Options in Property Transactions
One of the more useful devices that is often overlooked in property transactions is an option. Under the capital gains tax provisions, a contract that gives rise to an obligation to buy and sell a property will normally trigger a CGT event. This may be less than ideal, especially in situations where there is a substantial gap between the contract and settlement dates. The vendor may even find themselves having to find the cash to pay tax before they get any of the settlement proceeds in more extreme circumstances.
This is where an option will become invaluable. Under the law, if a vendor enters into an option to sell a property, no tax will generally be crystallised at that point, provided that the option will be exercised at a later date. To protect the interest of both the vendor and purchaser, a “put and call option” may be used, which means that the purchaser may exercise the option by calling upon the vendor to sell the property or the vendor may exercise the option by compelling the purchaser to buy the property under the terms of the option.
When the option is exercised, the vendor will be taken to have entered into a contract to sell the property, which may then trigger a CGT event. If the option was originally granted by the vendor for consideration, the amount paid for the option will be added to the cost base of the property for the purchaser and capital proceeds for the vendor.
On the other hand, if the option is not renewed, extended, or exercised before it expires, the taxing point will be reverted to when the option was originally granted, ie, the vendor will need to pay tax on any amount paid by the purchaser for the granting of the option, which could be nominal or for material value, depending on the commercial imperative behind the transaction.
The tax rules applicable to options may come in handy in certain circumstances. Consider the simple scenario where a vendor agrees to sell a property to a purchaser for $500,000 and the latter does not have all the funds to settle, eg, they may have immediate funds of $100,000 but the remaining $400,000 may only be available in 12 months’ time.
To ensure that the vendor will not be triggering a CGT event and therefore an immediate capital gains tax liability, an option may be granted to the purchaser for $100,000. In 12 months’ time, the option may then be exercised and the sale settled when the $400,000 becomes available.
For the vendor, their CGT event for the sale of the property happened when the option was exercised, rather than when the option was entered into, and the capital proceeds for the purpose of working out their CGT liability will be $100,000 (received upon the granting of the option) plus $400,000 (settlement monies), ie, $500,000. For the purchaser, the cost base of the property will also be $500,000.
As illustrated, an option may be used to manage the timing of when a CGT event happens to a property sale, which may be very useful in a variety of scenarios. However, depending on the jurisdiction, the granting of an option over land may be subject to stamp duty. Accordingly, a cost benefit analysis should be undertaken to ensure that the tax savings will outweigh the costs in using an option.
To that end, a good tax accountant should be able to suggest when it is appropriate to use an option to achieve the best result for their clients.