Edited version of your written advice

Authorisation Number: 1051317773697

Date of advice: 7 December 2017

Ruling

Subject: Sale of residential property

Question 1

Will the profit from the sale of the units (the Units) be treated as statutory income under the capital gain tax provisions in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the sale of the Units be a taxable supply under section 9-5 of the A New Tax System (Goods and Services tax Act 1999 (GST Act)?

Answer

No.

Relevant facts and circumstances

A is registered for GST in relation to their enterprise.

B is not registered for GST.

On DDMMYYYY A and B (You) purchased a residential property the House as joint tenants, each having a 50% ownership interest.

The purchase price of the House was $X.

The House was purchased with the intention of holding if for long term rental, and was used for that purpose.

The House was rented at $X per week.

Minor improvements were undertaken by you during the period it was tenanted. These improvements include removing carpet and cleaning floors in the living room and internal painting.

The House was in a deteriorating condition. The ingress of water from defective storm water pipes allowed water to lodge under the House, which lead to movement in the stumps, chimney and some walls. The House was also damaged by the tenants which resulted in court proceedings.

You investigated the costs of reinstating the house to a habitable state and estimated that the costs of re-stumping, drainage works and repairing cracks would cost $X.

You made the decision to demolish the House, subdivide the land and build X new units which would then be used for rental and investment purposes. You would have continued to rent the house if it was not extensively damaged.

Your rate notice shows that the estimated unimproved value of the land before the subdivision and building works were completed was $X.

You sought Council planning approval for the subdivision on DDMMYYYY.

As a contingency you completed the subdivision at the start of the process rather than the end as you thought it would be easier and more cost effective to complete the subdivision at the start.

The development was 100% financed as an interest only line of credit secured against your principal residence. The interest rate was X% and your loan totalled $X, incurring $X in weekly interest. The loan also included a residual amount of $X owing on the purchase of the House.

On DDMMYYYY the House was demolished and X new units were then constructed, the Units.

You engaged a builder to undertake the building construction.

There was approximately X% overrun in construction costs due to timing and asbestos removal.

You completed exterior works such as landscaping which were higher than anticipated.

The subdivision and construction costs included $X subdivision costs and $X construction costs. These costs were higher than expected and during the construction phase you decided to sell the Units to eliminate your debt exposure. You were also fearful of the impact of rising interest rates may have on your ability to repay the loan and interest, particularly given A operated their own business.

In MMYYYY, construction of the Units was completed. The Units were advertised for sale soon after and due to limited demand, the Units were rented from DDMMYYYY.

The Units have attracted rental income of between $X to $X per week (depending on the length of the tenancy).

You have not completed any previous subdivisions or similar projects and you do not intend to do so in the future.

You have another rental property.

You have not claimed any of the building and subdivision costs.

A potential purchaser has shown an interest in purchasing a unit for $X.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

A New Tax System (Goods and Services Tax) Act 1999 Section 9-5

A New Tax System (Goods and Services Tax) Act 1999 Section 23-5

A New Tax System (Goods and Services Tax) Act 1999 Section 188-10

A New Tax System (Goods and Services Tax) Act 1999 Section 188-25

Reasons for decision

Question 1

Summary

The demolition of the House and subdivision and construction of X units for sale does not amount to the carrying on of a business or an isolated commercial transaction and any gain made on the disposal of your ownership interest in each unit will represent a mere realisation.

Detailed reasoning

Taxation treatment of property sales

There are three ways profits from property sales can be treated for taxation purposes:

1. As ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA), 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, on revenue account, as a result of entering into a profit-making undertaking or scheme (including an isolated transaction).

3. As statutory income under the capital gains tax legislation.

Carrying on a business of property development

Section 995-1 of the ITAA 1997 states the term ‘business’ includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

Taxation Ruling TR 97/11 provides the Commissioner’s view of the factors used to determine if you are in business for tax purposes. In the Commissioner’s view, the factors that are considered important in determining the question of business activity are:

● whether the activity has a significant commercial purpose or character

● whether the taxpayer has more than just an intention to engage in business

● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

● whether there is regularity and repetition of the activity

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

● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as 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 sporting activity.

Isolated Commercial transactions

Profits arising from an isolated transaction as a result of entering into a profit-making undertaking or scheme will be ordinary income under section 6-5 of the ITAA 1997 and will be on revenue account (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium)). This is distinguished from a ‘mere realisation’ which is not ordinary income.

Paragraph 16 of Taxation Ruling TR 92/3 states that if a taxpayer not carrying on a business makes a profit, that profit is income if:

a) the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain; and

b) the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

Paragraph 13 of TR 92/3 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.

TR 92/3 outlines that the relevant intention or purpose of the taxpayer, of making a profit or gain, is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer’s intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

Capital gains tax provisions

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 happens if you dispose a CGT asset. A CGT asset is any kind of property, or a legal or equitable right that is not property.

When a CGT asset (the original asset) is split into 2 or more assets (the new assets), such as when land is subdivided, the subdivision of the land into subdivided blocks is not a CGT event. Each new subdivided lot will be viewed as having been acquired on the same date that the original asset was acquired.

Application to your situation

Taking all of the available facts into consideration, and on weighing the various factors, your activities in subdividing, building and preparing for sale X units is viewed as a mere disposal of an investment asset and will be taxed under the capital gains provisions.

You and your spouse acquired an ownership interest in the original House in YYYY and used the House for the purposes of deriving accessible income up until the House was demolished in late YYYY. Your intention was to retain the House as a rental property. The structural damage caused by a defective storm water drainage system rendered the House uninhabitable and you were faced with significant expenses associated with restumping and reinstating the chimney and walls to a safe condition.

Following the structural damage incurred to the House, you and your spouse obtained Council approval in YYYY to subdivide and build X unitsand took out an interest only loan of $X to cover the subdivision and construction costs. The costs exceeded your contract price by X% and you made a decision to advertise the units for sale to discharge the mortgage.

Your intention was to retain the X unitsas a rental and investment property. You continued to rent them out following the construction process. Your activities do not have any of the indicia associated with someone carrying on a business or entering into a profit making scheme. You have not engaged in similar transactions in the past and the amount of money involved in the transaction and magnitude of the profit is likely to be modest, given the significant mortgage outstanding in relation to both the House and construction costs of the X units and other expenses associated with the sale of the Units. Furthermore, you have not registered for GST in relation to your subdivision and construction activities and you have not claimed any GST credits on construction costs and related purchases.

Therefore, any gain arising from the sale of your ownership interest in the X units will be accounted for under the CGT provisions of the ITAA 1997.

Question 2

In this reasoning, please note:

● all legislative references are to the A New Tax System (Goods and Services Tax) Act 1999 (GST Act)

● all reference materials referred to are available on the Australian Taxation Office (ATO) website ato.gov.au

● all legislative terms of the GST Act marked with an asterisk are defined in section 195-1 of the GST Act.

As you, A and B are co-owners of the Units and are in receipt of rental income jointly we consider that you are a tax law partnership for GST purposes as outlined in Goods and Services Tax Ruling GSTR 2004/6 Goods and services tax: tax law partnerships and co-owners of property.

Therefore, you, being the tax law partnership of A and B must pay the GST on any taxable supply you make.

Section 9-5 provides that you make a taxable supply if:

a) you make the supply for consideration

b) the supply is made in the course or furtherance of an enterprise that you carry on

c) the supply is connected with the indirect tax zone (Australia), and

d) you are registered, or required to be registered, for GST.

However, the supply is not a taxable supply to the extent that it is GST-free or input taxed.

You will satisfy the requirements of paragraphs 9-5(a), 9-5(b) and 9-5(c) as you will make a supply of the Units in Australia for consideration in the course of your leasing enterprise. Further, the GST-free and input tax provisions are not applicable in this case. Of relevance is whether you are required to be registered for GST.

Section 23-5 provides that you are required to be registered for GST if:

a) you are carrying on an enterprise, and

b) your GST turnover meets the registration turnover threshold.

The registration turnover threshold is currently $75,000.

Section 188-10 provides that you have a GST turnover that meets a particular turnover threshold if:

a) your current GST turnover is at or above the turnover threshold and the Commissioner is not satisfied that your projected GST turnover is below the turnover threshold, or

b) your projected GST turnover is at or above the turnover threshold.

Of relevance here is your projected GST turnover. Section 188-20 provides that your projected GST turnover at a time during a particular month is the sum of the values of all the supplies that you have made or are likely to make during that month and the next 11 months other than input taxed supplies.

The rental of the Units is an input taxed supply of residential premises by way of lease pursuant to paragraph 40-35(1)(a) and the turnover from those supplies is not included in the calculation of your GST turnover.

However it is necessary to determine if the proceeds from the sale of the Units will be included in the calculation of your GST turnover.

In working out your projected GST turnover, paragraph 188-25(a) requires that you disregard any supply made or are likely to be made, by you by way of transfer of ownership of a capital asset of yours.

Goods and Services Tax Ruling GSTR 2001/7 Goods and Services Tax: meaning of GST turnover, including the effect of section 188-25 on projected GST turnover discusses the meaning of a ‘capital asset’ at paragraphs 31 to 36.

Capital assets are often referred to as structural assets used by an entity to produce an income. Capital assets are to be distinguished from revenue assets. If the means by which you derive income is through the disposal of assets, those assets will be revenue or trading assets rather than capital assets.

In this case the House was a capital asset from which you derived rental income. Due to the deteriorating state of the House from water damage and the damage done by the tenants you made the decision to demolish the original house and construct X units for rental. You have rented these units for $X to $Y per week.

You have subsequently decided to sell the Units to eliminate your debt exposure as the subdivision and construction costs exceeded you expectations and you are concerned interest rates will go up.

We have taken into consideration the following factors in relation to your intention to use the Units for rental income:

● Your intention was always to maintain a rental property on your land and but for damage to the House, you would have continued renting this property.

● You did not claim any of the building and subdivision costs for the Units which indicates you did not intend to conduct an enterprise of subdivision and construction of units for the purpose of sale.

● You have not completed any previous subdivisions or similar projects.

● You have another rental property.

On this basis the Units are considered to be a capital asset and not a revenue asset.

Therefore paragraph 188-25(a) acts to exclude the sale price of the Units from the calculation of your projected GST turnover.

As your turnover will not meet the GST registration turnover threshold you are not required to be registered for GST.

Therefore, you will not satisfy all the requirements of taxable supply under section 9-5 when you sell the Units.

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