Tax issues to consider when subdividing and selling land.

Subdividing land and selling it off is one of the quickest ways to make money through property. But there are costly traps you need to be aware of. Eddie Chung explains

Against the backdrop of historic low interest rates, a progressively improving post-GFC economy and a steadily growing population, the housing market has seen signs of life over the past year or two. Demand for residential land has been on the rise, which puts pressure on land prices. This encouraging environment has prompted landowners to turn their minds to subdividing their land and selling the lots to capitalise on profits.

Depending on when the land was originally acquired by the landowner and the purpose for which the land has been put to use, the tax implications of subdividing land for sale may give rise to dramatically different tax outcomes. The Australian Taxation Office is well aware of these implications and actively monitors movements in land ownership as part of its data-matching program with other government agencies to target their audit activities. Therefore, mischaracterising a subdivision has the potential to be very costly.

Revenue versus capital conundrum

Fundamentally, the income tax law recognises two mutually exclusive concepts – revenue versus capital. Revenue, otherwise known as income, is usually taxed at full tax rates. For instance, employment income is revenue and every dollar of wages you earn is included in your taxable income, which is taxed at marginal tax rates; similarly, if a company sells widgets and makes a profit, the profit is taxable in the hands of the company at the corporate tax rate.

In contrast, capital is generally taxed under the capital gains tax (CGT) regime and, provided that the underlying asset that gives rise to the capital gain has been held for at least 12 months (with the exception being where the owner of the asset is a company), the taxable capital gain may be reduced by as much as 50%. As an example, if you are an individual and make a capital gain on the sale of your investment property, the capital gain is halved provided that you held the property for at least 12 months before it was sold.

In addition to the CGT discount, there are a number of ‘exemptions’ under the CGT system that give preferential tax treatment to capital gains. For instance, if a capital gain is made on an asset that was acquired before 20 September 1985, the asset is a ‘pre-CGT asset’ and any capital gain or loss made on the disposal of the asset is disregarded. Also, a person’s home is specifically exempt from CGT, so any capital growth you realise on your main residence, regardless of how large the gain is, will always be tax-free.

Generally speaking, a subdivision project would invariably fall under one of the following categories for taxation purposes:

1. Mere realisation of a capital asset;
2. One-off profitmaking undertaking; or
3. Property development business.

These categories are mutually exclusive and they are not determined by choice – the facts surrounding a specific subdivision project will dictate how the project is characterised. While the categories are mutually exclusive, ie, a project can only fall under one of the categories within a certain timeframe, it is possible for different categories to apply to the same block of land during its ownership period, albeit the categories can never overlap and apply to the same period.

As mentioned above, the category that would give rise to the best tax outcome is the mere realisation scenario if the land for sale has been held for at least 12 months, which means that unless the land is held by a company, any capital gain made on sale will be eligible for the CGT discount. Even better, if you bought the land before 20 September 1985 or the land is where your home is located (albeit limited to up to two hectares of adjacent land), the capital gain on sale will be completely disregarded and is therefore tax-free! Therefore, there is certainly an incentive to characterise a subdivision project as the mere realisation of a long-term CGT asset.

While the law allows people to realise a CGT asset in the most enterprising way, there is a point at which the activities of the subdivision project would go beyond a mere realisation scenario and become either a one-off profitmaking undertaking or a property development business. In other words, the subdivision project will effectively be converted from being of a capital nature to revenue. The problem with this legal principle is that the line separating the capital and revenue scenarios is not defined and the facts surrounding each project must be discretely and closely examined to reach a conclusion on balance.

Naturally, the many shades of grey in the real world are the cause of many disputes between the Commissioner of Taxation and taxpayers. Over time, these disputes became legal precedents that provide some guidance in determining the side on which a subdivision project would fall in this great capital versus revenue divide.

The tipping point

As a blanket statement, the more work that is being done on the land in question, the more likely that the activities have tipped over from being capital to revenue in nature.

Based on a number of legal precedents, the tax office has issued a taxation ruling, which provides the Commissioner’s interpretation of the law and his view of the factors that will need to be considered to determine when a land subdivision project may tip over from being a mere realisation of a capital asset to a revenue undertaking. These factors may include the following:

• What is the landowner’s significant intention or purpose in buying the land and selling the subdivided lots?
• Is the subdivision part of the landowner’s business or commercial transaction?
• What is the amount of money involved in the subdivision project and the magnitude of the profit sought?
• What is the nature, scale and complexity of the subdivision project?
• How are the subdivision activities being carried out and who has the responsibility in undertaking the different aspects of the subdivision and sale of the lots?
• Who is actually undertaking the subdivision project and what is the relationship between the party undertaking the project and the landowner?
• What are the nature and scale of other activities that have been undertaken by the party who is undertaking the subdivision project?
• What is the timing of the acquisition of the land and the subdivision activities and what are the various steps involved in the project?

If it is concluded that a subdivision project has become revenue in nature upon the consideration of the above factors, a further analysis has to be conducted to determine if the project is an isolated one-off profitmaking undertaking or is part of a property development business.

As a general proposition, a business is mutually exclusive from a one-off profitmaking undertaking in that a business is usually carried out in a more systematic and businesslike manner and the activities are generally recurrent in nature as a going concern. Again, a number of factors will need to be considered in this differentiation, which may include the following:

• Does the project have significant commercial purpose or character?
• Does the landowner have more than just an intention to engage in business?
• Does the landowner have a purpose of profit as well as a prospect of profit from the activities?
• Are the activities repetitive and regular in nature?
• Are the activities of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business?
• Are the activities planned, organised and carried out in a businesslike manner that is directed at making a profit?
• What is the size, scale and permanency of the activities?

Tax implications

As discussed above, if you are undertaking a subdivision project to merely realise a capital asset in an enterprising way, depending on the nature of the entity that owns the land, the CGT discount may apply to any capital gain derived on the sale of the lots.

If the land is pre-CGT or is eligible for the main residence exemption, the capital gain may be disregarded altogether.

On the other hand, if the project has tipped over from being a capital transaction to a revenue undertaking, the income tax treatment of the gain on the subdivision project will depend on whether the project is a one-off profitmaking exercise or property development business.

If the project is a one-off profitmaking undertaking, a taxing point will only be triggered when the lots are sold. As a general proposition, the capital gain from the time the land was originally acquired to the point at which the project became revenue in nature (‘time of conversion’) will continue to be subject to CGT while the amount by which the sale price of the subdivided lots exceeds the market value of the land at the time of conversion and other development costs will be subject to full income tax. Therefore, a market valuation of the property at the time of conversion will be advisable.

If the project is a property development business, you have two choices:

1. Treat as if you sold the land at its market value at the time of conversion under CGT (even though you may not have sold the subdivided lots at that time because a CGT event is triggered at this point) and pay full income tax on the gain by which the sale price of the subdivided lots exceeds the market value of the land at the time of conversion and other development costs when the lots are sold; or
2. Treat as if you sold and reacquired the land at its original cost (there is a special way you need to calculate this cost but it is generally its original cost) and effectively pay full income tax on the gain by which the sale price of the subdivided lots exceeds the original cost of the land and other development costs when the lots are sold. However, no CGT event will be triggered until the lots are sold in the future.

If the land is pre-CGT, exempt from CGT due to the main residence exemption, or the landowner has sufficient tax losses to fully offset any CGT crystallised, choosing the first option should produce a better tax outcome as no tax liability will be crystallised at the time of conversion, unless the land has gone backwards in value since it was originally acquired.

Conclusion

The above provides a broad overview of the tax issues that may arise in a subdivision project. While the legal principles and tax rules may seem relatively straightforward, there are a number of complexities that may warrant the assistance of a professional tax adviser.

For example, if a project exhibits some characteristics of a mere realisation scenario and some characteristics of a one-off profitmaking undertaking, the correct tax characterisation of the project will be critical in arriving at the correct taxation outcomes. If required, your trusted tax adviser may assist you in adopting a defensive strategy where your case is particularly ‘grey’, eg prepare a reasonably arguable position paper to support the characterisation adopted, prepare and lodge an application for a private ruling with the tax office, etc.

The tax calculations may also pose other challenges. For instance, under a one-off profitmaking undertaking scenario, you are technically required to calculate the capital gain on the subdivided lots with reference to the original cost of the property and then subsequently reduce that gain by the amount of assessable profit from the one-off profitmaking undertaking that is calculated with reference to the market value of the land at the time of conversion.

Given the high monetary value of subdivision projects, engaging a trusted tax adviser with expertise in the property sector is more of a necessity than a choice.

Eddie Chung is Partner, tax & advisory, property & construction, at BDO (QLD) Pty.

Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.