Edited version of your written advice

Authorisation Number: 1012872136400

Date of advice: 2 September 2015

Ruling

Subject: Capital gains tax

Question 1

Will your share of the proceeds from the disposal of property B (the property) be assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Can your share of the relevant portion of rates, taxes and interest incurred from the time you purchased the original dwelling be included in the cost base of the property?

Answer

Yes.

Question 3

Can your share of the relevant portion of the demolition and subdivision costs be included in the cost base of the property?

Answer

Yes.

Question 4

Will the market value substitution rule apply in determining what the capital proceeds were for the disposal of the property?

Answer

Yes.

Question 5

Can you apply the 50% discount method to the calculated capital gain?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2015

The scheme commences on

1 July 2015

Relevant facts and circumstances

You and your spouse purchased a property in the mid-nineties.

You lived at the property for several years.

You have since had the house sat.

You have not returned any income or expenses in relation to the property.

You developed the property by demolishing the original dwelling and subdividing the block into two separate titles (property A and property B), with a new dwelling being built on each block.

You did not receive any capital proceeds on the demolition of the dwelling.

You engaged a builder to construct the new dwellings and you financed the development through your current financial institution.

You sold property B to a family member.

You have kept the other property as your retirement home.

You did not commission a valuation of the land and dwellings by a registered valuer.

The contact amount was agreed upon between you and the family member.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 112-25

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 115-25

Income Tax Assessment Act 1997 section 115-100

Income Tax Assessment Act 1997 section 152-205

Reasons for decision

Ordinary income

There are three ways profits from a land subdivision can be treated for taxation purposes:

1. As ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock.

2. As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of an isolated business transaction entered into by a non-business taxpayer or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose.

3. As statutory income under the capital gains tax (CGT) legislation, (sections 10-5 and 102-5 of the ITAA 1997, on the basis that a mere realisation of a capital asset has occurred.

In your case, you do not carry on a business of buying, selling or developing land. The initial property was purchased for domestic purposes and has been held for an extended period of time. The subdivision and the construction of the new dwellings have been done without any commercial intention as you have retained one of the properties as your retirement home and the other has been sold to your relative for their main residence.

Taking your circumstances into account, including the size and scale of the development, we consider that the sale of property B will be a mere realisation of a capital asset.

Accordingly, the proceeds from the sale of property B will not be included in your ordinary income. Rather, the sale will be considered a capital transaction subject to the capital gains tax provisions in Part 3-1 of the ITAA 1997.

Capital gains tax

Section 102-5 of the ITAA 1997 provides that your assessable income includes your net capital gain for the year.

Section 102-20 of the ITAA 1997 provides that a taxpayer makes a capital gain or loss as a result of a capital gains tax (CGT) event happening to a CGT asset. CGT assets include real estate acquired on or after 20 September 1985.

When selling a property, the CGT event occurs at the date of the contract of sale.

If a CGT asset is split into 2 or more assets, each of the split assets are new CGT assets (paragraph 112-25(1)(a) of the ITAA 1997). The splitting of a CGT asset is not a CGT event (subsection 112-25(3) of the ITAA 1997). A CGT event will happen if any of the new CGT assets are disposed of. This will constitute the happening of a CGT event A1 (section 104-10 of the ITAA 1997).

Therefore, a CGT event A1 occurred when property B was contracted for sale.

Cost base

For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your asset.

Section 110-25 of the ITAA 1997 provides that the cost base of a capital gains tax (CGT) asset is comprised of the following five elements:

• money or property given to acquire the asset

• incidental costs of acquiring the CGT asset or that relate to the CGT event

• costs of owning the asset

• capital costs to increase or preserve the value of your asset or to install or move it; and

• capital costs of preserving or defending your ownership of or rights to your asset.

Based on your circumstances the third and the fourth elements will apply.

Third element - costs of owning the asset

The third element of the cost base of an asset is the non-capital costs of ownership. These costs include interest on money borrowed to acquire the asset or to refinance such a borrowing, interest on money borrowed to finance capital improvements to the asset, repairs and maintenance, insurance premiums, rates and land tax.

For interest expenses to be included in the cost base of a CGT asset, it must be established that the borrowings have been applied to the acquisition of the asset, and not for another purpose. Where loans are for a mixed purpose, apportionment of interest is required.

You do not include such costs if you acquired the asset before 21 August 1991. Nor do you include them if you:

• have claimed a tax deduction for them in any income year, or

• omitted to claim a deduction but can still claim it because the period for amending the relevant income tax assessment has expired.

In your case the property was purchased after 21 August 1991 and it has not been used for an income producing purpose.

Therefore, you are entitled to include your share of the relevant portion of the non-capital costs of ownership from the date of purchase.

Fourth Element: Capital expenditure to increase value

The fourth element of the cost base for CGT purposes is capital expenditure you incurred for the purpose or the expected effect of which is to increase or preserve the asset's value, for example, costs incurred in applying (successfully or unsuccessfully) for zoning changes.

It also includes capital costs you incurred that relate to installing or moving an asset.

In your case, the demolition and subdivision costs are considered to be capital expenditure incurred to increase or preserve the value of the CGT asset.

Therefore, you are entitled to include your share of the relevant portion of the costs in calculating the cost base.

Market value substitution rule

Special rules apply if a sale is between family members or a related party and is not at market value. Such a transaction is considered a non-arm's length transaction, and requires modification to the capital proceeds used to calculate your capital gain or loss (section 116-30 of the ITAA 1997).

The market value substitution rule takes effect if you did not deal at arm's length with another entity in connection with the event (subsection 116-10(2) of the ITAA 1997). The market value substitution rule, broadly, is when the capital proceeds received are replaced with the market value of the asset.

The market value of the asset is worked out at the time the CGT event happens.

Where the market value of an asset needs to be determined an individual can obtain it by a number of means such as:

• a qualified valuer, or

• compute their own valuation based on reasonable objective and supportable data.

Note: The Australian Taxation Office (ATO) may challenge valuations were appropriate.

The ATO has released a publication titled Market valuation for tax purpose, which is available on our the website - www.ato.gov.au

You will make a capital gain if the market value at the time of the event (change of ownership of the property) exceeds the cost base of the property and you will make a capital loss if the market value at the time of the event is less than the reduced cost base.

In your case, the sale of the property to your relative is considered to be a non-arm's length transaction. The value of the property was based on how much they could borrow rather than the current market value.

Consequently, the market value substitution rule will apply and you will be taken to have received the market value of property B at the time of the CGT event A1.

CGT discount method

Capital gains may receive a more concessional tax treatment than other income after the introduction of the CGT discount in September 1999. The CGT discount means that individuals pay tax on only 50% of any capital gain they make on assets owned for at least 12 months.

You can use the discount method to calculate a capital gain if:

• a CGT event happens to an asset you own

• the CGT event happens after 21 September 1999

• you acquired the asset at least 12 months before the CGT event, and

• you did not choose to use the indexation method.

Based on your circumstances you satisfy the requirements to apply the discount method to only pay tax on 50% of the capital gain resulting from the CGT event that happened to property B.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).