In brief - Landowners should seek legal advice on their personal circumstances
Proceeds from a property development project may be taxed as a disposal of trading stock, profit making scheme, or capital gain. We take a look at how each of these income tax regimes produces different tax outcomes and the ways in which, using the advice of a tax lawyer, landowners may be able to reduce the amount of income tax payable.
Income tax regimes applicable to proceeds from a property development project
There are three possible income tax regimes that can apply to tax the proceeds from a property development project. These are:
- a disposal of trading stock,
- a profit making scheme, or
- a capital gain under the capital gains tax provisions.
If land is trading stock, the proceeds will be taxed exclusively under the trading stock provisions. If land is not trading stock, the proceeds may be taxed as a profit making scheme and a capital gain but the capital gain is reduced by the amount that is taxed as a profit making scheme.
The application of each regime may produce different tax outcomes. For some projects, the amount of income tax payable may be reduced if the landowner takes a very passive role in the project by engaging a developer to undertake the project. In some cases, it may be beneficial to achieve the outcome that capital gains tax provisions have exclusive application.
According to the Australian Taxation Office
(ATO), land which is acquired for the purposes of sale in the ordinary course of a property development or land trading business is trading stock. This includes a single acquisition of land and it is not necessary that the acquisition of land be repetitive.
Land may also be trading stock if it was not acquired for the purposes of sale in the ordinary course of a business, but is later held for this purpose. In this case the landowner is treated as having sold the land for either its cost or market value (at the election of the landowner) just before it became trading stock and to have reacquired it for the same amount.
Care needs to be taken in making the valuation election. If the landowner elects to use market value and that amount is more than the cost base of the land, then a capital gain arises. Tax on the capital gain is payable notwithstanding that the land has not been sold and no proceeds have been received. Despite this, in some cases it may be beneficial for the landowner to make a market value election to ensure that as much of the profit from the project is taxed under the capital gains tax provisions instead of the trading stock provisions. A capital loss arises if the cost base exceeds the market value.
Where land ceases to be held for the purpose of sale in the ordinary course of business, the landowner is treated as having sold the land for its cost and to have reacquired it for the same amount. In this case the trading stock provisions stop applying to the land.
The application of the trading stock provisions depends on whether a property development or land trading business is being carried on, which is a question of fact. The ATO considers that the following factors are relevant:
- the purpose and intention of the landowner in engaging in the activities
- whether there is an intention to make a profit from the activities and the likelihood that a profit will be made
- the repetition and regularity of the activities
- whether the activities are carried on in a manner that is similar to other property development projects
- whether the activities are organised and carried on in a businesslike manner and systematically
- the size and scale of the activities
- whether a business plan exists, and
- whether the landowner has knowledge, experience or skill to pursue the development
Trading stock considerations for landowners
The application of the trading stock provisions may not be an optimal tax outcome for the landowner since (among other things) deductions for acquisition and development costs are deferred until the land is sold. Tax structuring involves taking steps to minimise the likelihood that the landowner is carrying on a property development or land trading business. The landowner may consider taking a very passive role in the project by engaging a developer to undertake the project, including obtaining approvals and finance, project management, engagement of contractors, marketing and sales. The development agreement would need careful legal drafting to minimise the involvement of the landowner.
If the landowner and developer receive income jointly, this creates a partnership for tax purposes. To counter this, the development agreement would need careful legal drafting to provide (among other things) that the proceeds of the project are derived by the landowner and the developer's return is a fee for services.
Profit making scheme
If the land is not trading stock, the profit from the sale of land may be assessable if:
- the intention or purpose of the landowner in entering into the transaction (objectively determined) was to make a profit or gain, and
- the transaction was entered into and the profit made in the course of carrying on a business or in carrying out a business operation or commercial transaction
The ATO takes the view that it is usually, but not always, necessary that the purpose of profit making exists at the time of acquiring the land. Also, it is not necessary that the profit is derived in the manner originally intended.
In many cases, the application of this basis of assessment will turn on whether the landowner is carrying out a business operation or commercial transaction. Again this is a question of fact. If the profit is made in the course of carrying on a business, it is likely that the trading stock provisions will apply.
According to the ATO, some matters which may be relevant in considering whether a transaction amounts to a business operation or commercial transaction are:
- the nature of the entity undertaking the operation or transaction
- the nature and scale of other activities undertaken by the landowner
- 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, including whether professional agents and advisers were used
- the nature of any connection between the landowner and any other party to the operation or transaction
- the nature of the property, and
- the timing of the transaction or the various steps in the transaction
Profit making scheme considerations for landowners
Income tax is levied on the profit that is derived by the landowner from the sale of the land. This means that similar to the trading stock provisions, deductions for acquisition and development costs are deferred until the land is sold. There is little case law on the methodology for determining profit.
The application of these provisions may not be an optimal tax outcome for the landowner. Tax structuring involves taking steps to ensure that the landowner is not carrying on a business operation or commercial transaction. Again it may be beneficial for the landowner to consider taking a very passive role in the project.
Capital gains tax
The profit will not be assessable as income under the trading stock provisions or as a profit making scheme if it arises from the mere realisation of the land, even in an enterprising way. For such projects the capital gains tax provisions will have exclusive application. The application of the capital gains tax provisions will be advantageous where:
- the capital gain is eligible for the general 50% discount (which is not available for companies)
- the land is taken to be acquired before 20 September 1985 since the capital gain is not subject to tax
- the land is taken to be acquired after 19 September 1985 and before 21 September 1999 as the cost base of the land can be indexed up to 30 September 1999, that is adjusted for movements in the consumer price index
- the landowner has carried forward capital losses, or
- a specific exemption or concession applies, such as the main residence exemption or the small business concessions
The capital gain is equal to the difference between the capital proceeds from the sale of the land and its cost base. The cost base generally includes the acquisition cost of the land, certain incidental costs incurred by the landowner in acquiring or selling the land such as stamp duty and professional fees, capital expenditure on improvements and costs of owing the land such as interest on money to acquire the land. Expenditure that has been or can be deductible is generally excluded from the cost base.
The capital gains tax rules deem certain improvements to land made after 19 September 1985 to be separate post-capital gains tax assets. These improvements include any building or structure constructed on the land and other improvements of a capital nature, including intangible improvements such as a rezoning approval. For improvements of a capital nature to qualify as a separate asset, the cost base of the relevant improvement must exceed the improvement threshold for the income year (currently $147,582) and 5% of the capital proceeds.
Disclaimer: This article has been published by Colin Biggers & Paisley for information and education purposes only and is a general summary of the topic(s) presented. This article is not specific legal advice. Please seek your own legal advice for any questions you may have. All information contained in this article is subject to change. Colin Biggers & Paisley cannot be held responsible for any liability whatsoever, or for any loss howsoever arising from any reliance upon the contents of this article.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2021.