Tax on the subdivision and sale of land
Sally Preston
We often see people either acquiring large blocks of land or converting their large blocks of land into a new development. In some cases, the bare minimum is done to meet council approval for a subdivision, in other cases further steps are taken and property developers and architects are engaged to fully develop the land for sale.
The real question to ask in these scenarios is whether there is any income tax, GST and/or duty on any of the transactions involved.
Let's start with some tax basics on how a profit on the sale of property may be taxed. Three different classifications may be used for your transaction:
It may be taxed as business income – this is where you are in the business of property type transactions such a being a property developer.
It may be taxed as income when it is classified as an “isolated profit-making undertaking or scheme”.
It may be taxed as a capital event – this is where you are considered to have done no more than to merely realise the best value for your capital asset.
Determining which one your transaction will be classified as is not straightforward. In fact, it is quite complex and requires the interpretation and application of case law principles to your situation and weighing up a variety of factors.
Today we are not going to consider the perspective of a property developer and whether you could be classified as a property developer. We may consider this in a future episode. Instead, we will consider whether your transaction falls into category 2 (income) or 3 (capital).
Why does it matter?
Well depending on how the transaction is characterised, you may be eligible for the 50% general CGT discount on any gain from the activity. If a loss is made, where the transaction is classified as a capital loss, the loss will only be available to reduce capital gains and not gains from ordinary income.
If instead, the transaction does not qualify as a capital gain (or loss) then the income or loss will be reported as normal income and will not be able to access the general CGT discount.
To show you the impact on someone undertaking a sale of land, assuming this is undertaken by an individual and:
Profit on sale = $1m
Highest tax rate for an individual (including medicare levy) = 47%
General 50% CGT discount applies
That is a large difference in the amount of money you get to keep in your pocket!
So what factors are considered when deciding?
The ATO has recently published on their website more guidance on “Tax consequences on sales of small-scale land subdivisions” which seems to leverage off the case law. Please, take this as guidance though, as this is not a ruling and does not cover the more complex scenarios we see in practice.
We have used some of the published information in summarizing the factors you should consider when determining the tax treatment. Note that none of the below factors is determinative but may give you some insights into when your activities have crossed the line from being capital in nature to being potentially taxed as ordinary income.
GST consequences
Depending on what your activities are, you may also need to register for GST. This will generally be required where:
You have an intention to make a profit on the activities
While carrying on a business
As part of a business or commercial transaction
You can assume that where your transaction is classified as income (from the above) you have GST obligations. Having said that, even if your activities are considered capital in nature, you may still have GST obligations if you used the land in an enterprise you carried on or are already registered for GST. Otherwise, if the sale is taxable under the CGT rules, generally assume that you do not have GST obligations.
If you are required to pay GST, you can claim a credit for any GST included in the price you pay for things you purchased to make the sale. You must be registered for GST to claim a credit.
Where you do have GST obligations, it is best to get advice on this, as this can be complex to navigate through.
Example 1
Mr and Mrs Block purchased a house to live in on a large block of land in 2000. In 2017, they applied to subdivide the land for development. They planned to demolish the house and build 3 townhouses:
one townhouse for Mr and Mrs Block to live in
one townhouse to rent out
a third townhouse to be sold at a profit.
They hired an architect to design the townhouses. They engaged a developer to obtain the permit and subdivide the land. They funded the development using a bank loan and the property was used as security. The loan application and finance terms supported this.
The townhouses were completed in late 2018. Mr and Mrs Block planned to move into one townhouse. They hired a real estate agent to rent the second townhouse and sell the third.
However, an unexpected change in their circumstances occurred. Mr Block fell ill and had to move into a nursing home. Following their financial planner's written advice, they funded this move by selling all 3 townhouses in early 2019, making a substantial profit.
Income tax outcome
The land subdivision and sale is not carrying on a business.
The gain from the sale of the townhouse built to sell is ordinary income, from a profit-making undertaking or scheme.
The gain from the 2 townhouses not built to sell is not part of a profit-making undertaking and is the realisation of the capital value of those assets.
GST outcome
Mr and Mrs Block’s original intention for the townhouses included:
a private purpose for the townhouse intended to be their home – not subject to GST
making input taxed supplies (residential rent) for the townhouse intended to be a rental property
sale (a taxable supply) for the townhouse intended for sale.
The couple were carrying on a development enterprise and were intending to start a leasing enterprise.
They are required to register as a partnership for GST. They would meet the turnover test and:
the sale of the townhouses built to rent and sell will be taxable supplies as they will be made as part of their enterprises
they are entitled to GST credits for construction costs of the townhouse built to sell
they are not entitled to GST credits for construction costs of the other 2 townhouses
they are entitled to an adjustment to claim GST credits for the taxable supply of the townhouse intended for rent.
Example 2
Claude purchased his home on a single title from a private seller on 1 July 2001 for $300,000. The house was situated on the front portion of an 800m² block. Claude wished to remain in this home however maintaining the big backyard became a burden.
On 1 July 2020, Claude began detailed research and spoke with multiple local real estate agents to understand if he could subdivide his backyard to build a new house and sell it.
Claude's registered valuer valued the entire property at $600,000 split 60%:40%:
original house and land – $360,000
newly created subdivided lot – $240,000.
Claude decided to subdivide, build a house, and sell the newly created subdivided development. To do this, he:
lodged an application for subdivision and received council approval
engaged a project developer to
prepare and submit a development application
build the new house.
Claude funded the development expenses of $440,000 (GST inclusive) through a bank loan and expected the sale of the new house to pay the loan out in full.
He engaged a local real estate agent to sell the new house. He sold it via a contract signed on 1 July 2021 for $1,210,000. There is no agreement to apply the margin scheme to the sale.
Income tax outcome
Once the backyard got its own title, it became its own asset and was no longer part of Claude’s home as a domestic asset. Because Claude's transaction is more complex than just selling the vacant lot, his activities amount to a development activity.
The sale of the backyard became a profit-making activity once Claude made the decision to embark on that activity. The net profit from that activity will be included in his assessable income:
Claude made an overall gain (net profit plus capital gain) of $580,000. This will be the assessable income he pays tax on.
The overall gain ($580,000) is based on the GST exclusive sale proceeds ($1,100,000) minus the GST exclusive development expenses ($400,000) and the original cost attributable to the newly subdivided lot of $120,000 ($300,000 × 40%).
The increase in the value of the newly created subdivided lot from when it was originally acquired (1 July 2001) up to when the profit-making activities began (1 July 2020) should be treated as a capital gain.
The original cost, attributable to the newly created subdivided lot was $120,000 (40% × $300,000) on 1 July 2001.
The value of the newly created subdivided lot at the time Claude began to undertake profit-making activities on 1 July 2020 was $240,000. As Claude has held the subdivided block for greater than 12 months he is entitled to a 50% CGT discount, hence there is a discounted capital gain of $60,000.
The increase in the value of the newly created subdivided lot from when the profit-making activities began up to the time of sale should be treated as ordinary income.
The net profit ($460,000) will be based on the GST exclusive sale proceeds ($1,100,000) minus the GST exclusive development expenses ($400,000) and the value of the subdivided lot ($240,000).
GST outcome
As Claude has entered a profit-making activity and the projected sale price of the developed land will exceed the GST registration turnover threshold, he is required to register for GST. He will:
have a GST liability of $110,000 on the sale price of the townhouse
provide a notification to the purchaser of the amount at settlement to be withheld and paid to the ATO
be able to claim $40,000 credits for the GST included in the price of his development purchases (subject to the normal GST rules)
report these transactions by completing business activity statements.
Conclusion
The tax treatment of property sale is complex and, in some cases, may be one of the largest transactions you undertake in your lifetime.
Unless you are simply selling an existing property which has not had significant improvement or change, we highly recommend that you get advice from your accountant or tax adviser on the treatment of the property for tax purposes. Where you buy a property and make significant changes to it, including subdividing it, this advice should be sought up front rather than waiting for the sale to occur. It can make a huge difference to the amount of money you have in your hand once the transaction has been completed.