Property Development – CGT or Income Tax?

It’s not uncommon for landowners of decent sized blocks to release their land’s potential by subdividing and selling the ‘back yard’ or completely redeveloping land they own. Upon sale, there are a number of factors that determine whether the proceeds are assessed as income on the revenue account (taxed as normal business income), or assessed as a gain on the capital account (taxed as capital gains).

Why the distinction matters

Despite the introduction of the CGT regime in 1985, the capital vs income distinction remains important. Case law has used the tree (capital) fruit (income) as an analogy to explain the distinction, but the simplicity of such analogies do not provide all that much assistance in practice. One judge has said that the distinction between income and capital could be decided on the toss of a coin!

Characterising a receipt on capital account has the following advantages:

• the CGT 50% general discount may be available
• the small business CGT concessions may be available
• the capital receipt may not be subject to tax if it relates to a pre- 20 September 1985 asset, and
• the main residence exemption may be available.

On the other hand, a sale that is more than a ‘mere realisation’ will be on revenue account, with the sale proceeds assessable as either income from the carrying on of a business or income from an isolated, profit-making undertaking or scheme. This income may be able be reduced by an losses the taxpayer makes from the current year or losses that are carried forward from prior years.

Our CGT on Property Development article discusses Property Development CGT issues in more detail.

Three possibilities

In the context of the subdivision and development of land, there are three possible outcomes or alternatives:

• The subdivision and sale of land may constitute the mere realisation of a capital asset and the receipts will be on capital account.
• The subdivision, development and sale of land may constitute the carrying on a business of property development, in which case the proceeds will be on income account.
• The subdivision and development of land may be more than a mere realisation of a capital asset but it may not meet the requirements of carrying on a business. In such a case, the subdivision and development will give rise to a profit-making undertaking, scheme or plan (‘profit making plan’) and assessable on the revenue account as income.

The best tax outcome is usually achieved under option 1 except perhaps where the taxpayer has large unused revenue losses to apply.

Mere realisation

From those rulings, the following factors are relevant in determining whether the gain from an isolated transaction is on the income account or capital account:  If several of these factors are present, the subdivision or development will give rise to a profit-making undertaking, scheme or plan (‘profit making plan’) and assessable on the revenue account as income:
 

• 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 /development 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 / development costs was claimed as a business expense
• the seller’s motivation
• there is a level of development of the land beyond that necessary to secure council approval for the subdivision
• buildings have been erected on the land, and
• the timing of the transaction or the various steps in the transaction.

Examples of subdivisions/developments on revenue account

Example 1
Prakash and Indira have lived in the same house on a large block of land for a number of years. They decide that they would like to move from the area and develop a plan to maximise the sale proceeds from their land.

They consider their best course of action is to demolish their house, subdivide their land into two blocks and to build a new house on each block.

Prakash and Indira lodge the necessary development application with the local council and receive approval for their plan. They then arrange for:

• their house to be demolished
• the land to be subdivided
• a builder to be engaged
• two houses to be built
• water meters, telephone and electricity to be supplied to the new houses, and
• a real estate agent to market and sell the houses.

Prakash and Indira are likely to have the proceeds assessed on the revenue account as a profit-making undertaking or scheme…on the basis that their activities go beyond the minimal activities needed to sell the subdivided land. New buildings are erected to maximise the value of the land, outside parties are engaged, and their motivations are commercial.

Example 2
Steven buys a 100-hectare property. He believes that the property may be suitable to be developed as a resort. After investigation he decides that it would be more profitable to subdivide and sell the property. He decides to subdivide the property into one hectare lots and sell these.

He engages a town planner and a surveyor to survey the 100 hectare property and to establish how many hectare lots it can be subdivided into. Steven then approaches the local shire council and is advised that he may subdivide his property into 65 one hectare lots.

However, Steven must satisfy various shire council conditions if he wishes to obtain development approval. They are :

• the making of new sealed roads with kerbing and channeling within the subdivision
• the provision of water, electricity and telephone services to the new lots
• the provision of culverts and other storm water drainage works, and
• the transfer of certain areas of land to the shire council for parks, environmental and other public purposes.

Steven consults his accountant and legal advisers. Together they prepare a comprehensive business plan for the project. They approach a commercial lender to arrange a substantial loan, secured by the property, to cover all development costs and related expenses.

After gaining development approval from the council, Steven then engages a project manager who arranges for all the survey and subdivisional works to be carried out. Contractors are engaged to put in the roads, complete all the necessary drainage works and install the water, electricity and telephone services.

Steven also investigates a marketing strategy that will provide the best return for his project. Sales agents are retained to carry out the marketing program which involves a comprehensive advertising campaign using a promotional estate name , ‘ Bush Turkey Hill’.

Steven’s sale proceeds will be assessed on the revenue account as income, on the basis that the subdivision is an enterprise and it is more than a mere realisation of a capital asset. Significant factors that are relevant which lead to this conclusion are as follows:

• there is a change of purpose for which the whole property is held
• there is a comprehensive plan for the development of the property
• the subdivision is developed in a businesslike manner for example there is a project
• manager, significant development costs, a comprehensive marketing campaign
• including an estate name for the land, and
• a substantial loan has been taken out to finance the development.

Examples of subdivisions/developments on capital account

Example 1
Astrid and Bruno live on a large suburban block. The council has recently changed their by-laws to allow for smaller lots in their area. They decide to subdivide their land to allow their only child, Greta, to build a house in which to live.

They arrange for the approval of the subdivision through the council, for the land to be surveyed and for the title of the new block to be transferred to Greta. She pays for all the costs of the subdivision and the cost of her new house.

Astrid and Bruno have merely realized a capital asset and, as such, the sale will be on the capital account. It is a subdivision without any commercial aspects and is part of a private or domestic arrangement to provide a house for their daughter.

Example 2
A number of years ago Elsie and Karin purchased some acreage on which to keep their horses, which they rode on weekends. Karin now accepts a job overseas and they decide to sell the land.

They put the land on the market with little success. The local real estate agent then advises that it would be easier to sell the land if it was subdivided into smaller lots. They arrange for a development application to be lodged with the local council and obtain approval to subdivide the land into nine lots. Elsie and Karin arrange for the land to be surveyed. The land has a road running along its boundary and has some existing services such as electricity. Only minimal activity is required to subdivide the land.

Elsie and Karin would be assessed on the capital account. The sale is not considered to be an enterpriseor a profit-making activity but rather the mere realisation of a capital asset.

Example 3
Oliver and Eloise have lived on a rural property, Flat Out for the last 30 years. They live a self-sufficient lifestyle. As a result of a number of circumstances including their advancing years, Oliver’s deteriorating health, growing debt and drought conditions they decide to sell.

Oliver and Eloise put Flat Out on the market and are unable to find any buyers. They then receive advice from the real estate agent that they may be able to sell smaller portions of it. They initially arrange for council approval to subdivide part of Flat Out into 13 lots. They undertake the minimal amount of work necessary and sell the lots. They continue to live on the remaining part of their property.

A few years later Oliver and Eloise decide to sell some more land to meet their increasing debt obligations. They arrange for council approval to subdivide another part of Flat Out into four lots. Again they undertake the minimal amount of work necessary to enable the lots to be subdivided and arrange for the real estate agent to sell these lots.

Three years later Oliver’s and Eloise’s personal and financial circumstances are such that they again decide to sell some more land. They arrange for further council approval to subdivide part of their remaining property into three lots. Again they undertake the minimal amount of work necessary to enable the lots to be sold and arrange for the real estate agent to sell the lots.

Over the years involved Oliver and Eloise have subdivided 30 % of Flat Out. They continue to live on the remaining part of their property.

Oliver and Eloise are merely realising a capital asset. In this example the following factors are relevant:

• There is no change of purpose or object with which the land is held – it has remained their home.
• There is no coherent plan for the subdivision of the land – the subdivision has been undertaken in a piecemeal fashion as circumstances change.
• A minimal amount of work has been undertaken in order to prepare the land for sale.
• There has been no building on the subdivided land. The only work undertaken was that necessary to secure approval by the council for the subdivision.
• The reasons for the subdivisions are not commercial but rather related to their personal, changing circumstances.

Example 4
Ursula and Gerald live on a 2.5 hectare lot that they have owned for 30 years.

They decide to sell part of the land and apply to subdivide the land into two 1.25 hectare lots. The survey and subdivision are approved. They retain the subdivided lot containing their house and the other is sold.

Ursula and Gerald’s will be assessed on the capital account. The subdivision and sale are a way of disposing of some of the land on which their home is situated. It is the mere realisation of a capital asset.

Elsie and Karin would be assessed on the capital account. The sale is not considered to be an enterpriseor a profit-making activity but rather the mere realisation of a capital asset.