Edited version of your written advice

Authorisation Number: 1051438227972

Date of advice: 12 October 2018

Ruling

Subject: Property subdivision, construction and sale of dwellings

Question 1

Will the subdivision, construction and sale of the townhouses at the Property be a profit making undertaking and treated as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the subdivision, construction and sale of the townhouses at the Property be on capital account and subject to the Capital Gains Tax provisions in Part 3-1 and 3-3 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods

1 July 2018 to 30 June 20xx

1 July 2019 to 30 June 20xx

The scheme commences on

1 July 20xx

Relevant facts and circumstances

Taxpayer One and Taxpayer Two (collectively You), purchased a house and land (Property One) at an address in on a date prior to 20 September 1985. Property One has been your main residence since that time.

In 201W a discretionary family trust (the Trust), of which You are primary beneficiaries, purchased the house and land next door to Property One (Property Two). You had previously owned Property Two, before selling it to a third party.

Property One and Property Two are each valued at $X,XXX,000 in 201X.

You, along with the Trust, will demolish the buildings on Property One and Property Two, subdivide each block into X and build X townhouses.

You will borrow approximately $X,XXX,000 to fund the project. This loan will be secured by a mortgage over both Property One and Property Two.

You will sell X of the townhouses built on Property One, and use the proceeds to reduce the debt. You estimate you will sell each townhouse for $XXX,000.

You will hold onto the remaining X properties for more than five years, and use them to earn rental income. You will use this income to service the debt, pay down the loan, maintain the properties and fund your retirement.

You do not carry on any other business activities and your sole turnover will be from the sale proceeds from selling the developed townhouses.

You intend to commence the subdivision and construction as soon as practical. Once all approvals are sought and the subdivision is complete, the building works is expected to be completed within 15 months.

You intend to engage an independent third party developer to undertake all works associated with the development of the Property including:

● designing the development and specifying lot sizes

● obtaining all approvals for the works

● determining how to undertake the development and the development timeline

● You will be responsible for:

● engaging the surveyor and lawyer to complete the subdivision of the Property

● funding all works for the development including subdivision, marketing and sales

● engaging the selling agent for the final sale of X% of the developed lots.

Assumptions

For the purpose of this ruling it is assumed that:

● You will sell the units for a price that is reasonably consistent with your estimate of $XXX,000 each

● The construction costs and interest expenses will also be reasonably consistent with the projections.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-15

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-10(3)

Income Tax Assessment Act 1997 Section 109-10

Income Tax Assessment Act 1997 Section 112-25

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1997 Part 3-1

Reasons for Decision

Questions 1 and 2

Summary

On your projected figures you will make a $XXX,000 profit on the sale of the X townhouses. You will have fundamentally transformed the property. The Commissioner considers you to be engaged in a profit making scheme, and the net profit from the sale of the four townhouses will be ordinary income.

Detailed reasoning

Income or capital

As a general principle, profits from property sales will either be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

Where the profit has been made as a result of a taxpayer carrying on a business of property development or as a result of a taxpayer entering into an isolated business transaction, the profit will be assessable as ordinary income. However, where the profit is a mere realisation of a capital asset, the proceeds will be subject to the Capital Gains Tax provisions in Part 3-1 and 3-3 of the ITAA 1997.

There have been several cases in which the courts have addressed the question of whether the proceeds received for the sale of an asset are revenue or capital in nature. The decision in each case depended on its own facts, and very often will be a matter of degree.

The extent of the personal involvement of the taxpayer in much of the planning, organisation and management of the activities has been held to be significant factors in the determination of whether or not a business was being carried out. For example:

● In Stevenson v FC of T (1991) 91 ATC 4476; (1991) 22 ATR 56; (1991) 29 FCR 282 (Stevenson) the degree of the taxpayer’s involvement was seen as an indicator of a business being conducted; and

● The lack of personal taxpayer involvement was seen as a relevant to the finding that a business was not being conducted in the cases of Stratham V FCT 89 ATC 4070, McCorkell v FCT 98 ATC 2199 (McCorkell) and Casimaty v FCT 97 ATC 5 (Casimaty).

From the cases involving the subdivision of land and from Taxation Ruling TR 92/3 (TR 92/3), it would appear that the following are the most important factors to consider when determining whether profits made as a result of an isolated business transaction are assessable income:

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

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

In determining whether an isolated transaction amounts to a business operation or commercial transaction the following factors are relevant:

a) the nature of the entity undertaking the operation or transaction;

b) the nature and scale of other activities undertaken by the taxpayer;

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

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

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

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

g) if the transaction involves the acquisition and disposal of property, the nature of that property; and

h) the timing of the transaction or the various steps in the transaction.

The courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. However, if a transaction satisfies the elements set out above it is generally not a mere realisation of an investment.

Application to your situation

You will demolish the existing house on land you own, subdivide the land and build new townhouses on the subdivided land. The existing asset will be fundamentally transformed as part of a scheme to sell for an increased profit. Where an asset has been fundamentally transformed, it is no longer possible to say you are merely realising an asset in an enterprising fashion – instead you have created something new for the purpose of sale.

On the figures supplied you stand to make $XX,000 per townhouse. Where GST is applied using the margin scheme, the projected profit is reduced but will still be above $XX,000 per townhouse. While the profits that you are seeking are low compared to the costs of the scheme, there will be significant investment in the project. Spending more on a subdivision and building project than the original asset is worth is a clear indicator that an asset is not being merely realised. You will not be involved in the day to day organisation of the project, but will take the initial decisions and will ultimately bear the risks and financial rewards for the project.

While a significant part of your intent on entering into the project is to build townhouses that you can keep as a long term investment, part of your intent with this particular scheme is to build and sell four townhouses in order to pay down part of the debt. To render a scheme on revenue account, a profit motive does not need to be the sole reason, or even the dominant reason for entering into the scheme. It is enough that profit be a significant motive. You clearly intend to sell some of the townhouses for a profit.

When you enter into a profit making scheme, assets that you have held on capital account are brought to account at their market value at the time the scheme begins. This market value uplift forms part of the cost of your scheme.

The townhouse that you keep as an investment will remain on capital account.

Capital gains tax

Broadly, the capital gains tax (CGT) provisions calculate a capital gain or loss made when a CGT event happens to a CGT asset that you own and include a net capital gain in your assessable income.

Where the gain on the sale is also subject to tax as ordinary income, this will take precedence over the CGT provisions, and only the difference between the whole capital gain and the profit subject to ordinary tax will be subject to CGT.

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. However, any capital gain or capital loss made on the disposal of a CGT asset will be disregarded if the asset was acquired before 20 September 1985.

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, according to subsection 112-25(2). Where the original land was acquired before 20 September 1985, each new block retains its pre-CGT status.

Where an existing capital asset is brought into a profit making undertaking, a market value uplift is applied to bring the land in at its market value rather than cost. The difference between the existing cost base and the current market value would generally be subject to CGT. However, as the land is pre-CGT, this gain will be exempt.

Application to your situation

In this case, Property One was acquired before 20 September 1985. Therefore, Property One is a pre-CGT asset.

When you subdivide Property One, the subdivided blocks of land will retain its pre-CGT status. That is, your ownership interest in each subdivided block of land on what was previously Property One will be a pre-CGT asset.

Capital gains tax will apply to the difference between the profits for the purposes of ordinary income and the gain on the sale. As your development is on revenue account, the ordinary income profit calculations for the scheme will take precedence. CGT would only apply to the difference between the cost base and the market value uplift. And because Property One is a pre-CGT asset, no capital gains tax would be payable on the gains on the sale of this land.

The new townhouse that you keep on the pre-CGT land of Property One will be a separate post-CGT asset. You will need to apportion the proceeds of the sale of the individual townhouses between the one that you keep and the four that you sell, and between land and the building on a reasonable basis. The construction costs will need to be apportioned between the townhouses being sold and those being kept, and will form part of the cost base of the retained townhouses.

Where you have held the buildings for more than 12 months from the date you signed the contract for their construction, you would be eligible to apply the general 50% discount to any gains on their disposal.