Edited version of private advice

Authorisation Number: 1052266512078

Date of advice: 26 July 2024

Ruling

Subject: Income tax - income v capital

Question 1

Is any part of the sale proceeds of Lot X included in your assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in the 20YY-YY income year?

Answer

Yes.

Question 2

Will a capital gain made in the 20YY-YY income year due to the sale of Lot X, be reduced by the amount that is assessable under section 6-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 20YY

Income year ended 30 June 20YY

Income year ended 30 June 20YY

The scheme commenced on:

1 July 20YY

Relevant facts and circumstances

On DDMMYYYY, you (you and your spouse) signed a contract to acquire the property as joint tenants at the location (original land and dwelling). You purchased the property to generate passive rental income into your retirement.

An X% deposit of A$X was paid and settlement occurred on DDMMYYYY. The purchase price was $X.

To finance the purchase of the original land and dwelling, you borrowed $X the bank over a X year term, collateralising the loan against your own main residence.

The original land and dwelling was zoned R2 - Residential and the zoning remains unchanged.

The size of the lot was X square metres.

Minor improvements were immediately undertaken to the original dwelling before you made the property available for rent. The works were completed by MMYYYY.

The original dwelling was listed for rent from DDMMYYYY and the tenants lease commenced on DDMMYYYY.

During MMYYYY, you engaged with a local architect and began discussions to demolish the original dwelling on the land and construct a new dual occupancy. You sought to improve your investment portfolio and you learned that building dual occupancy could potentially double your rental income and provide housing for your children, into the future.

On DDMMYYYY you hired an architect to develop detailed plans to build on the property with an initial construction budget of $X.

The architect surveyed the site on DDMMYYYY and completed concept plans by DDMMYYYY.

The steps you undertook in the planning & construction phases of the development included:

•                     You commenced discussions with an architect to design the plans.

•                     You engaged a private certifier for both the building and the subdivision processes.

•                     Your builders executed the construction phase.

•                     X facilitated the land surveying works.

•                     Upon completion and approval of all tasks by the X you officially registered the property through X.

•                     You proceeded with applying for a Complying Development Certificate on DDMMYYYY which is a fast tracked approval process.

On DDMMYYYY, you refinanced your existing loans and obtained an investment home loan for $X from the bank. You also supplemented the development with your own personal savings and loans from family and friends of approximately $X.

Tenders were issued to builders and you received quotes ranging from $X to over $X to build the dual occupancy.

Additional costs, including landscaping, site works and demolition of the original dwelling, raised the initial budget to approximately X.

The tenants renting the property, vacated in MMYYYY.

Demolition of the original dwelling then commenced in late MMYYYY.

Significant construction delays due to weather conditions, and rising costs to do with supply chain issues led to multiple cost variations, including a $X increase in the cost of X in MMYYYY, and additional unforeseen costs.

The neighbouring property's construction also caused you delays due to the builder pausing frame installation to avoid potential ground failure. This also increased overall costs of the development.

Total project costs were at that point in time forecast to rise closer to approximately $X.

Planning documents, such as the original budget and the actual expenses incurred have been provided to us.

The subdivision component of the development primarily involved the following consultants/contractors, (excluding the builder and other works) and the approximate figures for remuneration for professional services are as follows:

•                     architect - $X

•                     private certifier - building - $X

•                     land surveyor - $X

•                     water - design and construct - $X

•                     private certifier - land development certificates - $X

•                     modular engineer - structural engineer - $X

•                     NBN - $X.

You and your spouse undertook the management and co-ordination of all of the professional consultants or contractors that were involved, and all of the works required to undertake the development and subdivision activities.

The survey works required for formal subdivision of the land into X lots, were specifically commenced from DDMMYYYY.

Due to the escalating costs of construction materials, weather delays and unforeseen issues onsite, as well as the potential for health risks, you began the process to sell one of the new properties. On DDMMYYYY, you engaged with the Real Estate to sell Lot X (this was prior to subdivision and construction completion).

On DDMMYYYY, as an off-the-plan sale, a contract for sale was signed for Lot X for $X.

Further, rising interest rates in Australia during the latter part of the construction phase, then added additional financial pressure to the situation.

Practical completion of the dwelling construction was achieved by DDMMYYYY.

However due to major non-compliance issues it took further months of negotiations between the builder, structural engineer, and the council to rectify the matters.

The occupation certificate was obtained on DDMMYYYY when the council endorsed the subdivision plan, which was registered on DDMMYYYY.

You and your spouse remained the registered owners of the land as joint tenants, both before and after subdivision was registered with the council. The Certificate of Title was received on DDMMYYYY.

Lot X was not sold and was retained to earn rental income and was leased to tenants from DDMMYYYY.

Lot X was sold as new residential premises and settlement of the contract for sale occurred on DDMMYYYY.

The total construction costs were $X.

The construction cost of Lot X was $X.

You or your spouse are not individually registered for goods and services tax (GST).

However, your previous registered tax agent applied for a partnership ABN on DDMMYYYY for you and your spouse as the partners with the X description and registered the partnership for GST from DDMMYYYY.

The partnership ABN X was listed on the contract for sale, signed on DDMMYYYY and GST withholding supplier credits relating to the partnership entity were paid to us.

You, your spouse or any related entities you control have never undertaken any subdivision activities or carried on any business involving land or property development.

This is the first subdivision you and your spouse have undertaken and do not plan on completing any further subdivision activities or property developments as you will soon retire.

Relevant legislative provision

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 118-20

Reasons for decision

Question 1

Is any part of the sale proceeds of Lot X included in your assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in the 20YY-YY income year?

Answer

Yes. The sale proceeds derived on settlement of the property are ordinary income on revenue account, rather than capital.

Question 2

Will a capital gain made in the 20YY-YY income year due to the sale of Lot X, be reduced by the amount that is assessable under section 6-5 of the ITAA 1997?

Answer

Yes.

Detailed reasoning

Tax treatment of property sales transactions

The profits from property sales will be treated for income tax purposes:

•                     as ordinary income under section 6-5 of the ITAA 1997 on revenue account, as a result of carrying on a business of property development, involving the sale of property as trading stock

•                     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 profit, entered into by a non-business taxpayer, or outside the ordinary course of business of a taxpayer carrying on a business, or

•                     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.

Transactions with a profit-making purpose

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 transactions' in paragraph 1 of TR 92/3 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.

Whether a profit from an isolated transaction is ordinary income is a question of fact and depends very much on the individual 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 of the taxpayer 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.

The relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case. 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 that profit-making is a significant purpose (paragraphs 7 & 8 of TR 92/3).

For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character (paragraph 12 of TR 92/3).

The types of factors that we consider are listed in paragraph 13 of TR 92/3, are used to determine whether the gain for income tax is a capital gain, or ordinary income from a profit-making undertaking:

•                     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.

A Federal court decision where the activities went beyond the mere realisation of a capital asset was McCurry & Anor v FC of T [1998] FCA 512; 98 ATC 4487 (McCurry), where two brothers purchased land in 1986 in NSW for $32,000. They subsequently borrowed $80,000 from a bank to enable them to construct three townhouses after demolishing an old house on the land. After being unsuccessful in their bid to sell the units prior to their completion, they lived in two of the units with various family members before successfully selling the units a year and a half later.

Relevant factors in the conclusion that the activities went beyond the mere realisation of a capital asset were that the taxpayers put the properties on the market shortly prior to their completion, took no steps to acquire tenants, and it was likely that they would need to sell the properties at some stage to repay the substantial bank loan. In the words of the Court:

Profit-making by the sale of the units always remained an option for the brothers, notwithstanding that, for some period, when it was convenient to do so, the units were used for another purpose.

Property may be acquired as an investment to provide either potential income returns which are foreseen or as a hedge against inflation in the value of the currency. As Barwick CJ said in Steinberg v Commissioner of Taxation (Cth) [1975] HCA 63; 75 ATC 4221 at 4227; 134 CLR 640 at 686:

The retention of property in the hope or expectation that its value will increase is a justifiable form of investment.

However, if a property is acquired in the course of a business or commercial dealing with a view to obtaining a profit from its development and sale, that venture is not regarded as an investment and the profit derived therefrom will be income for the purposes of section 25(1) of Income Tax Assessment Act 1936.

In the Administrative Appeals Tribunal hearing of Bowerman and Commissioner of Taxation [2023] AATA 3547 at 108, outlined the Commissioners attitude about the section 6-5 profit being assessable at the settlement date of the property:

The Commissioner argued that if there had been a gain on the sale of the .... Unit, and had that gain not been a capital gain but rather realised on revenue account, there would be no doubt that the gain, calculated as the balance of proceeds over cost, would have been derived at the time of settlement ...

The McCurry case demonstrates that a taxpayer can embark on a profit-making undertaking, even after the property was acquired for a different purpose. Your purpose when you enter into an arrangement to purchase, develop or sell the land determines if gains or losses are a capital gain or ordinary income. Your purpose may occur several years after you acquired the land, or can change during your ownership period.

Application to your circumstances

You purchased the original land and dwelling in MMYYYY to generate passive rental income. However, you leased the property to tenants for X before having discussions about demolition and constructing new dual occupancy. Your purpose changed when you embarked on the profit-making undertaking as part of an arrangement to make a profit beyond the appreciation in the value of the land only.

While we acknowledge that building dual occupancy could potentially increase your rental income from tenants and provide housing for your children into the future, Lot number X was sold off-the-plan for $X under a contract for sale signed on DDMMYYYY. There was never an attempt to seek tenants to earn rental income from Lot X because the property was sold swiftly by the real estate once placed onto the market. This was well prior to the practical completion of construction in MMYYYY and the council occupation certificate sign-off in MMYYYY.

In your case, the transaction is not in the ordinary course of a business, however another factor adding weight to the arrangement being commercial in nature with profit as a significant motive is that you were not selling the original dwelling. That may have been described a simple realisation of a capital asset. You have only retained ownership of Lot number X as an investment property to generate passive rental income.

Despite the fact you have never undertaken or been engaged in any building development, property speculation or other real estate development enterprises or similar business ventures, and even though the transaction may be described as one-off isolated transaction, the character of the development and sale of Lot number X for the purpose of gaining a profit is significant enough for the Commissioner to form this view based on court precedent.

Further, once interest rates began rising in Australia, you still had a substantial bank loan with the bank, and had borrowed money from family and friends.

Your construction costs had risen well above your initial construction budget of $X, with the total construction costs for being $X. For peace of mind, you were wanting to maximise your profit to reduce your overall financial risk and debt levels by selling Lot number X.

The net profit (derived on settlement) made on the sale of Lot number X is assessable as ordinary income on revenue account under section 6-5 of the ITAA 1997. It is only the net profit you make from your profit-making undertaking that will be assessable as ordinary income.

Capital gains tax

Section 118-20 of the ITAA 1997 contains anti-overlap provisions which operate to reduce capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 of the ITAA 1997, for example, as ordinary income under section 6-5 of the ITAA 1997.

Refer to quick code QC 71028 Tax consequences on sales of small-scale land subdivisions on our website ato.gov.au for worked examples on how to split the ultimate overall gain between a capital gain and the net profit which is ordinary income.