Edited version of private ruling

Authorisation Number: 1011691344741

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Ruling

Subject: Loss on isolated transaction

Question

Is the loss on the sale of the property deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

1 July 2007 to 30 June 2008

1 July 2008 to 30 June 2009

The scheme commences on:

1 July 2007

Relevant facts and circumstances

For two years prior, the taxpayer and two associates had been looking into the possibilities of undertaking some development activity.

In 2007, the taxpayer and the associates purchased a property as tenants in common.

The property comprised a house on a subdividable residential block.

The taxpayer funded the acquisition to expedite settlement, with the expectation that the other tenants in common would draw down on yet-to-be-obtained loans to repay the taxpayer. The taxpayer took steps to satisfy him that the other parties were in a position to obtain the necessary funding.

The property was selected with knowledge of other developments being carried out in the area and with the advice of a real estate agent who was seeking potential redevelopment properties for the parties.

The plan

In the private ruling application, the applicant stated that the property was acquired:

with a view to refurbishment of the existing house, subdivision of the block into three, sell the house at the front at a profit and build two units on the subdivided land at the back and sell them at a profit

The following work was to be commenced upon settlement:

§ Gutting of the house

§ Removal of paving, patio, pergola and garage, and repair of roof

§ Repainting of house

§ Installation of hot water system and stove, plumbing, gas and electrical repairs

§ Tiling of kitchen, bathroom, laundry and floors

§ Re-carpeting

§ Gardens

Simultaneously, in respect to the subdivision:

§ Plans to be outsourced

§ Landfill to be organised

§ Bobcat to clear and level ground

§ Finish pre-building work

As soon as subdivision approval was received from the council, the newly renovated front house and land was to be placed on the market. It had been estimated that three months would be allowed for planning approval from the completion of initial plans.

With the turnover of property in surrounding areas at the time of purchase it was envisioned that the sale of the house would take at the maximum one month from subdivision approval.

Once this property was sold, construction of the back units was to be commenced. It was estimated that the construction would take six months and be placed on the market upon completion and sold within two months.

The three parties were each to borrow and contribute one-third of the funds required. The funds remaining after the initial purchase were to be placed in a joint bank account managed by one of the parties.

The taxpayer and one of the other parties were to make available cash reserves if extra funding was required after the joint bank account was exhausted. Costings were performed and the proceeds from the sale of the original house were thought sufficient to cover the cost of construction of the rear units. Substantial profit was envisaged from the sale of the two units.

No plans were made to rent the house out at any time.

What actually happened

Almost immediately following settlement, the taxpayer proceeded to refurbish the existing house with the initial assistance of the other tenants in common.

Consultants were engaged to prepare the plans for the subdivision and the first payment was made to them in early 2008. Plans for the units were finalised in March 2008.

Soon after this, the taxpayer found himself in a position requiring him to purchase the other owners' share of the property, and he did so in mid 2008. The consideration was paid in exchange for the property being transferred fully to the taxpayer.

The taxpayer proceeded with the plans for the subdivision and contracted a bobcat to demolish, clear and level the backyard to allow for the subdivision.

In July, property prices had begun to fall so the taxpayer decided to rent out the existing house and the front portion of the land in an effort to recoup some of the money being expended.

He continued with the subdivision plan and a final submission for the subdivision was submitted to the local council.

The taxpayer then sought advice from a real estate agent and was informed that there was a surplus of blocks in the area. He was advised not to proceed with the development. At this time he decided to sell the property, as substantial expenditure was still required for water, sewerage and electricity connection before final approval would be granted.

The taxpayer's decision not to continue was influenced by difficulty he was experiencing repaying loans for the property due to an accident which affected his income earning ability.

The taxpayer sold the property to an unrelated party early in 2009.

A loss was incurred by the taxpayer for the development.

The taxpayer

The Commissioner was informed by the applicant that purchasing and developing or subdividing properties was not in the course of the taxpayer's ordinary business.

During the relevant period the taxpayer conducted a business as a tradesperson.

The taxpayer is registered for GST.

Other properties held by the taxpayer include his main residence and two rental properties.

Relevant legislative provisions

Income Tax Assessment Act 1997 8-1

Income Tax Assessment Act 1997 Division 70

Reasons for decision

The loss incurred by the taxpayer could potentially be deductible under section 8-1 of the ITAA 1997 as:

§ a loss on revenue account, where a taxpayer carries on a business, gross trading receipts are brought to account as assessable income and deductions are allowed for expenses. All trading stock on hand at the start of the year and all trading stock on hand at the end of the year are taken into account in working out the taxpayer's taxable income (Division 70 of the ITAA 1997).

§ a loss on revenue account, incurred as a result of an isolated commercial transaction entered into by the taxpayer.

Carrying on a business

The Commissioner's view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11, which cites 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

§ the volume of the operations and the amount of capital employed.

A decision is dependent upon 'the large or general impression gained' and whether these indicators provide the activities with a commercial flavour after considering the indicators in combination and as a whole (paragraph 16 of TR 97/11).

The taxpayer carries on a business as a tradesperson. However, the property development transactions were not entered into in the course of carrying on that business. It is necessary to determine whether he was carrying on a business of property development.

Due to the lack of repetition, regularity and volume of operations, the taxpayer is not considered to be carrying on a business of property development despite the fact that he is carrying on the other business.

Isolated business transactions

Taxation Ruling TR 92/3 provides the Commissioner's views on whether profits from isolated transactions are assessable income. Taxation Ruling TR 92/4 discusses situations where losses on isolated transactions are deductible. TR 92/3 and TR 92/4 are intended to be read together and the principles outlined in TR 92/3 apply to a taxpayer that has made a loss, instead of a profit, from a transaction or operation.

The term 'isolated transaction' is defined in these rulings as:

a) those transactions outside the ordinary course of business of a taxpayer carrying on a business; and

b) those transactions entered into by non-business taxpayers.

As stated at paragraph 16 of TR 92/4, a loss from an isolated transaction will generally be deductible when both of the following are present:

a) in entering into the transaction the taxpayer intended or expected to derive a profit which would have been assessable income; and

b) the transaction was entered into, and the loss was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

In very general terms, a transaction has the character of a commercial transaction if it would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions.

The intention of the taxpayer is determined by an objective consideration of the facts and circumstances of the case. Profit-making does not need to be the sole or dominant purpose for entering the transaction, but it must be a significant purpose. The purpose must exist at the time the transaction or operation was entered into and in the case of property, it is usually but not always necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

Paragraph 13 of TR 92/3 lists some of the factors that have evolved from case law that may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction. These are explained further at paragraph 49 and summarised below:

a) The nature of the entity undertaking the operation or transaction. For example, if the entity is a corporation with substantial assets rather than an individual, this may be an indication that the operation or transaction was commercial in nature.

b) The nature and scale of the activities undertaken;

c) The amount of money involved in the transaction and the magnitude of the profit that was sought or obtained;

d) The nature, scale and complexity of the operation or transaction;

e) The manner in which the operation or transaction was carried out. For example, whether professional agents and advisers were used and whether the operation or transaction was in a public market

f) The nature of any connection between the taxpayer and any other party to the operation or transaction. For example, the relationship may suggest that the operation was essentially a family dealing;

g) The nature of any property disposed of. For example, if the property has no use other than as a subject of trade, it is easier to infer the transaction was commercial in nature;

h) The timing of the transaction or the various steps involved. For example, if the transaction involves the acquisition and disposal of property, then holding the property for many years may indicate the transaction was not business or commercial in nature.

Application to your situation

As no assessable income was actually derived from the taxpayer's project, and following the principles found in TR 92/3 and TR 92/4, it is necessary to establish that there was an expectation to produce assessable income (Ronpibon Tin N.L and Tongkah Compound N.L. v. FC of T (1949) 78 CLR 47). It is accepted that profit-making was his intention at all relevant times. This has been discerned from an objective consideration of the circumstances of this case. By renovating the house and planning to subdivide the land, the taxpayer was attempting to maximise the profit on disposal, and therefore, the profit-making intention is considered a significant purpose.

The taxpayer has demonstrated how he believed the project would produce assessable income, and how he came to that conclusion with the advice of professionals. Unfortunately, the withdrawal of the other tenants in common, the rapidly declining property market and the accident all contributed to his decision not to continue the project through to completion.

The second step in determining whether the losses from the isolated transaction are deductible is to consider whether the transaction was entered into in the course of carrying out a business operation or commercial transaction.

Applying the factors at paragraphs 13 and 49 of TR 92/3 to this property transaction, the following comments can be made:

a) The transactions were carried out by the taxpayer, an individual, as a tenant in common with the associates, rather than by a corporation or other business entity.

Although not a determining factor, it is considered in Taxation Ruling TR 92/3 that a corporation with substantial assets rather than an individual with limited assets is more likely to conduct activities or enter into transactions of a commercial nature. It is noted that the taxpayer had access to sufficient capital to carry out his intentions.

b) The taxpayer operates a business as a sole trader. He has not previously carried on any other property development activities. He has an interest in three other properties, one of which is his main residence. The other two properties are rental properties which he has held for several years. This venture was to be one which derived profits which would be used to purchase bigger properties with bigger development potential.

Although the taxpayer had no property development experience and he holds other rental properties, he approached this venture differently to the rental properties. Funding was obtained without security on the property in order to allow for the plan to be implemented to sell part of the property once subdivided, to fund further development. Once it was considered unviable to continue with the development, he sold the property, rather than renting it out.

c) The taxpayer invested a substantial amount in the venture and was required to invest further with the withdrawal of the other tenants in common. Significant profit was envisaged from the investment.

d) The taxpayer's project involved more than merely acquiring property in the hope of sharing in gains in a rapidly growing market. The profit-making intentions are supported by plans to firstly use his and the other tenants in common' skills to renovate the house and secondly, to use the funds from this renovated house to finance construction of units on the newly subdivided property. A significant level of methodical planning was displayed.

e) Decision making by the taxpayer was aided by professional real estate agents to find a suitable area and property for development. They were also utilised in the decision making process which led to the sale of the property in deteriorating market conditions. The property acquisition and sale took place in a public market on an arms-length basis.

Professional consultants were also engaged to prepare plans for the development.

f) The initial property purchase and subsequent sale were transacted with unrelated parties. The intervening purchase of 2/3 of the property from the associated tenants in common was an unintended and unavoidable transaction which is not considered to detract from the commerciality of the transaction. The tenants in common, although associated, were also chosen with knowledge of their respective skills which would aid the development.

g) The property traded was at both the time of purchase and sale a residential block containing a house. It was capable of being, and was utilised eventually, though temporarily, as a rental property. The taxpayer intended to add value to the property by creating three properties from one, rather than relying on capital growth to increase the value of the single-residence property.

Whilst the act of leasing the house does not have the character of a property development business, it is accepted that this was a reaction to other events that delayed the carrying out of the plan. The profit-making intentions remained.

h) The timing of the purchase, renovation and subdivision planning are consistent with allowing for the profit-making intentions. Activities under the taxpayer's control were carried out in a timely fashion, consistent with a commercial operation.

Events affecting the other joint tenants, together with a slump in market conditions and a workplace accident, prevented the project coming to fruition. The plan to sell the house quickly after renovating it in order to finance construction of the rear units is consistent with a commercial purpose.

Conclusion

The overall impression from these factors and the case law discussed above as they apply to your situation is that the taxpayer's venture constitutes a business operation or commercial transaction.

It is found that:

§ the transaction was an isolated transaction

§ the entering into of the transaction was for the purpose of making a profit or gain, and

§ the transaction and the profit, if made, would have been made in carrying out a business operation or commercial transaction.

The loss incurred by the taxpayer is therefore deductible under section 8-1 of the ITAA 1997 in the 2008-09 income year.