We have had a client come to us recently with a development proposal which raises a number of interesting property development tax issues.
The basic facts are:
• The land to be developed is currently the client's principal place of residence
• The land (and house) were acquired in April 1984
• The current market value of the property is in the order of $550K- $600K
• The proposal is to demolish the existing residence and construct two new (Torrens titled) residences in its place
• The property would be subdivided such that each new residence is on its own separate allotment
• One of the new residences will become the current owner's new principal residence
• The estimated cost of the project for both new properties is $500K
• The anticipated market value of each new dwelling will be $700K
These facts raise several interesting tax related questions such as:
• What is the nature of this activity- Would it be considered property development?
• What about GST registration- will it apply to the sale of the new residence, and if so how would it be calculated?
• How will the profit on the sale of the property not retained as the new residence be treated
This activity would be considered to be property development as it involves more than simply disposing of a capital asset. lt is possible to make small improvements to land prior to selling it without it being treated as property development but in this case there is a significant improvement, being a new residence constructed with all the necessary steps involved.
As this project will be considered a property development, it also means it will be seen as carrying on an enterprise for GST purposes. The threshold for compulsory or GST purposes is current or projected turnover, (ie sales net of GST), of $75,000 or more.
As the second property is expected to sell for around $700,000, this is well above the compulsory registration threshold, and so GST registration, as well as an Australian Business Number, (ABN) will be required.
As a GST registered entity, the GST included in the relevant development costs can now be claimed as input tax credits by lodging Business Activity Statements, (BAS), for the periods in which the relevant expenses are either incurred, or paid, depending on the GST accounting method chosen when registering. This in itself is not necessarily straightforward and shouldn't be finalised before obtaining appropriate advice.
A further consideration in this instance is that approximately half the development costs will be in relation to the construction of the owner's new principal residence, ie for a private,non-creditable purpose. Briefly this means that roughly half the available input tax credits are not claimable, but again, this can occur in a couple of ways and the right advice could provide cash flow benefits.
When it comes time to sell the second property, as a GST registered seller, GST will apply to the transaction. There are a couple of options here also. The usual way GST is applied to a sale is to just add 10% to the sale price, which will result in the GST component being 1/11 of the total GST inclusive amount. In our example here, that would result in GST payable on the sale of $63,636. If we assume half of the GST on the development costs is claimed during the development, (the other half being private, non-claimable), the claimable input tax credits would be 1/11 of $250,000, or $22,727. The net GST payable using this normal method would therefore be $63,636- $22,727, or $40,909.
There is an alternative method of calculating GST when it relates to sales of real property, this is known as the margin scheme. Whilst the general principle of the margin scheme is relatively straightforward, there are a number of conditions to be satisfied to obtain its benefits, so expert advice is critical.
The margin scheme calculates GST payable on the sale by taking 1/11 of the margin between the sale price and the acquisition value, and ignores any development or other associated costs. If the property being sold was originally purchased on or after 1 July 2000, the acquisition value will be that purchase price. What about in this situation where the property was acquired in 1984 well before the introduction of GST, and furthermore, the owner was not registered or required to be registered in relation to property development until now? In this case the acquisition value will be either the market value of the property as at 1 July 2000 if the developer was registered at that date, otherwise the market valuation is taken at the date the developer became GST registered, (or the date of application for registration).
From our facts above, we know the current market value of the property is around $600,000, so half that amount can be applied as the acquisition value of the property being sold. This will give us a margin of $700,000- $300,000 or $400,000. The GST payable is therefore 1/11 of this amount or $36,364, just over half the GST payable under the standard calculation method. The relevant GST input tax credits are still claimable, so the net GST payable using the margin scheme becomes $36,364 - $22,727, or $13,637.
The Tax Office isn't quite finished with us yet. There is still the question of how the profit on the sale of the second property is treated. As noted earlier, this development will be treated as a business enterprise not the mere realisation of a capital asset. The profit won't be treated as a capital gain, but as ordinary business trading profits.
The calculation of business profits in simple terms is derived by subtracting the relevant costs or expenses from the sales in a particular period. In our example here we have the sale of the property for $700,000, but for income tax purposes the GST is dissected from the sale price as well as from the development costs. From our example above, we can see that applying the margin scheme will result in a lower GST bill, so this is the method chosen, (and specified as such in the sales contract). The sale proceeds net of GST are $700,000 - $36,364 =$663,636. We also know our development costs came to $250,000, less GST claimed of $22,727, giving net costs of $227,273. However we need to consider the land that the recently sold residence was built on.
The original property was acquired before the introduction of the capital gains tax regime in September 1985, so it would not be subject to capital gains tax, (CGT), upon sale for that reason alone, as well as the fact that the sale of one's principal place of residence is ordinarily exempt from CGT anyway. What effect will this have on the profit calculation on the sold property, and does it have any ramifications for the property retained by the owner as their new principal place of residence?
When the property development started as a business enterprise, the land ceased to be simply a capital asset, and instead commenced to be held as trading stock. Simply put, trading stock is what is held or acquired in order to be sold (hopefully), at a profit, whether it be property, cars or pencils. Ordinarily the cost or value of trading stock is determined by what was paid or given for it.
There are rules governing the value of trading stock where the asset in question was being held on capital account, as is the case here. The asset can be treated as having been acquired as trading stock at its original cost, which would result in no capital gain, but potentially a low cost for trading stock purposes, resulting in a higher, (taxable), trading profit.
In our circumstances here, the land in question is pre-CGT, so there can be no capital gain on its disposal. An election can be made for the land to be acquired as trading stock at its market value as at the commencement of the development, which does create a capital gain event, but it can be ignored here due to the pre-CGT status of the land. This will now mean the taxable profit on the sale of the property is reduced down to essentially the profit made on the construction of the dwelling, (assuming there is no significant increase in market value of the underlying land during construction).
The taxable profit on the sold property can now be calculated as:
$663,636 (sale proceeds net of GST) less applicable development costs $227,273, less the market value of the land sold as at the commencement of the project $300,000, leaving estimated net profit of $136,363.
“Information provided is of a general nature only, is not personal financial or investment advice, and we accept no responsibility for persons acting on information contained herein. Clients should not act solely on the basis of material contained in this document. We recommend that our formal advice be obtained before acting on the basis of the topics presented here.”
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