Summary: Subdividing land and building investment properties can be a tax minefield when it comes time to sell.
Key take-out: The profit on investment properties can attract capital gains tax or be taxed as business income, depending on the ownership structure. In cases of doubt, the Tax Office recommends investors apply for a private binding ruling.
Key beneficiaries: General investors. Category: Tax.
Q. I purchased an investment property in August 2014 that cost $890,000 as joint tenants with my husband, with us owning 35 per cent each, and a friend owning 30 per cent. The home was rented out until May 2016 when the tenants were evicted due to non-payment of rent and has been privately advertised for rent since then.
The property has been subdivided into two blocks that have a total cost – including purchase cost plus stamp duty, other acquisition costs, and subdivision costs – of $1,190,340. Block one represents 42 per cent of the original property while block two is 58 per cent.
I have two options as to what we can do with the property if we can’t find a tenant. The first is to sell the block with the existing house on it in and sell the second block as vacant land. The current cost of the block with the house on it is $560,340 with it having a value of $760,000. The cost of the second block is $630,000 with it having a value of $650,000.
The second option will be to demolish the existing house and build two new residences on each of the blocks and sell them. I estimate the construction costs for each house will be approximately $400,000, with each house and block being sold for $1,350,000 in 12 months' time.
What I would like to know is the following:
- If I decide to use option one, selling the existing house and land and the new block as separate items without any further improvements, will the profits be taxed as capital gains or as business income?
- If we decide to demolish the existing house, build two new residences and sell them, will we be regarded as conducting a business and therefore have to pay tax on the total profit made?
- Will we need to register for GST if option two is chosen and how will that affect the profit we make?
Answer: You should not be surprised to learn that according to the Australian Taxation Office, if your intention was to buy the property and sell it for a profit, it regards any profit made on the sale of the properties as business ordinary income and not a capital gain. This would mean tax would be payable on the full profit rather than receiving the 50 per cent general discount.
Interestingly I do not know of any cases that have been brought by the ATO to test its interpretation of the capital gains tax regulations. This could be because the ATO has not amended tax returns treating the profit not as a capital gain but rather as business income, or the ATO has not wanted to have its interpretation of tax law tested by the courts for fear of losing the case.
The unfortunate fact for taxpayers, under our self-assessment system where every tax return lodged is not checked for accuracy, is that the ATO tends to guide taxpayers in what they should be doing from an income tax point of view by issuing rulings, determinations and opinions.
There have been numerous cases of where the ATO’s interpretation of income tax legislation is incorrect, or it changes its mind. One example that affected self-managed super funds was the ATO’s opinion that, when the segregation of assets method was used for an SMSF with members both in accumulation and pension phase, separate bank accounts had to be used for the different types of member accounts.
This was the stated policy of the ATO for many years up until recently. In a 180-degree about-face the ATO’s position is, allegedly due to modern accounting systems that are able to differentiate between members in either accumulation or pension phase, that SMSFs can now have one bank account.
The other problem for taxpayers is that there is conflicting advice on the ATO’s own website. In the section that deals with capital gains tax the ATO states, “all assets you acquired since tax on capital gains started on 20 September 1985 are subject to CGT unless specifically excluded”.
The exclusions quoted are a person’s home, cars and most personal use assets such as furniture. At no point in this general introduction to capital gains tax is a statement saying that assets purchased for the purposes of resale at a profit are excluded from the CGT system, and taxed as normal income.
In cases of doubt, such as exists in relation to your investment property, the ATO recommends that taxpayers should apply for a private binding ruling. The problem is the methodology used by the ATO in deciding the tax treatment for a ruling is influenced by its understanding of how the tax legislation should be applied, and therefore maximises tax revenue collected.
Despite there being no court cases that have tested the ATO’s interpretation of whether the CGT system applies to subdivided land, I do remember reading a case that was decided in the favour of the taxpayer. In this case it was found that the profit on the sale of an asset was taxable under the CGT system because taxpayers are able to maximise the selling value of an asset, and actions taken to do this did not always mean the profit was made as part of a business and therefore was not ordinary income.
I believe that if you are able to argue that the property was first purchased for the purposes of producing rental income and to produce a capital gain, and therefore was not part of a profit undertaking or scheme, the profit made under your first option should be taxed as a capital gain with the 50 per cent discount applying.
If you decide to demolish the existing home, build two new residences, and then sell them, this could be held to be part of a profit-making undertaking or scheme and therefore all of the profit would be taxable as ordinary income.
No matter what the CGT treatment will be, if a decision is made to build the two new residences, your property partnership will need to register for GST. It will be able to claim all of the GST included in the costs associated with building the two residences, but then GST will need to be included in the selling value of each property.
Because the original property was purchase without GST included in its cost you will be able to use the margin scheme to calculate how much GST will be included in the selling value of the properties.
Under the margin scheme, the GST included in the selling price is one-eleventh of the difference between the purchase price of each block and the selling price.
In your question you stated that the purchase cost was $890,000. This would mean that block one would have a purchase cost under the margin scheme of $373,800 and block two would have a cost of $516,200. With the selling price of $1,350,000 for each block the GST on block one would be approximately $88,700 and $75,800 for block two. As a result of having to pay the GST on the two properties the profit made on this venture would be reduced by approximately $164,500.
Due to the complex tax nature of what you are proposing to do you should seek professional advice before taking any action.