Edited version of private advice

Authorisation Number: 1051852844313

Date of advice: 19 August 2021

Ruling

Subject: Income tax - assessable income - income vs capital - profits from an isolated transaction

Issue 1:

Income tax - Assessable income - whether profits on this transaction are considered income or capital?

Question 1

Are the profits from the sale of the property assessable as ordinary income under section 6-5 of theIncome Tax Assessment Act 1997?

Answer 1

Yes.

Question 2

Are the profits from the sale of the property assessable as statutory income under the capital gains tax provisions contained in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997?

Answer 2

No.

Issue 2:

Income tax - What is the cost base or reduced cost base of the property?

Question 3

What is the cost base to be applied against the transaction?

Answer 3

The cost base using the market valuation should be apportioned on reasonable basis between the two subdivided blocks, in addition to half of the eligible costs of the new development applicable to this transaction.

This ruling applies for the following periods:

For the income year ended 30 June 20XX

For the income year ended 30 June 20XX

For the income year ended 30 June 20XX

For the income year ended 30 June 20XX

The scheme commences on:

During the income year ended 30 June 20XX

Relevant facts and circumstances

You are an Australian resident for taxation purposes.

In 19XX you acquired a post-CGT residential property in Australia for approximately $X.

You incurred incidental acquisition costs such as stamp duty of $X and legal costs of $X.

The total land area is less than two hectares and the no part of the property has ever been used to produce assessable income.

You resided in the original dwelling for the entire ownership period and you have always considered it to be your main residence for CGT purposes.

You have recently been preparing for retirement however due to your financial position, you may not yet be able to cease working permanently.

Your intention though, was to consider downsizing into a home with lower maintenance as the property was ageing and in need of major repairs and maintenance.

In 20XX you started looking at the prospect of demolishing the existing dwelling and subdividing the land exactly in half, creating two blocks of equal land size.

In 20XX you engaged a builder as you believed that demolition, subdivision and then building a new dual occupancy development on the land with the intent to sell one of the new dwellings once completed, would be the best solution to suit your circumstances.

You received no capital proceeds on the demolition of the original dwelling.

In 20XX certified valuers assessed the existing property to be valued at $X, with land being $X and improvements $X.

The local council signed off on the new development in 20XX and registration of development plan number X occurred in 20XX.

Half of the total costs of the new development to 20XX was $X (GST Inclusive) plus interest and other associated holding costs of the asset.

The legal title of both properties was registered in your individual name with both dwellings being identical in all physical aspects, including an equal market value.

Your intention was always to reside in one of the new dwellings once construction was completed and the second new dwelling was to be sold with the anticipation of making some profit from the sale transaction.

During the relevant years, there continued to be a mortgage over the property, and you borrowed further funds in order to finance the new development.

You continued to pay interest on the property development until the dwelling was sold in 20XX when you then paid off your mortgage in full to the lender.

You have not undertaken any property development in the past and you consider this subdivision to be a one off event or transaction only.

You have not provided us any business plans with respect of the new development.

A sale contract was signed in 20XX and settlement occurred in 20XX for $X.

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 102-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 108-55

Income Tax Assessment Act 1997 section 112-25

Income Tax Assessment Act 1997 section 112-30

Income Tax Assessment Act 1997 section 116-25

Income Tax Assessment Act 1997 Division 115

Income Tax Assessment Act 1997 Parts 3-1 and 3-3

Reasons for decision

Tax treatment of property sales transactions

The profits from property sales are treated for taxation purposes in one of three ways:

1.     As ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) on revenue account, as a result of carrying on a business of property development, involving the sale of property as trading stock; or

2.     As ordinary income under section 6-5 of the ITAA 1997 on revenue account, as a result of an isolated commercial transaction with a view to a profit, entered into by a non-business taxpayer, or outside the ordinary course of business of a taxpayer carrying on a business; or

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

Ordinary income

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Statutory income - 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. Real estate property is considered a CGT asset (section 108-5 of the ITAA 1997).

CGT event A1 happens if you dispose of a CGT asset (section 104-10 of the ITAA 1997).

When a CGT asset (the original asset) is split into 2 or more 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).

Profits from an isolated transaction

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.

Paragraph 1 of TR 92/3 refers to 'isolated transactions' as:

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

•                 those transactions entered into by non-business taxpayers.

Whether a profit from an isolated transaction is ordinary income depends very much on the circumstances of the case. Paragraph 6 of TR 92/3 provides that profits from an isolated transaction is generally income when both of the following elements are present:

•                 the intention or purpose in entering into the transaction was to make a profit or gain; and

•                 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.

It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose. If the transaction involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property (paragraphs 8 & 9 of TR 92/3).

However, that is not always the case because the purpose can change. This was demonstrated in the High Court decision in FC of T v Whitfords Beach Pty Limited 82 ATC 4031. This is explained in the example at paragraph 41 of TR 92/3:

41. if a taxpayer acquires an asset with an intention of using it for personal enjoyment but later decides to venture or commit the asset either as the capital of a business or into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction, the profit is income even though the taxpayer did not have the purpose of profit-making at the time of acquisition.

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 Numberaligns 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.

In determining whether activities relating to isolated transactions are an enterprise or the mere realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. 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 (paragraph 266 of MT 2006/1).

In addition to a profit making intention the transaction must have a business or commercial character. Paragraph 47 of TR 92/3 states:

47. For a transaction to be characterised as a business operation or commercial transaction, it is sufficient if the transaction is business or commercial in character... Whether a particular transaction has a business or commercial character depends very much on the circumstances of the case.

Paragraph 49 of TR 92/3 provides a number of factors which may be relevant in 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 that property; and

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

Specifically, in relation to the sale of subdivided land, the following factors have been considered by the courts to determine whether proceeds was income from carrying on a business or carrying out an isolated commercial transaction, or was from the mere realisation of a capital asset:

•                 whether the landowner held the land for a considerable period of time prior to any subdivision and sale;

•                 the purposes for acquiring the property, and whether it was used for any other purposes prior to sale;

•                 whether the landowner conducted farming or other activities on the land prior to beginning the process of developing and selling the land;

•                 whether the landowner originally acquired the property as an investment, such as long term capital appreciation or to derive income;

•                 whether the land was originally acquired near the urban fringe of a major city or town;

•                 if the property has been rezoned, whether the landowners actively sought that rezoning;

•                 whether a potential buyer made any offers to the landowners before they commenced discussion to enter into a proposed or final development agreement;

•                 whether the landowners had tried to sell the land without subdivision;

•                 whether the landowner had any history of buying and profitably selling developed land or land for development;

•                 the extent to which the development goes further than that required to obtain council approval;

•                 whether the operations will be planned, organised and carried on in a business-like manner;

•                 whether the landowners have changed their business activity relating to the land from one business to another (for example, from farming to property development);

•                 the scope, scale, duration and degree of complexity of the proposed development;

•                 the reasons for selling the land;

•                 who initiated the proposal to develop the land for resale;

•                 the complexity of the development;

•                 the level of involvement that the taxpayer had in the development, marketing and sale of the property;

•                 the level of legal and financial control maintained by the landowners in the proposed or final development agreement;

•                 whether any finance must be obtained in order to fund the development activities; and

•                 the level of financial risk borne by the landowner in acquiring, holding and/or developing the land.

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.

Demolition of a dwelling

CGT event C1 occurs

CGT event C1 will happen when a CGT asset is demolished or destroyed (subsection 104-20(1) of the ITAA 1997). The time of the event is when the destruction occurs. Paragraph 4 of Taxation Determination TD 1999/79 Income tax: capital gains: does the expression 'lost or destroyed' for the purposes of CGT event C1 in subsection 104-20(1) of the Income Tax Assessment Act 1997 apply to: (a) a voluntary 'loss' or 'destruction'? (b) intangible assets?, confirms that CGT event C1 can happen on the voluntary destruction of an asset where for example, a taxpayer might demolish a building in the course of redeveloping a property.

Subsection 104-20(3) of the ITAA 1997 provides that you make a capital gain from CGT event C1 if the capital proceeds from the loss or destruction are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base. Section 116-25 of the ITAA 1997 provides that the market value substitution rule does not apply to CGT event C1.

The effect of the cost base rules in subsections 112-30(2) and (3) of the ITAA 1997 and the capital proceeds rule in section 116-25 of the ITAA 1997 is that no capital gain or capital loss arises when CGT event C1 happens on the demolition of a dwelling if no capital proceeds are received for it. This is explained in ATO Interpretative Decision ATO ID 2002/63 Income tax: Capital gains tax: demolition of a dwelling: CGT event C1.

Subdivision of land

When a block of land is subdivided, the original land parcel is split into two or more separate CGT assets. Subdivision itself is not considered to be a CGT event as subdividing does not change the ownership of the subdivided block. The acquisition date of the subdivided block is the same acquisition date as that of the original block. Therefore, a capital gain or capital loss is not made at the time of the subdivision.

The cost base of the asset should be apportioned between the two new blocks on a reasonable basis as outlined in Taxation Determination TD 97/3 Income tax: capital gains: if a parcel of land acquired after 19 September 1985 is subdivided into lots ('blocks'), do Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 treat a disposal of a block of the subdivided land as the disposal of part of an asset (the original land parcel) or the disposal of an asset in its own right (the subdivided block)?

Application to your circumstances

With consideration to the above authorities and relevant factors in determining whether your property subdivision & development would be viewed as isolated transaction with a view to a profit, the following general observations have been made in this case:

•                 There was a partial change in the nature or purpose of owning the original property when the decision was made to demolish, subdivide and rebuild an additional dwelling for resale with a view to profit.

•                 You had intention and a profit-making purpose in the activities undertaken in order to provide you additional retirement funds in future years.

•                 The transaction has been undertaken in a planned, organised and carried on in a business-like timely manner in that the new dwelling was placed on the market and sold under contract soon after completion.

•                 The decision to pursue the subdivision shows a choice by the landowner to engage in the exposure to the financial risks of the development, including the profits, losses and its general success for the purpose of maximising the potential profit made on the sale of the new dwelling.

•                 This is also demonstrated as additional finance was obtained in order to fund the development activities.

•                 There was no intention by the landowner to retain the new dwelling for long term capital appreciation or to derive rental income.

•                 The facts indicate a sophisticated undertaking with a view to a profit by a non-business taxpayer.

•                 The conclusion that the property was built for the purpose of trade and, therefore, that the transaction was commercial in nature, would be readily drawn as to the nature of the property sold in your case.

It is the Commissioner's view that the subdivision and sale of the new dwelling is more than a mere realisation of a capital asset or investment.

From the reasons you have provided, the significant purpose you had in mind by undertaking these activities was to sell at a profit. Although you may not have had this initial purpose when you acquired the property in 19XX, the disposal is considered an isolated transaction on revenue account as ordinary income, rather than on capital account. Any profit made on the transaction is assessable income under section 6-5 of the ITAA 1997.

In your case, the dwelling was not a separate CGT asset from the land because none of the balancing adjustment provisions in subsection 108-55(1) of the ITAA 1997 applied to it. However, the note to subsection 104-20(1) of the ITAA 1997 makes it clear that CGT event C1 can apply to part of a CGT asset.

However, as you did not receive any capital proceeds upon the demolition of the original dwelling, the combined effect of these provisions is that no amount is apportioned to the cost base or reduced cost base of the demolished dwelling. As the capital proceeds from the demolition were nil and the cost base attributed to the original dwelling is also nil, you will not make a capital gain or capital loss upon the demolition of the dwelling itself. A capital gain or capital loss does not arise at the time of the demolition of the dwelling as no capital proceeds were received.

Disposal of a dwelling

The cost base using the market valuation should be apportioned on reasonable basis between the two subdivided blocks. In addition, half of the eligible costs of the new development can also be included to work out the total expenses or cost base to be applied against the transaction. Ordinary income does not attract the 50% CGT discount contained in Division 115 of the ITAA 1997 which is only provided for when assessed under the CGT provisions.

The disposal of the new dwelling is an isolated transaction and any profit made on the sale is included in your assessable income under section 6-5 of the ITAA 1997.