Edited version of private advice

Authorisation Number: 1051783949747

Date of advice: 24 November 2020

Ruling

Subject: Capital gains tax

Question 1

Are you carrying on a business for taxation purposes where you rent out your main residence?

Answer

No.

Question 2

Do you satisfy the absence rule under section 118-145 of the Income Tax Assessment Act 1997 where you move out and rent your main residence to an unrelated third party for six years?

Answer

Yes.

Question 3

Would subdividing your property into xx lots and selling lots as needed with minimal work be regarded as carrying on a business for taxation purposes?

Answer

No.

Question 4

Would the capital gain made on the disposal of your main residence be fully disregarded if part of the property was used for a bed and breakfast?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2021

Year ended 30 June 2022

Year ended 30 June 2023

Year ended 30 June 2024

The scheme commences on

1 July 2020

Relevant facts and circumstances

In xxxx you purchased a property.

As soon as the contract allowed, you applied for a permit and commenced convergence to turn the property into your main residence.

On completion you moved in.

You wish to supplement your income and are considering various options such as renting out the property or subdividing.

In xxxx, you had the property valued. You were told that the property would be worth approximately $xxxx, however after seeking expressions of interest, only one offer was made for $xxxx. Subsequently an offer of $xxxx was reached, however you declined the offer.

Following this, you do not consider the sale of the property as a whole the most prudent way to go.

You would like to see the building retained and don't want a developer to demolish it. You sought financial advice.

You also own a holiday home.

You are considering a six year lease to provide you with a fixed yearly income. Given the size of the property, you are unlikely to find a single family to maintain the property.

You wish to be absentee passive landlords, with no involvement in the running of the property. You are hoping to lease your property to a group and the property to be used as a holiday place. Alternatively, you may lease the property out with a right to sub-lease. The property may be put in the hands of a real estate agent or holiday rental agent.

Where the property was not rented, you initially considered subdividing the property into xxxx lots. However, after talking with the Town Planner, he suggested a few extra blocks would enable you to dispose of the property in the most efficient manner. No road works would be required for such a subdivision, as the property is surrounded on three sides by roads and constructed entry points to most blocks. Water, sewerage and electricity are close by and the land is level and cleared. By retaining the building, clearance costs would be minimal. Lots could be subdivided and sold to cover living expenses as required.

You don't wish to demolish the buildings and subdivide into xxxx blocks.

Another option is to live in part of the property and use part of the buildings for a bed and breakfast. However, this option is unlikely.

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 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 112-25

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 118-110

Income Tax Assessment Act 1997 section 118-145

Income Tax Assessment Act 1997 section 118-190

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Am I carrying on a business

Under subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997), the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Business is defined in section 995-1 of the ITAA 1997 to be 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

The Commissioner's view on whether the letting of property amounts to the carrying on of a business is found in a number of places.

The Australian Taxation Office publication Rental properties 2020 states on page 5:

A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a business of letting rental properties, either alone or with the other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities.

Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? outlines some factors that indicate whether or not a business of primary production is being carried on. These factors equally apply to other types of businesses. No individual factor is determinative, but should be weighed up in conjunction with the other factors.

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.

In Case G10 75 ATC 33, the taxpayer owned two properties of which six units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a seven day a week activity. The Board of Review held that the activity constituted the carrying on of a business.

Where you rent out your main residence and remain passive landlords, such activities would not be regarded as a business for taxation purposes.

Capital gains tax

Under section 6-10 of the ITAA 1997, assessable income also includes statutory income. Capital gains are included as assessable income under section 102-5 of the ITAA 1997.

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens to a CGT asset. The property is a CGT asset (section 108-5 of the ITAA 1997).

The most common CGT event, CGT event A1, occurs when you dispose of your ownership interest in a CGT asset to another entity.

The capital gain or capital loss is made at the time of the event (section 104-10 of the ITAA 1997).

Main residence exemption

Generally, an individual can disregard a capital gain or loss from a CGT event that happens to their ownership interest in a dwelling that is their main residence.

Land adjacent to a dwelling is its adjacent land to the extent that the land was used primarily for private or domestic purposes in association with the dwelling. The maximum area of adjacent land covered by the exemption is 2 hectares.

To get the full exemption from CGT:

•         The residence must be your home for the whole period that you owned it (paragraph 118-110(1)(b) of the ITAA 1997).

•         You must not have used the dwelling to produce assessable income (unless the temporary absence rule in section 118-145 of the ITAA 1997 applies) (section 118-190 of the ITAA 1997).

For the main residence exemption to apply for your whole ownership period, you must move into the dwelling as soon as practicable after you acquire the dwelling.

Absence rule

As a general rule, a dwelling is no longer your main residence once you stop living in it. However under section 118-145 of the ITAA 1997you may choose to have a dwelling treated as your main residence for CGT purposes even though you no longer live in it.

This choice needs to be made only for the income year that the CGT event happens to the dwelling, for example the year that you enter into a contract to sell it.

Under subsection 118-145(2) of the ITAA 1997, if you use the part of the dwelling that was your main residence for the purpose of producing assessable income, the maximum period that you can treat it as your main residence under this section while you use it for that purpose is 6 years. You are entitled to another maximum period of 6 years each time the dwelling again becomes and ceases to be your main residence.

However if you make this choice, you cannot treat any other dwelling as your main residence while you apply this section.

In your case where you do not live in your main residence and use your property to produce assessable income for up to 6 years and satisfy the above requirements, you will still be entitled to the full main residence exemption when you sell your main residence.

Who organises the rental and the type of tenant does not alter the above. That is, whether the rental is organised by a real estate agent or by a holiday rental agent or whether it is organized privately does not alter the above exemption. Similarly, who the tenant is does not alter the above exemption. That is, the same principles will apply whether the property is rented to a family or other entity.

Please note, that where the property is rented, the rental income is regarded as assessable income and the associated allowable expenses can be claimed as deductions.

Subdivision

Generally, an amount received in relation to subdividing land would be assessable either as:

•         ordinary income under section 6-5 of the ITAA 1997 as business income,

•         ordinary income under section 6-5 of the ITAA 1997 as an isolated commercial transaction with a view to a profit, or

•         statutory income under the capital gains tax (CGT) provisions contained in Part 3-1 of the ITAA 1997 as a mere realisation of a capital asset.

Carrying on a business of property development

As outlined above TR 97/11 provides some factors that indicate whether or not a business is being carried on. The question of whether a business is being carried on is a question of fact and degree.

Based on the information provided, where you subdivided your main residence block into xxxx lots and sold a lot as needed with minimal associated activities, we do not consider that any proceeds you would receive from the sale of the subdivided lots would be derived in the course of carrying on a business.

Other information

Profits from an isolated transaction

Profits arising from an isolated commercial transaction will be ordinary income if the 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 a taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693).

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are ordinary income and therefore assessable under section 6-5 of the ITAA 1997.

The term isolated transaction refers to:

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

•         those transactions entered into by non-business taxpayers.

If a taxpayer not carrying on a business makes a profit from an isolated transaction or operation, that profit is assessable income if both of the following elements are present:

•         the intention or purposes 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.

Profit-making does not need to be the sole or dominant purpose for entering into the transaction. A profit-making purpose must exist at the time the transaction or operation was entered into. Whether an isolated transaction is business or commercial in character will depend on the circumstances of each case.

Although you are not in the business of property development, to decide if any profit you make is ordinary income, consideration needs to be given to determine if the transaction was entered into, and the profit was made in carrying out a commercial transaction.

TR 92/3 lists the following factors which are relevant in determining whether an isolated transaction amounts to a business operation or commercial transaction:

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 and the various steps in the transaction.

In contrast, paragraph 36 of TR 92/3 notes that the courts have often said that a profit on the mere realisation of an investment is not ordinary 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.

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. The profit from the activity is income even though the taxpayer did not have the purpose of profit-making at the time of acquiring the asset.

In addition to the above factors, for the purposes of determining whether the activities undertaken in relation to real property and development equate to a profit-making undertaking or scheme, Miscellaneous Taxation Ruling MT 2006/1 The New Tax System: the meaning of entity carrying on an enterprise for the purposes of entitlement to an Australian Business Number aligns itself with TR 92/3 and provides a list of factors which, if present may be an indication that a business or profit-making undertaking or scheme is being carried on.

The factors listed in paragraph 265 of MT 2006/1 are as follows:

•         there is a change of purpose for which the land is held;

•         additional land is acquired to be added to the original parcel of land;

•         the parcel of land is brought into account as a business asset;

•         there is a coherent plan for the subdivision of the land;

•         there is a business organisation - for example a manager, office and letterhead;

•         borrowed funds financed the acquisition or subdivision;

•         interest on money borrowed to defray subdivisional costs was claimed as a business expense;

•         there is a level of development of the land beyond that necessary to secure council approval for the subdivision; and

•         buildings have been erected on the land.

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.

Numerous cases have considered the assessability of profits or proceeds from the sale of land including the following cases:

Whitfords Beach Pty Ltd v Federal Commissioner of Taxation (1983) 14 ATR 247 where the taxpayer acquired 1.584 acres of land for non- commercial purposes. Thirteen years later, the original shareholders sold out and the company and the new ownership adopted an entirely new set of articles. It then embarked on a long and complex course of activity which involved the land being rezoned and developed as a residential subdivision. Vacant lots were sold over a period of many years for a substantial profit. The High Court held that the adoption of a new set of articles resulted in a change in the intended usage of the land. This resulted in the taxpayer's activities going beyond the realisation of a capital asset, with the activities constituting the carrying on of an actual business of subdividing and selling land.

Statham & Anor v. FC of T 89 ATC 4070 20 ATR 228 where the property was subdivided and sold after a business of raising cattle had failed. The taxpayer relied on the local council to carry out the subdivision work and the local real estate agents handled the advertising and sale of the lots. The Full Federal Court held that what occurred was the realisation, by the most advantageous means, of the asset which the owners had on their hands when they abandoned the intention of farming the subject property.

Casimaty v FC of T 97 ATC 5135; (1997) 37 ATR 358 where due to the growing debt and the ill health of the taxpayer, primary production land was progressively subdivided and sold off over a period of 18 years. There was no coherent plan conceived for the subdivision of the whole property. The taxpayer had acquired and had continued to hold and use the residence and conduct the business of a primary producer on the property. Therefore, there was no change of purpose of object for which the property had been held. In his judgment, Ryan J in the Federal Court held that the profits resulted from the mere realisation of a capital asset and as such the profits were not assessable as ordinary income.

In determining whether activities relating to isolated transactions are a profit making undertaking, 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.

TR 92/3 and MT 2006/1 are available on the website for further information. MT 2006/1 paragraphs 149-208 and 262-302 provides further information on whether there is an enterprise being carried out for GST purposes. Please note, an enterprise under the GST provisions is not the same as a business for tax purposes. That is, even though a person is not carrying on a business for tax purposes, they may be an enterprise for GST purposes and GST may apply.

Subdivision and capital gains tax

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 lots is not a CGT event (subsection 112-25(2) of the ITAA 1997). Each new subdivided lot will be viewed as having been acquired on the same date that the original asset was acquired. The cost base of the original asset is apportioned between the newly created assets.

Where subdivision activities are assessable as ordinary income, section 118-20 of the ITAA 1997 contains anti-overlap provisions which operate to reduce any capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 as a result of the sales.

Where the subdivision is a mere realisation of a CGT asset, the capital gain for each event is worked out by comparing the cost base of the asset with the capital proceeds for its disposal. Where the asset is held for more than 12 months, the capital gain 50% CGT discount will generally apply. Please note that a vacant subdivided lot sold separately to the main residence dwelling is not eligible for the main residence exemption. Any capital gain realised is taxed at the relevant marginal tax rates.

Bed and breakfast in part of the home while living there

A full main residence exemption is not available if you use part of the dwelling to produce income (such as renting out a room), and you would be allowed a deduction for interest (had you incurred it) on money borrowed to acquire the dwelling.

To work out the capital gain that is not exempt, you need to take into account a number of factors, including:

•         the proportion of the floor area that is set aside to produce income,

•         the period you use it for this purpose and

•         whether you're eligible for the 'absence' rule.

You will also need to know your home's market value at the time you first used it to produce income.

There is further information on the above on the Australian Taxation Office website including a Property exemption tool calculator.

Small business CGT concessions

The CGT provisions provide some small business relief in Division 152 of the ITAA 1997.

To qualify for the small business CGT concessions, the basic conditions as contained in subdivision 152-A of the ITAA 1997 must be satisfied.

The basic conditions are:

•         A CGT event happens in relation to a CGT asset of yours in an income year,

•         The event would have resulted in a gain,

•         The CGT asset satisfies the active asset test, and

•         At least one of the following applies;

•         you are a small business entity for the income year,

•         you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997,

•         you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership, or

•         you do not carry on a business, but your CGT asset is used in a business carried on by a small business entity that is your affiliate or an entity connected with you.

A CGT asset will satisfy the active asset test if:

(a) you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the test period, or

(b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7½ years during the test period.

Subsection 152-40(1) of the ITAA 1997 details that a CGT asset is an active asset at a time if it is used, or held ready for use, in the course of carrying on a business that is carried on by you, or your affiliate, or another entity that is connected with you.

Subsection 152-40(4) of the ITAA 1997 provides some exceptions and lists some assets that cannot be active assets. Paragraph 152-40(4)(e) of the ITAA 1997 provides that an asset whose main use is to derive rent cannot be an active asset, unless that main use was only temporary. That is, even if the asset is used in a business it will not be an active asset if its main use is to derive rent.

Taxation Determination TD 2006/78 outlines the circumstances when premises that provide accommodation may satisfy the active asset test.

In certain circumstances, if you are not entitled to a full main residence exemption because you use your home for business purposes, you may be able to apply the small business CGT concessions to reduce your capital gain. However, the concessions are not available if the main use of the premises is to derive rent.

As outlined above, you are not considered to be carrying on a business for tax purposes. Even where you use the property for a bed and breakfast in part of your home, this is not generally sufficient activity to be regarded as carrying on a business. Furthermore, such activity is generally regarded as deriving rent and as such the property will not satisfy the active asset test.