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Ruling

Subject: Inherited land - realisation of a capital asset

Question and Answer

Will the sale of subdivided blocks on inherited land be the realisation of a capital asset?

1. Will the sale of subdivided blocks on inherited land be the realisation of a capital asset?

Yes.

2. Is the first element of the cost base the market value on the day the deceased died?

Yes.

3. Does the cost base include the market value of the land, any subsequent costs of the subdivision activity and other incidental costs?

Yes.

4. If any contracts are entered into 12 months after the deceased's passing, and there is a capital gain, is the gain eligible for a 50% discount?

Yes.

This ruling applies for the following period

1 July 2010 - 31 December 2012

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Prior to 20 September 1985 the deceased inherited farming land.

Prior to 20 September 1985 the deceased made an application to the council to upgrade the farm and construct some large sheds; approval was granted on the condition that after X years the land would be re-zoned as 'Residential".

Prior to 20 September 1985 the council issued a new planning scheme and the hatchery land was re-zoned back to "Rural".

Post 20 September 1985 the deceased retired from farming, largely due to urban encroachment and the economics of poultry farming on land that was increasingly close to residential property.

Following applications by the deceased for rezoning so as to realize the asset, the land was re-zoned 'Residential".

The deceased decided to subdivide so as to provide a capital base for retirement.

Lots in title one were sold, one lot was retained as a residence.

The deceased sought advice from engineers and town planners to subdivide the remaining titles.

Final development was granted for a subdivision split over a number of stages.

The deceased intentionally applied and paid for a subdivision covering a number of stages to prevent the possibility of the council changing their planning rules, which may apply if any further stages are developed.

The deceased decided to only proceed with the first stage, less than X lots; several will be gifted to family members and the remainder will be sold.

Recently the deceased passed away.

Under the Will the land passed to the spouse, who has no commercial or business experience, especially in property matters.

The spouse decided to continue with the sub-division.

Work commenced to create the Lots.

The spouse does not have to borrow and will use personal funds for the subdivision (apart from an amount drawn down from an existing mortgage for a short-term)

The work carried out is limited to the basic roads and services required for a small subdivision.

The work was carried out by third parties, with no involvement from the spouse.

The work for practical purposes has recently been completed.

The spouse will have no involvement in the marketing of the land and local agents will be appointed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 15-15

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-10(4)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Subsection 112-25(2)

Income Tax Assessment Act 1997 Subsection 112-25(3)

Income Tax Assessment Act 1997 Section 115-25

Income Tax Assessment Act 1997 Subsection 128-15(2)

Income Tax Assessment Act 1997 Subsection 128-15(4)

Reasons for decision

Ordinary Income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) includes in a taxpayers assessable income, where the taxpayer is an Australian resident, all ordinary income derived by the taxpayer both in and out of Australia during an income year. Ordinary income is defined as income according to ordinary concepts. The legislation does not provide any specific guidance on what is meant by income according to ordinary concepts. However, a substantial body of case law has evolved over time that identifies various factors that are taken into account in determining when an amount is income according to ordinary concepts.

Ordinary income includes income that arises in the normal scope of a taxpayers business. In certain circumstances, gains not within the ordinary scope of the taxpayers business may form part of ordinary income.

Statutory Income

An amount is statutory income if it is not ordinary income and it is included in assessable income by virtue of a specific provision of the tax law.

Under section 6-10 of the ITAA 1997 amounts are included as assessable income where a provision of the tax law makes them assessable income. These amounts are included even where they are not ordinary income.

Capital Gains Tax

Deceased estate

Division 128 of the ITAA 1997 contains rules that apply when an asset owned by a person just before they die, passes to their legal personal representative or to a beneficiary in a deceased estate.

Subsection 128-15(2) of the ITAA 1997 provides that your deemed date of acquisition of property from a deceased estate, is the date of the deceased's death.

Subdivision

Land, or an interest in land, is a Capital Gains Tax (CGT) asset (section 108-5 of the ITAA 1997). Section 112-25(2) of the ITAA 1997 states, that the subdivision of land into a number of lots is not itself a CGT event (Taxation Determination TD 97/3).

When any of the subdivided lots is sold, CGT event A1 applies by virtue of section 104-10 of the ITAA 1997. Subsection 104-10(4) of the ITAA 1997 provides that a capital gain will arise if the capital proceeds from the disposal are more than the asset's cost base and a capital loss will arise if the capital proceeds are less than the asset's reduced cost base.

Any gain made on the sale of the subdivided land will be a capital gain and subject to subsection 104-10(4) of the ITAA 1997 and will be included in assessable income under section 6-10 of the ITAA 1997.

The original block of land is deemed to have been split into a number of new assets as a result of the subdivision. The cost base and the reduced cost base of the new asset is worked out under the method statement in subsection 112-25(3) of the ITAA 1997.

Under the method statement, each element of the asset's cost base or reduced cost base is determined at the time the original asset is split. When the split of the original asset occurs, each element of the cost base or reduced cost base is apportioned in a reasonable way to each new asset.

Cost base

The cost base of a CGT asset is made up of five elements (section 110-25 of the ITAA 1997);

1. money or property given for the asset

2. incidental costs of acquiring the CGT asset or that relate to the CGT asset

3. cost of owning the asset

4. capital costs to increase or preserve the value of your asset or to install or move it

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

First element: money paid or property given for the CGT asset

This element includes money paid (or required to be paid) for the asset and the market value of property given (or required to be given) to acquire the asset.

Second element: incidental costs of acquiring the CGT asset or of the CGT event

There are ten incidental costs you may have incurred in acquiring the asset or in relation to the CGT event that happens to it (including its disposal).

They are:

§ remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser (you can include the cost of advice on the operation of the tax law as an incidental cost only if the advice was provided by a recognised tax adviser and you incurred the cost after 30 June 1989)

§ costs of transfer

§ stamp duty or other similar duty

§ costs of advertising or marketing (but not entertainment) to find a seller or buyer

§ costs relating to the making of any valuation or apportionment to determine your capital gain or capital loss

§ search fees relating to an asset (such as fees to check land titles and similar fees, but not travel costs to find an asset suitable for purchase)

§ the cost of a conveyancing kit (or a similar cost)

§ borrowing expenses (such as loan application fees and mortgage discharge fees)

§ expenditure that

§ is incurred by the head company of a consolidated group to an entity that is not a member of the group

§ reasonably relates to a CGT asset held by the head company

§ is incurred because of a transaction that is between members of the group.

§ expenditure (also known as termination or exit or similar fees) that is incurred as a direct result of your ownership of a CGT asset ending.

You do not include costs if you:

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

§ did not claim a deduction but can still claim it because the period for amending the relevant income tax assessment has not ended.

Third element: costs of owning the CGT asset

The costs of owning an asset include rates, land taxes, repairs and insurance premiums. Non-deductible interest on borrowings to finance a loan used to acquire a CGT asset and on loans used to finance capital expenditure you incur to increase an asset's value are also third element costs.

You do not include such costs if you acquired the asset before 21 August 1991.

Also, you do not include them if you:

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

§ did not claim a deduction but can still claim it because the period for amending the relevant income tax assessment has not ended.

You cannot include them at all in the cost base of collectables or personal use assets.

You cannot index these costs or use them to work out a capital loss

Fourth element: capital costs to increase or preserve the value of your asset or to install or move it

The fourth element is capital costs you incurred for the purpose, or the expected effect, of increasing or preserving 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.

However, it does not include capital expenditure incurred in relation to goodwill, which may be deductible as a business related cost.

Fifth element: capital costs of preserving or defending your title or rights to your CGT asset

This element includes capital expenditure you spend to preserve or defend your ownership of, or rights to, the asset - for example, if you paid a call on shares.

Modification to the cost base

Subsection 128-15(4) of the ITAA 1997 sets out the modifications to the cost base and reduced cost base of the CGT asset in the hands of the legal personal representative or beneficiary.

Item four of the table states; for an asset acquired prior to 20 September 1985 the first element of the assets cost base is the market value of the asset on the day you died.

Mere realisation of a capital asset

The mere realisation of a capital asset is not income. However, if the capital asset is ventured into in a business operation or commercial transaction with a profit making intention, the profit may be assessable. The dividing line between realisations that give rise to assessable income and those that involve the mere realisation of a capital asset is narrow. In IRC v. British Salmson Aero Engines Ltd [1938] 2 KB 482, Lord Greene MR stated, at 498:

There have been many cases which fall on the border-line. Indeed, in many cases it is almost true to say that the spin of a coin could decide the matter almost as satisfactorily as an attempt to find reasons.

This was demonstrated in the leading case of Californian Copper Syndicate v. Harris (Inspector of Taxes) (1904) 5 TC 159. In that case, the taxpayer argued unsuccessfully before the court that the gain was the mere realisation of a capital asset. Lord Justice Clerk stated, at 165-166, that:

It is quite a well settled principle in dealing with questions of assessment of Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit assessable to Income Tax. But it is equally well established that enhanced value obtained from realisation or conversion of securities may be so assessable, where what is done is truly the carrying on, or carrying out, of a business What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being Is the sum of gain that has been made a mere enhancement of values by realising a security, or is it a gain made in an operation of business in carrying out a scheme of profit-making?

It will be necessary to determine if the proposed subdivision to be conducted by the taxpayer will be conducted in the course of carrying on a business.

Assessable income arising from an isolated transaction

Taxation Ruling TR 92/3 provides guidance in determining whether profits from isolated transactions are income. Paragraph 15 of TR 92/3 states that where a taxpayer is not carrying on a business, a profit made from a transaction or operation which is not in the course of a taxpayer's business is income where:

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

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

The intention or purpose of the taxpayer in making a profit or gain is the objective rather than the subjective purpose: paragraph 38 of TR 92/3. Therefore, if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income.

TR 92/3 outlines a number of factors which must be considered in determining whether an isolated transaction amounts to be business operation or commercial transaction, including:

§ 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 the any connection between the relevant taxpayer and any other party to the operation or transaction;

§ if the transaction involved the acquisition and disposal of property, the nature of that property; and

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

In deciding these cases, it is useful to look at some of the court decisions made on similar cases.

In McCorkell v. FC of T 98 ATC 2199; (1998) 39 ATR 1112, the Court found that proceeds made by the applicant, who had subdivided land he previously used in his orchard activities and subsequently sold the subdivided lots, did not constitute assessable income as the applicant was not carrying on a business of subdividing and selling land in the relevant years. Relevant factors in the decision included the following:

§ the taxpayer had no direct involvement in the planning and contracting work for the subdivision or in selling the blocks;

§ the taxpayer relied on the surveyors and engineers to carry out the work required;

§ the works carried out in developing the subdivisions were no more than what was necessary to secure the approval of the authorities and enhance the presentation of the individual lots for sale;

§ the taxpayer had no site office or building on the land and had no direct contact with contractors or potential purchasers;

§ the taxpayer had no involvement in advertising or promoting the sale of the land; and

§ the land was sold simply by placing it in the hands of two real estate agents who recommended and had accepted prices. All negotiations for sale were conducted by the agents.

The decision stated that the facts were very similar to those in Statham v. FC of T 89 ATC 4070; (1988) 20 ATR 228. In this case, the Court found that the sale by subdivision of farming land constituted a mere realisation of the asset and not proceeds of a business. In reaching the decision, the following factors were considered relevant by the Court:

§ the owners were at first content to sell the land as one parcel, but were unable to do so;

§ no moneys were borrowed by them, although a guarantee was provided to the Kingaroy Shire Council by way of a bank guarantee;

§ only very limited clearing and earthworks were involved;

§ the owners relied on the Kingaroy Shire Council to carry out road works, kerbing, electricity and sewerage works which were required to be done;

§ the owners did not erect buildings on the land, not even, for example, a site office;

§ they had no business organisation, no manager, no office, no secretary, and no letterhead;

§ the taxpayer maintained his original occupation;

§ the owners did not advertise the land for sale;

§ the owners did not engage any contractors, although they did seek some professional advice from an engineer; and

§ the lots were sold by listing them with local real estate agents.

In Casimaty v. FC of T 97 ATC 5135; (1997) 37 ATR 358, the taxpayer acquired a farming property from his father. The next year, the taxpayer purchased more land on which he erected a homestead. For many years, the taxpayer conducted a farming business but, because of growing debt and ill health, the taxpayer subdivided and sold off a large part of the property. In all, there were eight separate subdivisions.

Most of the subdivisions required the taxpayer to construct roads, provide water and sewerage facilities and to fence the boundaries. Although the subdivisions were numerous and ultimately were a large part of the original property, the court held that the sales from the subdivisions occurred as part of the mere realisation of a capital asset of the taxpayer.

The court was primarily influenced by the fact that the taxpayer continued to use the property as a farm and a residence. The court said that it did not detect any change in the purpose for which the property was acquired. The taxpayer did not undertake any works or developments on the land beyond that which was necessary to secure approval for each subdivision. The land was sold as vacant lots; the taxpayer did not construct houses, provide internal fencing or make additional improvements.

Section 15-15 of the ITAA 1997

Section 15-15 of the ITAA 1997 states:

(1) Your assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan.

(2) This section does not apply to profit that:

(a) is assessable as ordinary income under section 6-5; or

(b) arises in respect of the sale of property acquired on or after

20 September 1985

Section 15-15 of the ITAA 1997 does not apply in this case as the spoused acquired the property after 20 September 1985, through the deceased estate.

50% Discount Method

Section 115-25 of the ITAA 1997 states:

To be a discount capital gain, the capital gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event.

The discount capital gain can be used if the asset was acquired between

20 September 1985 and 11.45 am on 21 September 1999, and if it was disposed of after 11.45 am on 21 September 1999.

When calculating the discount capital gain, the capital gain is calculated and then decreased by 50%. This in effect halves the capital gain that needs to be included in as assessable income

If the CGT discount method is used, the cost base cannot be indexed. It must also be noted that any capital losses made are first applied to any capital gains, before the CGT discount is applied

Application to your circumstances

The farm was inherited by the deceased who continued the tradition of farming the land and lived in the residence on the property. The deceased retired from farming because of the logistics of farming close to residential property.

The deceased decided to subdivide to realise the asset in the most beneficial way so as to provide a capital base for retirement.

The deceased sought advice from engineers and town planners to subdivide the land and council gave approval for a subdivision over a number of stages.

The deceased passed away and under the Will the land passed to the spouse.

A decision has been made to only go ahead with the first stage. As the deceased's spouse has no commercial or business experience, especially in property matters, the work, to create the lots, was carried out by third parties, with no involvement from the spouse. The work carried out was limited to the basic roads and services required for a small subdivision.

The spouse will have no involvement in the marketing of the land and local agents will be appointed.

On the basis of the above;

§ The proceeds from the subdivision of the spouse's land are not income according to ordinary concepts; they represent the mere realisation of a capital asset, carried out in an enterprising way so as to secure the best price.

§ The first element of the cost base of the property is the market value of the property on the day the deceased passed away.

§ The cost base, of lots sold, includes the market value of the land, any subsequent costs of the subdivision activity and other incidental costs.

§ Any lots sold 12 months after the deceased's passing will be eligible for the 50% discount method.