Edited version of your written advice

Authorisation Number: 1051265289931

Date of advice: 8 August 2017

Ruling

Subject: Property - development - Am I in business? – profit making undertaking

Question 1:

Will the profit from the sale of the new dupex be treated as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) as a result of you carrying on a business of property development?

Answer:

No.

Question 2:

Will the profit from the sale of the new duplex be treated as ordinary income under section 6-5 of the ITAA 1997 as a result of a profit making undertaking?

Answer:

Yes.

Question 3:

Will the profit from the sale of the new duplex be treated as statutory income under the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997?

Answer:

Yes. However, section 118-20 of the ITAA 1997 will apply to reduce the capital gain to the extent that the profit from the sale of the new duplex is otherwise included as assessable income under section 6-5 of the ITAA 1997.

Question 4:

Will it be reasonable for the market value of the land on which the new duplex is located be determined as at the date you registered for Goods and Services Tax?

Answer:

Yes.

Question 5:

Will you be entitled to a full main residence exemption in relation to the sale of the new duplex and the land it is located on under section 118-110 of the ITAA 1997?

Answer:

No.

Question 6:

Will you be entitled to a partial main residence exemption in relation to the sale of the new duplex and the land it is located on under section 118-185 of the ITAA 1997?

Answer:

No.

Question 7:

Will you be entitled to apply the 50% capital gains tax discount to any capital gain made on the sale of the land on which the new duplex is located if you meet the conditions contained in Division 115 of the ITAA 1997?

Answer:

Yes.

This ruling applies for the following period

Income year ending 30 June 2016.

The scheme commences on

1 July 2015.

Relevant facts and circumstances

You wanted to enter the property market and purchase a property to either live in or use for rental purposes.

You were not able to source finance to purchase a property on your own and the banks would only approve a loan if your parents were named as guarantors.

After 20 September 1985, you and your parents entered into a contract to purchase the Property with settlement occurring during the following month.

You and your parents obtained a loan to purchase the Property in the same month that the purchase contract was entered into. The loan was XX% in your name and X% in your parent’s names, with them listed as Guarantors.

You and your parents have the same ownership interest in the Property as the bank loan.

You and your parents made a verbal agreement in relation to the Property and there is no partnership agreement.

You moved into the Property the day after settlement occurred and continued to live there for a number of months when you moved back to your parent’s property.

The Property was rented out from the day after you moved out and you made the absence choice in relation to the Property.

A number of years after the Property had been purchased the prices for properties in that area had increased from the time you had purchased the Property.

You decided that you would demolish the existing dwelling on the Property and construct a number of duplexes so that you could sell one of the duplexes and reside in the remaining duplex.

A development application was lodged with the council in the year you had moved out of the Property.

Early the following year, the Property ceased being rented out.

A number of months after the Property had ceased being rented out you registered for Goods and Services Tax (GST).

You and your parents obtained a loan of $XXX,XXX to fund the construction of the duplexes on the Property.

In the same month you had registered for GST the dwelling located on the Property was demolished and the construction of the duplexes commenced (the Project).

You managed and oversaw the Project as you have knowledge of the building process. You obtained quotes and engaged the services of contractors to undertake the Project activities including the services of an architect to design the plans for the two duplexes and obtain approval from the council.

The construction of the duplexes, being Duplex A and Duplex B, were completed a number of months after the construction activities had commenced.

The market value of the Property prior to the Project being commenced was $XXX,XXX to $XXX,XXX and the cost to construct the duplexes was $XXX,XXX.

You claimed GST input tax credits in relation to the costs associated with the Project.

The duplexes remained vacant for a period of time after construction was completed while you addressed the subdivision of the Property with council, surveyor and land titles office.

You moved into Duplex A a number of months after the construction of the duplex was completed.

A number of months later, a contract was entered into for the sale of Duplex B for $X,XXX,XXX, with settlement occurring the following month.

The proceeds from the sale of Duplex B were distributed between you and your parents in accordance with your ownership interests in the Property.

You incorporated a company (the Company) of which you are the director. The Company entered into a contract to purchase a property prior to the date you moved into Duplex A for the purpose of developing it into a duplex (Project B), however it is currently being rented out.

Prior to the Project you had not undertaken any similar activities and do not anticipate at this point undertaking any further projects other than Project B in the future.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

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 118-110

Income Tax Assessment Act 1997 Section 118-145

Income Tax Assessment Act 1997 Section 118-150

Income Tax Assessment Act 1997 Section 118-185

Income Tax Assessment Act 1997 Division 115

Reasons for decision

Question 1, Question 2 and Question 3

Summary

The proceeds from the sale of Duplex B will be assessable income under section 6-5 of the ITAA 1997 as a result of you undertaking an isolated commercial transaction with a view to making a profit.

Detailed reasoning

Taxation treatment of property sales

Broadly, there are three ways profits from a land development, subdivision and sale can be treated for taxation purposes:

● as ordinary income on revenue account, as a result of carrying on a business of property development, involving the sale of land and buildings as trading stock;

● as ordinary income 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, where the land was acquired or subsequently held for the purpose profit making; or

● as statutory income under the capital gains tax legislation on the basis that a realisation of a capital asset has occurred.

Whether the proceeds are treated as income or capital depends on the situation and circumstances of each particular case.

We will consider each of these in relation to your situation as follows:

Carrying on a business of property development

Section 995 of the ITAA 1997 states the term 'business’ includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

The Commissioner’s view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 (TR 97/11) which uses the following indicators to determine whether a taxpayer is carrying on a business:

● whether the activity has a significant commercial purpose or character;

● whether there is repetition and regularity of the activity;

● whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

● whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit;

● the size, scale and permanency of the activity; and

● whether the activity is better described as a hobby, a form of recreation or a sporting activity.

In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impressions gained from looking at all the indicators and whether these indicators provide the operations with a commercial flavour.

Application to your situation

You and your parents purchased the Property after 20 September 1985. You resided in the dwelling located on the Property for a number of months and then moved out. The Property was rented from the day after you moved out until a number of months prior to the dwelling being demolished.

A number of years after you purchased the Property the prices for properties in that area had increased from the time you had purchased the Property. You were getting married the following year and decided that it would be a good time to demolish the existing dwelling on the Property and to construct duplexes so that you could sell one of the duplexes to set yourself up financially and reduce your debt levels. Your plan was to reside in the remaining duplex.

The original dwelling on the Property was demolished, the new duplexes were constructed and the Property land was subdivided into two lots with a duplex located on each lot.

You moved into Duplex A and sold Duplex B a number of months after the construction of the duplexes were finished.

After reviewing the information and documentation provided, it is the Commissioner’s view that your activities in relation to the Project are not those of an entity carrying on a business of developing and selling property.

The activities undertaken do not display the salient indicator of a business, which are transactions entered into on a continuous and repetitive basis.

While you are undertaking the management and co-ordination of the Project, it is a small project that is not being carried out in a manner similar to other property development businesses.

Therefore any gain made on the disposal of Duplex B will not be assessable income under section 6-5 of the ITAA 1997 as ordinary income from the carrying on of a business.

Profits from an isolated transaction

Profits arising from an isolated business or commercial transactions will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693) (Myer Emporium).

Taxation Ruling TR 92/3 considers the principles outlined in the Myer Emporium case and provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 of the ITAA 1997 as ordinary income.

Whether a particular transaction has a business or commercial character depends very much on the circumstances of the case. Paragraph 13 of the ruling outlines the following factors which may be relevant when considering whether an isolated transaction amounts to a business operation or commercial transaction:

● the nature of the entity undertaking the operation or transaction;

● the nature and scale of other activities undertaken by the taxpayer;

● the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

● the nature, scale and complexity of the operation or transaction;

● the manner in which the operation or transaction was entered into or carried out;

● the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

● if the transaction involves the acquisition and disposal of property, the nature of the property, and

● the timing of the transaction or the various steps in the transaction.

Paragraphs 41 and 42 of TR 92/3 outline that where a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction, the activity of the taxpayer constitutes the carrying on of a business operation or commercial transaction carrying out a profit-making scheme, as the case may be.

In determining whether activities relating to isolated transactions are a profit making undertaking or are the realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. This may require a consideration of the factors outlined above; however there may also be other relevant factors that need to be weighed up as part of the process of reaching an overall conclusion. No single factor will be determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities.

The direction provided within TR 92/3 indicates that profits in this context are more likely to be considered ordinary income if they are made in the ordinary course of carrying on a business. Further, ordinary income may be derived from an isolated transaction which becomes commercial in nature, or as a result of profits on a transaction in which the initial intention was to make a profit on sale.

Application to your situation

Although your initial intention when you acquired the Property may have been for private purposes, your intention changed from it being used for passive rental purposes with the demolition of the existing dwelling and the construction of the duplexes for multiple purposes, being private in relation to the duplex you moved into, and profit making in relation to the duplex you sold.

The estimated market value of the Property prior to the Project was $XXX,XXX to $XXX,XXX and the construction of the duplexes cost $XXX,XXX. You received $X,XXX,XXX for the sale of Duplex B. Therefore, the undertaking of the Project significantly improved the Property, increasing its value to a combined value of the duplexes which was significantly higher than the value of the Property prior to the Project being undertaken.

The simplest way you could have sold the Property was to sell it as a whole. However, there was a coherent plan of demolition, construction and subdivision with the intention to profit as you constructed the duplexes with the intention of selling Duplex B specifically for the purpose of making a profit so that you could set yourself up financially and reduce your debt levels.

The nature of the Property changed from a single dwelling located on the Property to duplexes located on a separate subdivided lot.

The manner in which the Project was entered into and was carried out by you had the nature of a commercial transaction. The development of the duplexes was not a simple and uninvolved development and your actions demonstrate that the development of the duplexes and the sale of Duplex B were undertaken on the basis that it would be profitable, and that a gain would be made on the disposal of Duplex B.

Based on the information provided, it is viewed that the Project has the characteristics of a commercial transaction and that your activities were the carrying out of a profit making undertaking. Therefore, any profit made on the sale of Duplex B will be assessable as ordinary income under section 6-5 of the ITAA 1997.

Capital gains tax

The capital gains tax (CGT) provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997. Broadly, the provisions include in your assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own.

CGT event A1 under section 104-10 happens if you dispose a CGT asset.

The inclusion of the profit or gain on the sale of a CGT asset as ordinary income does not mean that a CGT event does not happen in relation to the asset. However, section 118-20 of the ITAA 1997 operates to ensure that amounts which are assessable income outside of the CGT provisions are not also taxed as capital gains.

Therefore, while CGT event A1 will occur when an asset is sold, any capital gain will be reduced by the amount included as ordinary assessable income under section 6-5 of the ITAA 1997.

Application to your situation

Making an overall assessment on the factors set out in TR 92/3, it is the Commissioner’s view that the sale of Duplex B will not be a realisation of a capital asset. Therefore, any profit made on its sale will be included in your assessable income under section 6-5 of the ITAA 1997.

While CGT event A1 will occur on the sale of Duplex B, any capital gain made on its disposal will be reduced to the extent that the profit from its sale will be included in your assessable income under section 6-5 of the ITAA 1997.

Question 4:

Summary

It is reasonable for the market value of the land at the time the profit making undertaking commenced to be used when determining the profit or loss made on the sale of Duplex B.

Detailed reasoning

When a property development activity is a one-off profitmaking undertaking, a taxing point will only be triggered when the relevant property/ies are sold.

As a general proposition, the capital gain from the time the property was originally acquired to the point at which the project became revenue in nature, the time of conversion, will continue to be subject to CGT while the amount by which the sale price of the subdivided lots exceeds the market value of the land at the time of conversion and other development costs will be subject to full income tax.

Therefore, a market valuation of the property at the time of conversion would be considered to be a reasonable amount when determining the profit/loss made on the sale of a property sold as a result of a profit making undertaking.

Application to your situation

In your case, the nature of the land changed from being a capital asset to being on revenue account when the profit making undertaking is ventured into.

You registered for GST around the time the dwelling was demolished and claimed GST input credits in relation to the Project.

Based on the facts of your situation it would be reasonable to view that you had commenced the profit making undertaking when you had registered for GST in relation to the Project given that it supports that your intention in relation to Duplex B was to construct it, claim GST input credits as it was being constructed and then sell it as you have done.

Therefore, it would be reasonable for you to use the market value of the land, being the land on which Duplex B is located, at the time you registered for GST.

Question 5 and Question 6

Summary

You will not be entitled to either a full or partial main residence exemption as the main residence exemption relating to the original dwelling on the Property ceased when it was demolished. Additionally, you cannot make a choice under section 118-150 of the ITAA 1997 because you did not meet the conditions for you to be eligible to make the choice.

Detailed reasoning

Main residence exemption

Under section 118-110 of the ITAA 1997 you can generally disregard a capital gain or capital loss you make from the disposal of a dwelling that qualifies as your main residence when the dwelling was your main residence for the whole period you owned it, and your interest in the dwelling did not pass to you as a beneficiary in, and you did not acquire it as a trustee of, the estate of a deceased person.

If you moved into the dwelling when it was first practical to do so, the dwelling will be treated as you main residence for the period from when you acquired the interest to when you actually moved in.

The following extensions can extend the main residence exemption when the relevant conditions are met:

Absence choice

Where the dwelling that was your main residence is used to produce rental income, you can make the choice to continue to treat the dwelling as your main residence for a period of up to six years while you use it for that purpose, or indefinitely if it is not rented out.

Constructing a dwelling on land you already own

You will qualify for a full main residence exemption for a dwelling that was built to replace a main residence that was demolished or destroyed provided you make a valid choice under section 118-150 of the ITAA 1997, and satisfy the relevant conditions.

Ordinarily where a dwelling is demolished or destroyed and a new dwelling is constructed, the main residence usage of the first dwelling would not count towards an exemption for the new dwelling and land.

However, you can get a full main residence exemption when a newly constructed dwelling is built to replace a previous dwelling that was demolished or destroyed when you dispose of the property if:

● the original dwelling was your main residence for the full period you owned it, you did not use it to produce assessable income, and it was on land covering an area of two hectares or less; and

● the new dwelling becomes your main residence as soon as practicable after it is completed, it continues to be your main residence until you dispose of it, and that period is at least three months; and

● you make a choice under section 118-150 of the ITAA 1997 to treat the vacant land and new dwelling as your main residence in the period starting when you stopped occupying the previous dwelling and ending when the new dwelling becomes your main residence, and this period is four years or less, and

● you dispose of the land and new dwelling together

the two dwellings may be treated as one and the main residence usage of the former will count towards the main residence exemption for the new dwelling and land.

The effect of making a choice under section 118-150 of the ITAA 1997 in these circumstances will be that there is an unbroken period of occupancy of a main residence on the land from the time when the first dwelling became your main residence until the new dwelling ceases to be your main residence.

Application to your situation

In this case, you and your parents purchased the Property, with settlement occurring shortly afterwards. You moved into the dwelling located on the Property the day after settlement and continued to live there for a number of months when you moved out. Therefore, it was your main residence.

The Property was rented from the day after you moved out and you made the absence choice.

The dwelling on the Property was demolished and CGT event C1 occurred. Generally as the cost base and capital proceeds are nil a capital gain or capital loss would not be made. However, any capital gain made on the demolition of the dwelling would be disregarded as the main residence exemption in relation to the dwelling located on the Property continued until the dwelling was demolished.

After the dwelling was demolished the main residence exemption did not continue to apply in relation to the land of the Property. To have the main residence exemption extend to cover the land after the dwelling was demolished you needed to be able to make the choice under section 118-150 of the ITAA 1997. However, you are not eligible to make the choice under section 118-150 of the ITAA 1997 because you did not move into Duplex B.

Therefore, the main residence usage of the original dwelling will not count towards the main residence exemption on the sale of Duplex B and land it is located on as you do not have an unbroken main residency occupancy period during your ownership period of the land.

As you did not reside in Duplex B, and are not entitled to the make the choice under section 118-150 of the ITAA, you are not entitled to either a full or partial main residence exemption on the sale of the land and Duplex B. Therefore, any capital gain made on its sale cannot be disregarded under the main residence provisions.

Question 7

50% CGT discount

Where a CGT event A1 occurs, a discount is available on the capital gain where the following conditions in Division 115 of the ITAA 1997 are met:

1. The capital gain is made by an individual;

2. The CGT event occurred after 11.45am on 21 September 1999;

3. The cost base has not been indexed; and

4. The asset must have been acquired at least 12 months before the CGT event.

Where these conditions are met, the capital gain is reduced by 50% for individuals.

Application to your situation

In your case, no CGT event occurred when the Property was subdivided into two lots and the two subdivided lots will be treated for CGT purposes as if they had both been acquired when the Property was acquired. Therefore, you owned the subdivided lots for longer than 12 months prior to the sale of Duplex B.

If you do not use the indexation method to calculate the capital gain made on the sale of Duplex B you will meet the conditions listed above and will be entitled to apply the 50% CGT discount to the capital gain made on the sale of Duplex B.

Note: When calculating the cost base of the land on which Duplex B is located, the original purchase price of the Property will need to be apportioned between the land of the Property and the original dwelling located on the Property.

When the Property was subdivided, the cost base of the land will be apportioned between the subdivided lots 'in a reasonable way’ between the subdivided lots. Taxation Determination 97/3 provides that the Commissioner will accept any reasonable method of apportioning costs between different assets, such as area basis or valuation.

Costs attributable to each subdivided lot will be included in the cost base of the relevant subdivided lot.

The construction cost of Duplex B will be included in the fourth element of the land on which Duplex B is located.

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