The revenue/capital distinction
It is very important to determine whether a property is being sold on revenue or capital account as it determines whether:
- any gain is exempt because it is a disposal of a pre-CGT asset
- the 50% discount and the CGT small business concessions will be available
- capital losses can be recouped (they can only be offset against capital gains)
The sale of the property will generally be on a capital account where it represents the mere realisation of an asset. However, to ensure the sale is regarded as a mere realisation it will be necessary to prove that:
- the property was not acquired:
- as part of a business of trading in the land; or
- with the intent to sell the land at a profit; or
- as part of some profit-making undertaking or scheme
- and that any development of the property is a mere realisation of the property in an enterprising way; and not itself a business operation or commercial transaction.
The characterisation will depend on the facts in each case.
The revenue vs capital issue is discussed in more detail in our Property Development – CGT or Income Tax? article.
The consequences of subdivision
Depending on the facts, subdivisions may qualify as a mere realisation of the land. In Casimaty v FCT 97 ATC 5135 the Federal Court held, based on the facts in that case, that a subdivision was a mere realisation of farmland.
All the comments below are based on the premise that the sale is on a capital account.
Subdividing pre-CGT land
The subdivision of pre-CGT land does not result in the land losing its pre-CGT status. Each of the smaller blocks retains the pre-CGT status attributable to the larger block. This is because no CGT event has happened. The subdividing of the land is not itself a CGT event – section 112-25 of Income Tax Assessment Act 1997 (ITAA 97).
Subdividing post-CGT land
If an original land parcel is split into two or more blocks, and the same taxpayer is the beneficial owner of the original land parcel and each of the new blocks, section 112-25 ITAA 97 provides that each element of the cost base of the original asset (worked out at the time of the split) is apportioned reasonably and included in the corresponding element of the cost base of each new asset.
Each of the subdivided blocks is regarded as an asset in its own right. The disposal of a subdivided block of land is treated as the disposal of an asset in its own right and not part disposal of the larger previous asset.
Disposal of composite assets
In some cases, property acquired pre-CGT will have new buildings, improvements, or extensions post CGT.
Section 108-55 ITAA 97 provides that a post-CGT building or structure constructed on pre-CGT land is taken to be a separate post-CGT asset.
Section 108-70 ITAA 97 provides that a post-CGT capital improvement to a pre-CGT asset is taken to be a separate post-CGT asset if its cost base (assuming it were a separate CGT asset) when a CGT event happens (except one that happens because of death) concerning the original asset is:
- more than the improvement threshold for the income year in which the event happens; and
- more than 5% of the capital proceeds from the event.
For the 2022-2023 income year, the improvement threshold is $162,899. For the 2023-2024 income year, the improvement threshold is $174,465.
In Taxation Determination TD 2017/1, the ATO states that for example, if a farmer, holding pre-CGT land, obtains council approval to rezone and subdivide the land, those improvements may be separate CGT assets from the land.
Related improvements will be aggregated to determine whether the improvement threshold and the 5% test have been exceeded. Section 108-80 ITAA 97 sets out the factors for deciding whether capital improvements are related to each other. The factors include:
- the nature of the CGT asset to which the improvements are made;
- the nature, location, size, value, quality, composition and utility of each improvement;
- whether the improvement depends on a physical, economic, commercial or practical sense of another improvement;
- whether the improvements are part of an overall project;
- whether the improvements are of the same kind; and
- whether the improvements are made within a reasonable period of each other.
Maximising the five cost base elements
The higher the cost base, the lower the capital gain. It is therefore imperative to be aware of what can be included in the cost base and to keep the necessary records to enable it to be determined.
Section 110-25 ITAA 97 provides that the cost base consists of 5 elements.
The five elements are:
1. The money paid, and the market value of any other property given to acquire the asset.
2. The incidental non-deductible costs of acquiring the asset or of the CGT event:
- remuneration for specified professional services
- transfer costs
- stamp duty or similar duty
- advertising costs
- valuation costs
- marketing expenses
- search fees
- the cost of a conveyancing kit
3. Capital and non-capital costs of ownership such as interest and rates which are not deductible (for assets acquired after 20 August 1991).
4. Expenditure of a capital nature incurred to increase or preserve the value of the asset, or that relates to installing or moving the asset.
5. Expenditure of a capital nature incurred to the extent to which it was incurred in establishing, preserving or defending the taxpayer’s title to, or a right over the asset.
The timing of the gain
Capital gains made on the sale of the property will be assessable income in the year the contract is entered – section 104-10 ITAA 97. This will usually be in exchange for the contract, not the date of settlement.
If a contract is subject to a condition (e.g. a subject to finance clause), it does not affect the time of the entering into the contract, unless it is a condition precedent to the formation of the contract.
Accessing the discount and concessions
Qualifying for the CGT 50% discount
Generally, to qualify for the CGT discount, a CGT asset must have been owned by the taxpayer for at least 12 months at the time of the CGT event happening – section 115-25 ITAA 97.
If the taxpayer chooses the CGT discount, capital losses will be applied against capital gains before applying the CGT discount.
Fixed and discretionary trusts can claim a 50% discount on disposals of assets. However, companies do not qualify.
Where a trust claims the discount, it will flow through to beneficiaries and there will be no adverse impact on the cost base of the beneficiary’s interest in the trust. A beneficiary of a trust receiving a distribution from the trust that is attributable wholly or partly to a “discount capital gain” of the trust (because the trustee has claimed the CGT discount in calculating the net income of the trust) needs to gross up the distribution before applying any capital losses. The beneficiary will then apply the appropriate CGT discount (provided the beneficiary is an individual or trust or complying superannuation entity) to any remaining discount capital gains.
Accessing the CGT small business concessions
The four available CGT small business concessions are:
- 15-year exemption – a full exemption from CGT on the disposal of an active asset that has been held continuously for 15 years
- 50% active asset exemption – 50% exemption on disposal of active assets
- Small business retirement exemption – exemption of up to $500,000 on disposal of active assets
- Small business rollover – deferral of the making of capital gains
To qualify for any of the CGT small business concessions, 3 major conditions must first be satisfied:
- a taxable capital gain must be made
- from the disposal of an active asset; and
- just before the CGT event, either the net value of CGT assets that the taxpayer and entities connected with it and its affiliates and entities connected with them must not exceed $6m just before the CGT event; or the taxpayer must be a small business entity with an aggregated turnover of less than $2m.
Further conditions then may need to be satisfied concerning each of the concessions.
Active asset requirement
Section 152-40 ITAA 97 provides an active asset is owned by the taxpayer and:
- is used or held ready for use in the course of carrying on a business (e.g. the business premises); or
- is used or held ready for use in the course of carrying on a business by the taxpayer’s affiliate; or an entity connected with the taxpayer.
However, assets that are specifically excluded from being an active asset include those whose main use is to derive rent unless the main use for deriving rent is only temporary.
Assets used mainly to derive rent will be excluded from being an active asset even if they are used in the course of carrying on a business (e.g. commercial premises rented to tenants).
Due to the restrictive definition of what is an active asset, unfortunately, most disposals of commercial or residential rental properties, and properties not being actively used in a business will not qualify for the small business CGT concessions.
Accessing the CGT small business concessions via a company or trust
All the small business CGT concessions are available to companies or trusts where the necessary conditions are satisfied. However, there are various issues to be aware of – some of these are listed below.
THE 15-YEAR EXEMPTION
For example, for companies or trusts to access the 15-year exemption concession on the disposal of an active asset, section 152-110 ITAA 97 provides that it needs to be ensured:
- that the entity continuously owned the asset for the 15 years ending just before the CGT event;
- the entity had a significant individual for a total of at least 15 years (even if the 15 years were not continuous and it was not always the same significant individual) during which the entity owned the CGT asset;
- an individual who was a significant individual of the company or trust just before the CGT event either:
- was 55 or over at that time and the event happened in connection with the individual’s retirement; or
- was permanently incapacitated at that time.
Generally, a significant individual is an individual who directly or indirectly has a 20% interest in the entity and has received at least 20% of any distributions of income and capital. A significant individual of a discretionary trust is an individual who, where distributions are made by the trust, is beneficially entitled directly or indirectly to at least 20% of the distributions of income and capital made by the trust during the income year.
The 50% active asset exemption
Section 152-220 ITAA 97 provides that taxpayers may choose not to apply for this exemption. This would result in greater access to the retirement exemption and rollover concessions.
This choice should be seriously considered where the CGT event occurs to an asset held by a company or fixed trust. This is because a problem with this concession is that the exempt amount when paid out of a company is taxed in an individual shareholder’s hands as an unfranked dividend. Where a fixed trust has benefited from the 50% active asset exemption, unfortunately when the exempt portion is paid out to the beneficiaries, this will be a CGT E4 (section 104-70 ITAA 97) event. The effect is that the exempt component will reduce the cost base of the beneficiary’s interest in the trust.
A discretionary trust is a preferable structure when it comes to accessing the 50% active asset concession. This is because the exempt component in the discretionary trust when paid out to the beneficiaries will remain exempt and will not result in a CGT E4 event.
Tax deductions for capital works
Division 43 ITAA 97 provides a 2.5% or 4% capital works deduction for the cost of capital works on income-producing buildings and structural improvements.
Where ownership of the building changes, the right to claim any undeducted construction expenditure passes to the new owner.
If the vendor does not or is unable to provide the information necessary to calculate the deduction, a building cost estimate by a quantity surveyor may be used to determine the amount that may be claimed.
There are no assessable balancing adjustments arising to the vendor on the sale of property where capital works deduction has been claimed.
However, if the asset being disposed of was acquired after 13 May 1997, the deductions allowed under Division 43 are removed from the cost base on disposal. This is referred to as the Division 43 clawback – section 110-45 ITAA 97.
Division 43 and CGT event E4
CGT event E4 (section 104-70 ITAA 97) requires a cost base adjustment to interest or unit held by a beneficiary in a trust where an amount of non-assessable income is received as a distribution from the trust. Where this amount exceeds the cost base of the beneficiary’s interest or unit in the trust, a capital gain may arise.
Unfortunately, the distribution of non-assessable amounts from a trust that arises due to the trust claiming a deduction under Division 43 will result in CGT event E4 applying.
Note however that CGT event E4 does not have any application to a purely discretionary trust. This is because the event can only apply where a beneficiary has an interest or unit in a trust.
Beware of Division 149 ITAA 97
Division 149 deems pre-CGT assets to be acquired for market value at the time of a change in majority underlying interests.
The majority of underlying interests are defined in subsection 149-15(1) ITAA 1997 to mean more than 50% of the beneficial interests that ultimate owners have, whether directly or indirectly, in the asset and in any ordinary income that may be derived from the asset.
This is a Division that buyers of shares and units must be made aware of. For example, the purchaser of the majority of the shares in a company needs to know that any pre-CGT assets in the company will be deemed to be post-CGT as a result of the acquisition, due to the operation of Division 149.
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.
