Contents
- What is CGT event K4?
- Who does the CGT event apply to?
- What time does the CGT event happen?
- How to make a CGT event K4 election under section 104–220?
- How to calculate the capital gain or capital loss on conversion?
- What if a K4 election is not made?
- The CGT discount
- The CGT small business concessions
- Capital losses
- Pre CGT assets
- The prevention of double tax outcomes
- The benefits of making a K4 election under section 104–220
- The downsides of making a K4 election under section 104–220
- What about the replacement cost valuation method?
- How is market value determined?
- The main residence exemption
What is CGT event K4?
CGT event K4 addresses a situation where a taxpayer that holds a CGT asset on capital account starts to instead hold that asset as trading stock. This is most common in a property development context where a taxpayer that owns property for another purpose decides to develop that property. For example:
- Where the taxpayer acquires land for the purpose of farming but subsequently decides to venture the land into a business whereby the land becomes trading stock of that business.
- Where the taxpayer acquires land for the purpose of using it as an active asset in a business but subsequently decides to venture the land into a business whereby the land becomes trading stock of that business.
- Where the taxpayer acquires land for the purpose of using it to support an investment property or private use property but subsequently decides to venture the land into a business whereby the land becomes trading stock of that business.
However, if the taxpayer acquires property and from the outset earmarks it as trading stock, CGT event K4 or another other CGT event will not be relevant (unless the trading stock is converted to an asset held on capital account). This is because the property will be entirely subject to the trading stock rules and will be outside of the scope of the CGT rules.
Remember that land can constitute trading stock because of the way that business is defined in section 995-1 of the ITAA 1997 and the way trading stock is defined in section 70-10 of the Act.
Business is defined to include:
‘…any profession, trade, employment, vocation or calling, but not occupation as an employee…’
Trading stock is defined to include:
‘anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of business.’
In this way, if land is held for the purpose of sale in a business which has the core purpose of selling land, that land can be trading stock.
Note that land which is not (yet) in a condition that is ready to be sold can be trading stock provided the land is held for the purpose of sale. In this situation, the unready land will be treated as a single item of trading stock until the time the land is subdivided into lots that are in a sale ready condition, at which time each lot will become a separate item of trading stock.
It is also important to recognise that a single parcel of land can be classified as trading stock. It is not necessarily a requirement that multiple blocks of land are acquired and sold to establish that there is a business of trading in land. Instead, Taxation Determination 92/124 provides the relevant test for determining when land will be treated as trading stock.
‘[where] it is held for the purpose of resale and where a business activity which involves dealing in land has commenced…The business activity is taken to have commenced when a taxpayer embarks on a definite and continuous cycle of operations designed to lead to the sale of the land. It is not necessary that the acquisition of land be repetitive. A single acquisition of land for the purpose of development, subdivision and sale by a business commenced for that purpose would lead to the land being treated as trading stock’
The tax law provides different regimes for taxing CGT assets. Each regime has a different set of rules for determining tax outcomes. For example, a CGT asset which is held on capital account is typically taxed under the CGT regime contained in Part 3-1 and 3-2 of the ITAA 1997, whereas an item of trading stock (which can include a CGT asset) is taxed under the trading stock regime contained in Division 70 of the ITAA 1997.
The question then becomes, how do these regimes interact with one to tax a CGT asset that is originally held on capital account and which subsequently becomes an item of trading stock?
The simplified answer is that the CGT regime applies (in a sense) until the CGT asset is converted into an item of trading stock. Upon conversion the CGT asset / item of trading stock be deemed to have been sold and re acquired (although that is not actually the case) as an item of trading stock. From that point onwards the CGT asset will be subject to the trading stock rules.
Practically speaking, the extent to which the CGT rules versus the trading stock rules have scope to tax gains on converted property (i.e. from the time the CGT asset is originally acquired to the time the asset is converted to trading stock) is heavily dependent on the way the taxpayer approaches section 104-220 of the ITAA 1997.
That section provides a taxpayer with the choice (via an election) to recognise a capital gain or loss under CGT event K4 just before asset exits the CGT regime and the trading stock rules take over.
The effect of the election is explored in depth throughout the remainder of this article.
Who does the CGT event apply to?
The CGT event happens to the owner of the CGT asset converting it into an item of trading stock.
What time does the CGT event happen?
If an election is made the CGT event is triggered at the time the CGT asset is held as trading stock.
This is at the point in time that the first activities commence to start developing and subdividing the land, not necessarily when the land is in a subdivisible ready state.
How to make a CGT event K4 election under section 104-220?
The taxpayer must make a voluntary election under paragraph 70-30(1)(a) for CGT event K4 to apply.
The election is usually required to be made by the time of lodgement of the income tax return for the income year in which the taxpayer starts holding the item as trading stock. However, there may be time extensions available to the taxpayer in the circumstances set out in subsection 70-30(2). For example, where the taxpayer inadvertently failed to realise that they had started holding an item of trading stock or where the Commissioner decides to allow a taxpayer to make a late election.
How to calculate the capital gain or capital loss on conversion?
If an election is made the taxpayer will be treated as having disposed of the CGT asset for market value just before it started being held as trading stock and then re acquiring the asset as an item of trading stock for the same value.
Note that the use of the term market value throughout this article has a loaded meaning which is explained in the below heading How is market value determined?
The taxpayer will make a capital gain if the asset’s market value just before it starting being held as trading stock exceeds the cost base of the asset.
Conversely, the taxpayer will make a capital loss if the asset’s market value is exceeded by the reduced cost base of the asset.
What if a K4 election is not made?
If an election is not made CGT event K4 will not be triggered.
The asset will effectively exit the CGT regime and any capital gain or capital loss related to that exit will be disregarded as set out in section 118-25.
The asset will treated as if it had been sold to someone else at cost (as an asset on capital account) and then immediately re acquired at that value as an item of trading stock.
In this situation, the trading stock rules will effectively become the dominant regime for taxing the asset on the basis that the cost does not take into account the increase in value of land between the time the asset is originally acquired and conversion. The gain referrable to that period will be picked up when the subdivided lots are sold and settle.
Note that the use of the term cost is a reference to the cost valuation method. This is one of a number of methods for valuing trading stock. Amounts which can be included in the cost of trading stock are explained below.
The CGT discount
If an election is made the CGT discount is available to reduce a capital gain made under CGT event K4 provided the asset is held for at least 12 months and the other eligibility criteria in Division 115 of the ITAA 1997 are satisfied.
If an election is not made, the 50% discount will not be available on eventual disposal of the asset (in the form of trading stock) as it will no longer be on capital account and subject to the CGT regime.
Remember that the CGT discount is not available to companies.
The CGT small business concessions
If an election is made, the small business CGT concession may be available to reduce a capital gain made under CGT event K4 provide the owner satisfies the active asset test, the basic conditions and any relevant additional conditions as set out in Division 152 of the ITAA 1997.
As with the 50% CGT discount, if an election is not made the small business CGT concessions will not be available on eventual disposal of the asset as the CGT asset (in the form of trading stock) will no longer be on capital account and subject to the CGT regime.
Capital losses
If an election is made, any capital loss from CGT event K4 can be set off against other capital gains in the manner prescribed in section 102-5 and/or carried forward.
As with the above concessions, if an election is not made, the capital loss will be disregarded and the taxpayer will lose the benefit of using it to offset against other capital gains.
Pre CGT assets
If the taxpayer acquires the asset prior to 20 September 1985 any capital gain or capital loss made in respect of the asset will be disregarded.
As with the above concessions, if an election is not made, the pre CGT exemption will not be available on eventual disposal of the land as trading stock.
With pre CGT assets being converted to trading stock, it is almost preferrable to make an election under CGT event K4.
The prevention of double tax outcomes
Section 118-25 of the ITAA 1997 provides that a capital gain or capital loss made from a CGT asset is disregarded where that asset is held as trading stock.
This provision prevents double taxation (once under the CGT regime and once under the trading stock regime).
The benefits of making a K4 election under section 104–220
As explained above, CGT event K4 only applies if a market value election is made to recognise the conversion of the CGT asset to an item of trading stock.
The primary benefits of making an election are set out under the below sub headings.
The opportunity to maximise the benefits of the CGT regime
The benefit of having gains taxed under the CGT regime is the opportunity to take advantage of a number of concessions available to taxpayers that are uniquely available under that regime.
This includes the 50% discount and the small business CGT concessions. These concessions enable gains to be reduced or evenly eliminated for tax purposes. There are no equivalent concessions under the trading stock rules. That is, the trading stock regime does not enable gains in the value of the assets to be discounted or eliminated for taxation purposes.
The decision not to make an election under section 104-220 essentially eliminates the involvement of the CGT regime in taxing the capital gain and means the taxpayer may miss out on the opportunity to discount any capital gain between the time the CGT is acquired and the time of conversion. The trading stock rules will become entirely responsible for taxing the gain on the eventual disposal of the item of trading stock, including that part of the gain that is referrable to the period between the CGT asset being acquired and the time it is converted to trading stock.
In this way, it will often be preferable for the taxpayer to voluntarily elect for CGT event K4 to apply to maximise the opportunity to discount gains on the disposal of CGT assets.
To illustrate this concept, assume Sam acquires a property in 2010 for $500,000. In early 2020, Sam decided to sub divide the land which, in this case, meant she had started to carry on a land development business. At that time, the privately owned property becomes trading stock of the business with a market value of $1,100,000. Sam eventually completes the sub division of the property and sells the subdivided lots in early 2024 for a combined total of $2,000,000. To simplify this example, we will assume she did not incur any development or holding costs in undertaking the subdivision project.
Assume Sam decided not to make an election in respect of her venturing land into the business. Also, assume she had no other assessable income or deductions. Her tax outcome was as follows:
$645,667 (excluding medicare levy). That being:
- $2,000,000 (amount derived from sale and settlement of the subdivided lots) – $500,000 (cost of the property under cost valuation method) = $1,500,000 x marginal tax rate.
If she had instead made an election under section 104-220, her tax outcome would have been as follows:
$483,764 (excluding medicare levy). That being:
- In the 2019-20 income year, $108,097 (excluding medicare levy). That is, $1,100,000 (market value of the property – assuming this agrees with the definition of market value in Taxation Determination 97/1) – $500,000 (cost base of the property) = $600,000 x CGT 50% discount = $300,000 x marginal tax rate. PLUS:
- In the 2023-24 income year, $375,667 (excluding medicare levy). That is, $2,000,000 (amount derived from settlement of the subdivided lots) – $1,100,000 (market value of property at the time of conversion) = $900,000.
Sam decision not to make a K4 election led her to paying an additional $161,903 in tax.
The uplift in the value of the CGT asset under the trading stock rules
If no election is made when the CGT asset converts to trading stock, the converted CGT asset will be valued at cost under the trading stock rules.
The cost valuation method does not provide an uplift in the value of the item of trading stock at the point of conversion. This because the cost method not take into account the gain in the value of the asset from the time it was originally acquired to the time it converts to trading stock. That means that any gain made between the time the asset is acquired and converted to trading stock will be assessable to the taxpayer under the trading stock rules.
However, if the taxpayer uses market value as the valuation method, the CGT asset will be deemed to have been acquired as an item of trading stock at market value at the time of conversion. That means there is an uplift in the value of item of trading stock at the point of conversion such that the trading stock rules will only be responsible for assessing the gain between the time the asset is converted and ultimately sold. The gain made between the time the asset is acquired and converted to trading stock will be addressed under the CGT regime.
The ability to spread out assessable gains over two or more different income years
The ability to spread an assessable gain over two or more different income years can be an effective way to reduce amounts exposed to higher marginal tax rates.
To illustrate, assume a taxpayer derives assessable income of $400,000 with no deductions of offsets. If the taxpayer is assessed on the amount in one income year (say 2023-24), the taxpayer will have a tax liability of $150,667 (excluding medicare levy). However, if the taxpayer was able to be assessed on the amount over the course of two separate income years, the taxpayer would have a tax liability of $121,334 ($60,667 in one income year and $60,667 in another). In this situation, the taxpayer would have saved $29,333 in tax.
The dilution of the assessment of a capital gain under CGT event K4 (at the time of conversion) and then later under the trading stock rules (at the time of sale and settlement of the subdivided blocks) can provide such an advantage.
There is also an opportunity to spread out assessable income over multiple years where there are multiple blocks which are sold and settle in different income years.
The tax advantage described under this heading would not be available to a company because of the flat rate of tax which applies regardless of the amount of taxable income.
The access to capital losses
A further benefit of making an election is the opportunity to retain capital losses to offset against other capital gains, either in the present year or in a future income year.
Without an election being made, any capital loss will be disregarded and effectively lost.
The ability to recognise capitalised expenditure
Another advantage of the election is the ability to take advantage of capitalised expenditure that is added to the cost base of the underlying land.
To illustrate, assume Bob acquired a large block of land in 2003 for $700,000. Bob holds the land for private purposes and is therefore unable to deduct various expenses incurred in relation to the land, including holdings costs such as land tax, council rates, interest on loan repayments, maintenance of the land etc. Although these costs were not deductible expenses for Bob, they were still able be added to the cost base of the land.
In 2023, Bob decides to subdivide the land. The subdivision activity constitutes the carrying on of a business and the land becomes trading stock of that business. At this point in time, the market value of the land is $1,200,000. Because Bob has held the land for 20 years, he has also amassed $800,000 worth of non deductible expenses which have been added to the cost base of the asset. Therefore, the cost base of the land is $1,500,000.
Bob would likely be better off making an election. Firstly, because he will be able to utilise the capital loss of $300,000 to offset against other capital gains. Secondly, because the land will also receive a higher value as trading stock. This will ultimately decrease the amount assessable to Bob on the future sale and settlement of the subdivided lots.
If he choose not to utilise the election, the capital loss would have been entirely lost (because of the operation of section 118-25). To make matters worse, the land would receive a lower value as trading stock. This would have the effect of increasing the amount assessable to Bob on the future sale and settlement of the subdivided lots.
Whether the election is made or not, the frustrating issue for Bob in this situation is that the $800,000 of holding costs which are part of the underlying asset cost base are not able to be added to the cost value or indeed the market value of the land once it becomes trading stock. Taxation Determination 92/132 provides that holding costs in relation to trading stock such as interest expenses, council rates, marketing expenses and land tax on and after acquisition of land are not able to be absorbed into the value of the trading stock. Rather, those holding costs may be deducted in the year they are incurred as ordinary business expenditure.
The problem for Bob here is that the holding costs were incurred whilst the property was held for a private purpose and were therefore not deductible to Bob at the relevant time. Unfortunately, the $800,000 of holding costs are not able to be included in the value of trading stock either under the cost method or the market value method.
IT 2350 and the Kurts Development Limited case have provided help guidance on costs that can be absorbed into the cost of trading stock under the cost valuation method. Examples include:
- Internal infrastructure costs including the costs of drainage, sewerage, parks, roads and other infrastructure-type costs which occur on the land etc.
- Certain external infrastructure costs which refers to costs which occur outside of the land but which are necessary to obtaining council approval to subdivide. This could include upgrading facilities such as sewerage or roads that are external to the land in order to obtain council approvals.
- Insurances related to the building which being constructed.
- Insurances related to the use of equipment in construction.
- Any depreciation on the equipment used in construction.
- wages related to construction.
- electricity costs related to construction.
The downsides of making a K4 election under section 104–220
Timing of tax liability and cash flow issues
The primary downside of electing for CGT event K4 to apply is that it can have the effect of bringing forward a tax liability. This can be particularly problematic from a cash flow perspective as the taxpayer may have a significant tax liability without having liquidated the underlying asset in order to fund the consequential tax bill.
To illustrate, assume Sally acquired a large block of land in 2003 for $500,000. Sally holds the land for private purposes. In late 2023, she decides to subdivide the land. At this point in time, the market value of the land is $1,300,000. The subdivision activity constitutes a business and the land becomes trading stock of that business. That is, the land is a capital asset that is ventured into the business. If Sally makes a market value election which triggers CGT event K4, she will be liable to pay tax on the capital gain (after taking into account any discounts, concessions, offsets and other capital gains and losses as required under the method statement in section 102-5 of the ITAA) following the end of the 2023-24 income year. This is despite the fact that she has not received any actual proceeds from the use or realisation of the property (and may not for some years). In this case, her tax bill in 2023-24 (assuming no other assessable income, deductions, carried forward losses or concessions apply, other than the 50% discount) will be $150,667. This may present genuine cash flow issues for Sally, particularly if she also having to fund the cost of the development and subdivision of the land.
The primary benefit of not making the market value election is that the taxpayer can defer tax until the point in time at which the land is sold (and settles).
To manage the cash flow risks and ensure the land is taxed exclusively under the CGT regime, some taxpayers may simply prefer to realise the property by selling it to a third party developer. Of course, in this situation the taxpayer would be giving up on the financial benefits which would could be achieved if they were able to hold onto the land until the subdivision and sale of lots occurred.
Where cost is greater than market value
Theoretically, it is possible that the market value of the land at the time it is ventured into a business is less than the cost value of the asset.
In this case, it may be preferable to not make an election, because the trading stock ventured into the business will be awarded a higher value. This will reduce any future assessable income when the land is sold and settles.
However, the downside here is that any capital loss to the taxpayer (as a result of the decrease in the value of the land) will be disregarded if an election is not made and the cost valuation is used.
What about the replacement cost valuation method?
The replacement cost valuation method is not available as an alternative method to value land
How is market value determined?
The market value of a CGT asset subject to GGT event K4 is determined according to the highest and best use of the land.
That requires the taxpayer to factor in of any potential use of the land (e.g. the potential for subdivision) and the probability of consent for council approval. As a result, it is possible that a standard market value may vary from the market value determined for K4 purposes.
Keep in mind that land which is not yet subdivided is valued as one lot. It is not necessary to add up the value each future separate subdivided lot when valuing the overall land.
Refer to Taxation Determination 97/1 for further guidance on valuation in the context of CGT event K4.
The main residence exemption
This article does not provide a detailed address of the interplay between CGT event K4 and the main residence exemption.
Broadly speaking, to the extent the eligibility criteria in subdivision 118-B of the ITAA 1997 are satisfied, the main residence exemption is available at the point of conversion of the land provided an election is made under section 104-220 to trigger CGT event K4.
However, please seek advice in relation to the risks of venturing of the land which supports your main residence into a business of land trading.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.