The Taxing Issues of Subdivision
It is not uncommon for property investors to dabble in property development every now and then and one of the most logical places to start is land they already own. As vacant land in growth areas is becoming increasingly scarce and block sizes available for sale are progressively decreasing due to population growth, subdividing larger blocks into smaller ones is a natural progression for many.
One of the classic analogies used to determine if an activity is revenue versus capital in nature is the fruit tree...
Revenue Vs Capital
Like most property transactions, the income tax implications associated with land subdivision are anything but straightforward. At the outset, you need to work out if the subdivision is on revenue or capital account.
This differentiation is critical because any profit arising from the sale of subdivided land on revenue account is generally subject to full income tax. In contrast, if the subdivision is taxed on capital account, any capital gain derived will be taxed under the capital gains tax (CGT) regime, which generally provides a 50% discount if the land has been held by an individual or trust for at least 12 months.
One of the classic analogies used to determine if an activity is revenue versus capital in nature is the fruit tree (I promise this has nothing to do with Adam and Eve). The trunk is likened to capital because it is the body of the tree that bears fruit. The fruit, on the other hand, is revenue – it is a product of the capital. The fruit gets picked and is consumed while the trunk provides a lasting benefit, which will provide more fruit in future.
Overlaying this analogy onto, say, a rental property, the property itself is capital because it is the enduring asset that keeps producing rent while the rent is revenue and is a recurring product of the capital. That is why for tax purposes, rent is taxed as revenue and the capital growth on the property, if it is sold, is taxed as a capital gain.
So when is a subdivision revenue or capital in nature? The courts have considered the same question time and time again because the tax legislation does not provide a clear-cut methodology to help you work that out. Like a lot of “grey area” type transactions, all the facts and circumstances surrounding the subdivision will need to be considered on a case by case basis. Ultimately, the determination is based on a question of fact and having regard to the extent and degree of the activities undertaken on balance.
As a blanket statement, the more work is being done on the subdivision, the more likely that the activities are of a revenue nature. To provide guidance on how to apply the law, the Australian Taxation Office has generously summarised the number of factors that should be considered in a tax ruling, which are drawn from the legal principles established by various common law precedents.
Again, all the factors have to be considered together and no one factor is determinative. Based on the tax ruling, you should ask yourself the following questions to determine if your subdivision is revenue or capital in nature...
(a) What was your significant intention or purpose in buying the property and selling the subdivided blocks?
This requires more than just assessing your subjective intention and purpose; an objective consideration of the facts and circumstances will be considered to ascertain your “true significant intention”. Generally, if you originally bought the land to hold as a capital asset (eg, a rental property) and the subdivision is merely to facilitate the realisation of the property, then any gain on sale is likely to be capital in nature. On the other hand, if you bought the property with the intention to subdivide and sell for a profit, the gain on sale will likely be revenue in nature, regardless of whether you ended up subdividing the property.
(b) Is the subdivision part of your business or a commercial transaction?
If the subdivision is undertaken as part of a business you operate or commercial arrangement you are undertaking, then it is likely that the arrangement is revenue in nature. On the other hand, it is less likely the case if the property was bought as a private transaction, provided that your significant intention and purpose behind the arrangement was not an isolated one-off profit-making undertaking.
(c) Who is undertaking the subdivision?
If the subdivision is undertaken by a company with substantial assets, it may be an indication that the subdivision is commercial in nature and the subdivision should then be treated as a revenue affair. On the other hand, if the subdivision is owned by a family trust or an individual, that conclusion may not be drawn so readily.
(d) What are the nature and scale of other activities you have undertaken?
The relevant experience of and other activities carried on by the person undertaking the subdivision may provide a clue on the characterisation of the subdivision. If the person has done subdivisions before or are operating multiple subdivision projects contemporaneously, the regular, repetitious, and recurring nature of the activities may suggest a commercial flavour, which may weigh towards a revenue determination. In contrast, if the person has never done a subdivision before and is engaged in other full time income earning activities while undertaking the subdivision, it is more likely that they are merely realising a capital asset and should therefore be taxed on capital account.
(e) What is the amount of money involved in the subdivision and the magnitude of the profit sought?
The capital employed in the subdivision project provides an indication regarding the extent of commerciality of the activities. The larger the amount of money invested in the project, the more likely that the activities are commercial or business in nature, which means that the project should be taxed on revenue account. Reciprocally, the smaller the amount of money involved, the less likely that the activities are anything more than a private realisation of capital assets, which should be subject to the CGT regime instead.
(f) What is the nature, scale, and complexity of the subdivision?
While not determinative in its own right, the larger the magnitude of the activities undertaken in the subdivision, the more likely the subdivision is revenue in nature. To assess the magnitude of the subdivision, things to look at include the size of the land area, the number of subdivided lots for sale the amount of work done on the site, etc. Generally, minimal subdivision work done on land to satisfy local council requirements, ie, limited clearing and/or earthworks, is more atypical of a capital arrangement.
(g) How is the subdivision being carried out and how are transactions entered into?
In general, a person undertaking a subdivision in a commercial context is more actively involved in and hands-on with all aspects of the subdivision activities, which suggests that the subdivision has more of a revenue flavour. In contrast, a person who is merely realising a capital asset tends to outsource the majority of the subdivision activities to external professional experts and advisors, eg, real estate agent, project managers. The more passive role of the person undertaking the subdivision in such cases tends to weigh more towards a capital determination.
(h) What is the nature of any connection between you and another party to the subdivision?
If the subdivision is undertaken by unrelated parties who are in a joint venture arrangement with each other, there is a higher likelihood that the arrangement is motivated by a specific profit-making purpose, which has a revenue character. However, if the parties to a subdivision are family members, the arrangement may essentially be a family dealing that is not business or commercial in nature and the subdivision may therefore lean towards a capital characterisation.
(i) What is the timing of the subdivision or the various steps involved?
If the property was bought, subdivided, and sold over a relatively short period of time, the short time gap between the steps may suggest that the arrangement constitutes a systematic profit-making undertaking, which means that the subdivision will likely be on revenue account. On the other hand, if the property has been held for many years before it is subdivided and sold, there is a higher likelihood that the subdivision amounts to a mere realisation of a capital asset, which will be subject to CGT.
Once the revenue versus capital character of a subdivision is determined, it will be necessary to work out how the profit or loss from the subdivision is dealt with for income tax purposes.
If the subdivision is on capital account, the normal CGT rules apply, which means that the amount by which the sale proceeds of the subdivided lots exceeds their apportioned cost base is the assessable capital gain from the subdivision. If the property was originally acquired before 20 September 1985, the capital gain will be disregarded. If a capital loss is incurred, the capital loss will only be available to offset other capital gains derived. Any capital loss not recouped may be carried forward indefinitely to offset future capital gains.
On the other hand, if the subdivision is revenue in nature, you will generally need to work out if the arrangement constitutes:
- An isolated one-off profit-making undertaking; or
- A property development business.
If the subdivision is a one-off profit-making undertaking, it is generally the development profit that is the assessable amount. This profit is calculated by deducting all the development costs (eg, purchase price of land, development approvals, surveying and engineering works, etc) from the sale proceeds of the lots. However, an important aspect that is often overlooked is that it will still be necessary to do CGT calculation in respect of the lots sold. To the extent that the capital gain exceeds the development profit (which could happen because “development costs” and “cost base” are different concepts that do not always align), the difference will still be taxable under the CGT rules. However, the part of the capital gain that is already taxed as development profit will not be subject to CGT again under the anti-overlapping rules to prevent double taxation.
If the subdivision is undertaken as part of a business, the sale proceeds are assessable. While the cost of the property is generally tax-deductible, the subdivided lots will be treated as trading stock of the business, which means that the apportioned costs associated with the lots that remained unsold at the end of the income year, if any, will effectively be held back and deducted only when the corresponding lots are sold in future.
In both instances, if the subdivision generates a tax loss, the loss is generally available to offset both revenue and capital gain derived by the entity that undertook the subdivision.
Conversion from capital to revenue
It is common for one to acquire a property as a capital asset at the outset, which was later ventured into a profit-making undertaking. In these cases, the capital gain from the time the property was originally purchased up to the time when it was converted to a revenue undertaking will be subject to CGT. The capital proceeds for the purpose of calculating the CGT will be taken to be the market value of the property at the conversion time. If the property was then subdivided and sold, the development profit on the subdivision will be calculated by deducting from the sale proceeds the development costs, which include the market value of the property at the time of conversion.
It should be noted that the capital gain derived up to the conversion time is only crystallised when the subdivided lots are eventually sold off. The venturing of the property into a profit-making undertaking does not in itself trigger a CGT event at that earlier point.
It is obvious from the above that the determination of whether a subdivision is revenue or capital in nature is not an exact science. It is therefore important to weigh all the relevant facts peculiar to your specific circumstances against all the determining factors to arrive at a defensible position.
Further, the calculation of the subdivision profit or capital gain may not be straightforward, especially in circumstances where there was a change of purpose associated with the property. As always, professional assistance should be enlisted to ensure that the outcome is consistent with the law.