The larger and more complex developments are more akin to be an isolated transaction. The commissioner takes the view in TR 92/3 that; ”A profit from an isolated transaction is generally income when both of the following elements are present: a. The intention or purpose of the taxpayer(s) in entering the transaction was to make a profit or gain or b. The transaction was entered into, and the profit was made, in the course of carrying on a business.” 16. Have you erected buildings on the land? If buildings have been erected on the land this almost certainly indicates a profit making scheme unless the building is built for personal and domestic use.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

The ATO indicates in MT 2006/1 that one of the indicators of a profit making purpose is the erection of a building on the land. Hence, if you subdivide the main residence and sell the block of land, then provided the other factors above are satisfied (e.g. you are not undertaking this transaction on a regular basis) you can usually argue that the sale of the land is a mere realisation of an asset and any profit would be on capital account. However, if you arranged for the construction of a building on the subdivided block of land (even if you outsourced the construction to a building company) then the ATO is likely to argue that the transaction has a profit-making purpose. This is likely to be the case even though you may have never undertaken a property development of this nature previously. To minimise the chances of the sale of land being considered an isolated transaction and section 6-5 applying, uou must carry out the absolute minimum development that is required by council, as well as minimising your personal involvement.

Is a one-off transaction a mere realisation or an isolated profit making scheme? Many people think that, if they are not in the business of developing property, then any proceeds they receive from selling off their property will be on capital account, no matter how much they have developed the property. This is not always the case as we have demonstrated above; there are a lot of other factors to consider. For example when land which was not acquired for the purpose of profit–making by the sale is later subdivided, developed and the individual lots sold, there are a number of tax treatments that would apply in relation to that property. Where the taxpayer is not in business, the fundamental question is whether the sale of the property represents a mere realisation (in which any profit are on capital account) or whether the taxpayer entered into the transaction with a profit-making purpose (in which the profit would be on revenue account). It is obviously critical to establish whether you are carrying on a property development business or not, as it will affect how you bring to account for tax purposes the income and expenses of the development and what the most effective structure that should be used.

Tax Implication of an “isolated transaction with a profit making purpose” In relation to a one-off transaction with a profit making purpose, any profit generated is assessable under section 6-5 and classified as being on revenue account. The net profit is the difference between the proceeds from the sale of the developed property, and the cost of developing the property. So in this situation there is no application of the 50% discount that would normally be available to a capital gain on an asset that is held for more than 12 months. In addition a capital gain will also usually arise in relation to an isolated transaction. The reason for this is that, whilst the transaction is on revenue account, it still involves the sale of a capital gains tax asset, being the land. However to avoid double accounting / tax, the capital gain will be reduced to the extent the net profit is included in the assessable income ref section 118-20.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

Tax Implication of a “mere realisation” If, after considering the factors listed in the check list, the sale is only a mere realisation and not an isolated transaction with a profit making purpose or generated from a property development business, then any capital gain or loss made in relation to the sale will be on capital account. Which means that a capital gain or loss on the sale is calculated as the difference between the capital proceeds and the cost base (or reduced cost base) of the property as per Divisions 110 and 116 of the ITAA 1997. There also may be available the 50% capital gains tax discount and potentially the capital gains tax small business concessions could apply that could reduce the capital gain. It is also important to understand that capital gain is not occurred by the mere subdivision of land, because ownership of the land has not changed (ref Section 112-25(2)). Instead the owner of the land is still treated as having acquired each subdivided lot at the time the original land was acquired. So when calculating the cost base of the subdivided land, the cost base will include a reasonable proportion of the cost base of the original property, as at the time of the subdivision. By way of background, when land is subdivided and new titles are issued for each new block, what has happened is that one asset has been split into two or more assets. In these circumstances, the cost base of the original property must be apportioned across the new blocks on a reasonable basis. The ATO under TD 97/3 will accept any apportionment approach that is appropriate. Where the new blocks are of equal size and value, then an apportionment based on “area” would usually be more reasonable. Where the new blocks are of unequal size and value, an apportionment based on the relative “market value” of each block (at the time of the subdivision) would usually be reasonable.

How is Your Transaction Classified? Without doubt, a sale on capital account is preferred. Before capital gains tax was introduced, most people generally tried to argue that profits were on capital account because pre 2oth September 1985, the profits would have been completely tax free. For transactions subsequent to the 20th September, 1985 where capital gains tax would apply on any gains, to have it on capital account would be preferred as the reason for this is that capital gains tax concessions, such as the 50% general discount or the small business concessions could apply. However these concessions do not apply in respect of a net profit that are assessable under section 65 as they would be generated either as a sale of trading stock or an isolated transaction with a profit making purpose. Ultimately, whether a one-off transaction is a mere realisation or an isolated profit making scheme or as trading stock is a question of fact and degree, and can only be answered after considering all of your facts;

Facts of this case study       

The development is a substantial 3 unit development. The whole project is predominately funded by borrowed funds. Mum and dad’s involvement in the development process is limited. Buildings will be erected on the land. Purpose is to sell two of the 3 units to fund future developments. There is intention to do more developments subsequent to the current. One of the units will be kept as a principle place of residence.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

Even though, in this case study they have not undertaken other property development projects in the past, it could be considered that two of the units would be classified as an isolated transaction with view to making a profit and any gains would be taxed under section 6-5 along with a potential capital gain tax adjustment with the sale of the land. Based on this conclusion there are several factors to consider; 1. The tax structures that can be used in a property development project. 2. The apportionment of the cost base of subdivided land. 3. The apportionment of the construction costs. 4. The GST implications of the project. 5. Tax consequences when a developer keeps a unit or an apartment. 6. The tax planning strategies available to you.

Different Types of Tax Structures In most cases once you have decided to engage in a property development, you will need to decide on a structure that best suits the development for tax and other purposes. As with any business or undertaking, there are number structures available to a property developer, these include: 1. 2. 3. 4. 5.

Sole trader. Partnership of individuals or other entities. Joint venture. Company or Trusts including self-managed superannuation trusts.

Certain structures are more common than others, the ones that are appropriate for this development is a partnership.

Partnership When two or more parties come together in a business or other undertaking, it is convenient to refer to the arrangement as a partnership. However, a partnership for tax purposes is strictly defined, and it will be necessary to analyse the relationship between the parties to a property development to establish whether or not the arrangement is, in fact, a partnership. “Partnership” is defined under section 995-1(1) of the ITAA 1997 as; “Is an association of persons…carrying on business as partners or in receipt of ordinary income or statutory income jointly”. This definition includes not just partnerships recognised under the general law in the various State and Territory Partnership Acts but also personas not in business together, but who are receiving income jointly. These two types of partnerships are referred to as “general law partnerships” and “tax law partnerships”, respectively. This means for example, co-owners of a rental property can also be a partnership for tax purposes. There for when a partnership exists, the partnership is generally required to lodge a partnership tax return. Each of the partners is then required to show their share of the net income or loss of the partnership in their own tax return. A partnership return may not be required where the only income derived by the partnership is interest or rental income, and each partner shows their share of that income, and claims their share of partnership expenses, in their own tax return. Concepts & Results Pty Ltd December 2015 www.cr.com.au

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

So in this case it can be said that the investment property that you both own at 17 Wantirna Road Carnegie and acquired in October, 2005 jointly is in fact a partnership for tax purposes. A consequence of forming a property development partnership is where a land owner confers a part of their land to another partner on forming the partnership. If there is actual change in legal or beneficial ownership, the disposal may give rise to a capital gains tax (CGT) event (A1). In this situation there has not been any change in beneficial ownership and there for a CGT event A1 is deemed not to have occurred. Another consequence of forming a property development partnership is that any contribution of land of one or more of the partners to the partnership will be a “supply” to the partnership for GST purposes, where it is credited to the partners’ capital account in the partnership’s accounts at an agreed value and the partner making the contribution is also registered for GST purposes. Refer para 46 of GSTR 2009/1. In the event where GST may be applicable, a partner may be able to avoid ‘suppling” the land to the partnership where they merely permit the partnership to have use of the real property by way of lease or licence which means that the land does not become partnership property. Usually such arrangements would need to be documented.

Apportioning The Cost Base on Subdivided Land A capital gains tax event does not happen on the mere subdivision of land, because ownership of the land has not changed (refer section 112-25(2)) Instead, the owner of the land is still treated as having acquired each subdivided lot at the time the original land was acquired. The acquisition date of these subdivided lots will not be freshened up to the date of the subdivision for CGT discount purposes. When calculating the cost base of subdivided land, the cost base will include a reasonable proportion of the cost base of the original property, as at the time of the subdivision. Under section 112-25(3), it states that the cost base must be apportioned across each of the new blocks on a reasonable basis. Also in TD97/3, the Australian Tax Office will accept any apportionment approach that is appropriate in the circumstances. Where the new blocks are of equal size and value, then an apportionment based on “area” would be usually more reasonable. Where the new blocks are of unequal size ad value, an apportionment based on the relative “market value” of each block (at the time of the subdivision) would usually be reasonable. Given your current circumstances, where one of the units will be your principle place of residence and the land area is larger than the other two it would be recommended that you obtain a market value of the land at subdivision and apportion the land cost base ($452,000 plus costs) as a percentage of the land value at the time of the subdivision.

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

Apportionment of development costs The development costs should be spread on a reasonable basis. The commissioner has the view that the anticipated selling price method should be adopted when it comes to apportioning the construction and development costs of each project. Again as one of the units is going to be your principle place of residence and it is larger and is a two storey construction, the estimated selling method is recommended if the builder does not supply a separate contract. Certain costs of developing will be immediately deductible, i.e., they will not need to be included in the cost of construction as they would be deductible under section 8-1 in the year in which they are incurred. These costs include, • • • •

General administration expenses. Interest on borrowings to develop the units that are going to be on sold only. Council rates applicable to the units being sold. Land tax applicable to the units being sold.

GST Implications The goods and service tax (GST) would appear to be relatively simple tax – those registered or require to be registered for GST are effectively required to add 10% to the sale price of the goods or services they sell, and claim back 1/11 of the cost of the goods or services they acquire. However, this is a deceptively simple summary of the operations of the GST. Since its introduction on the 1st July 2000, two areas in particular have caused considerable problems for taxpayers and the ATO, being the input tax nature of a supply of residential premises and the application of the margin scheme. Unfortunately for property developers, both of them directly relate to supplies of real property. When the GST was originally introduced, as a matter of policy, the government intended transactions involving residential premises basically be excluded from the GST regime. This intent was realised by making the sale of residential property input taxed unless it was the sale of new residential premises, under subdivision 40-C. So for residential property developers the GST situation is as follows; If the property is residential premises and is “new residential premises” the sale is a taxable supply. It is therefore crucial for a property developer to properly classify the type of property they are “selling for GST purposes”, to ensure they apply the correct GST treatment (both when selling the property, but also when claiming any input tax credits for developing the property. Also the question of whether an entity undertaking a property development activity is carrying on a business enterprise for GST purposes needs to be considered even in an isolated transaction such as a one off development where the development was entered into for the purpose of profit-making by sale. Where a tax payer is not already resisted for GST (or required to be registered) undertakes a one-off transaction with a profit-making purpose the taxpayer is required to be registered for GST if the activity is an enterprise and the registration turnover threshold ($75,000) is likely to be met on the basis of projected annual turnover. Although projected annual turnover generally excludes proceeds from the sale of capital assets, this exclusion does not usually apply to the sale of an asset from an isolated transaction which is revenue in nature as it is taxed under section 6-5

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

In summary an isolated transaction with a profit-making purpose is deemed an enterprise for GST purposes, and you (partnership) will need to be registered for GST. Let’s also look at what is new residential property? The best way to look at this is to examine what is not new residential property. Residential premises are not new residential premises if they have only been used to make input taxed supplies (e.g. rental) for at least five years since the premises: • First became residential premises; • Were last substantially renovated; or • Were last built.

So, in conclusion the two properties that mum and dad intend to sell in this case study would be subject to the GST regime and they will be required to add 10% to the sale price and also be entitled to the input tax credits on the construction costs incurred and submit the difference to the ATO. It is also recommended that they register for GST as soon as they start the development and keep appropriate records on the two units they intend to sell.

The Margin Scheme The margin scheme in division 75 of the GST Act provides an alternative option for suppliers of property to calculate the GST payable on a taxable supply of freehold interest in land, a stratum unit or a long term lease. If a tax payer makes a taxable supply of real property (e.g. the sale of new residential premises) the GST payable in relation to the supply is generally 1/11 of the sale price. However, a taxpayer who makes a taxable supply of real property by; • Selling a freehold interest in land, • Selling a stratum unit, or • Granting or selling a long term lease, May be able to choose to apply the “margin scheme”(provided the vendor and the purchaser have agreed in writing that the margin scheme is to apply ref section 75-5(1) of the GST Act) Under the margin scheme, the GST payable is 1/11th of the margin for the supply. The margin in relation to the supply is generally the amount by which the consideration for the supply exceeds the consideration for the acquisition of the property. (e.g. the sale price of the unit may be $600,000 and the cost base of the land may be $200,000 then the margin where the 1/11th GST will apply is on the difference of $400,000 not the selling price) Consideration for the acquisition of the property does not include any of the following; • Consideration for the improvement, construction or development costs of the building works; or • Activities in bringing the interest, unit or lease into physical or legal existence (i.e. subdivision costs)

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.

However, input tax credits can generally be claimed in relation to these costs. It is important to note that the entity that you sell your unit to (the recipient of the supply) is not entitled to an input tax credit in relation to that supply if you have used the margin scheme. Whether or not a developer should use the margin scheme (i.e. provided the recipient agrees) depends on a number of factors, including the following: 1. The initial acquisition – The GST treatment of the initial acquisition is important, as it will determine whether or not the developer is eligible to use the margin scheme. For example a developer cannot use the margin scheme if the supply to them was a taxable supply on which GST was calculated without applying the margin scheme. 2. The tax status of the purchaser – If the developer is selling to an unregistered GST entity (e.g. mum and dad buying a house and land package from the developer) the unregistered purchaser (mum and dad) will be unable to claim the input tax credit in relation to that property. Applying the margin scheme in this case may lead to less GST on the transaction (and potentially lower sale price of the property or higher profit) Based on the facts provided, it is recommended that mum and dad use the margin scheme for the units they intend to sell and they ensure their sale contracts refer to the fact that they are using the margin scheme.

Tax Consequences of Keeping a Unit There are tax consequences for a property developer who decides to keep it for rental purposes. The property is treated as if it has been sold to a 3rd party at cost and the developer bought it back for the same amount. The implications are that the developer may be able to claim depreciation and interest costs just like any other property held as an investment on capital account. However, according to the ATO division 43 deductions (i.e. the building write-off) may not be available as they indicate that the deductions were incurred on revenue account rather than on capital account in the construction of the property. There is however a potential argument under section 70-110 which specifically states that you would have acquired the property at the cost that it was deemed to have been sold to you as above and thus division 43 deductions could be available. There are also input tax credits that may have to be paid back to the ATO as the creditable purpose would have changed. It may sometimes be unavoidable that a property changes its purpose, in an event that the market has fallen and it would not be economically or profitable to sell the property the developer may consider holding for a period of time. In such events it is important to remember that it will have an effect on the tax positions.

Warning for first time property developers There is so much to consider when doing a property development. It is important that you seek advice from people who understand the industry and a familiar with the whole process. One of the divisions of our accounting firm Concepts and Results Pty Ltd is that we have our own property development company, building house and land, apartments and land subdivisions so our knowledge and active participation in this industry make us truly valuable to people who are seeking to undertake their first development. Call us on 9569 5676 to discuss your project. Or visit our website at www.cr.com.au Concepts & Results Pty Ltd December 2015 www.cr.com.au

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Whilst all care is taken in the preparation of this material, the information provided is of a general nature and individuals should seek advice as to their own specific needs. Accordingly no responsibility for errors or omissions is accepted by the company or any member or employee of the company.