Private ruling: Capital Gains Tax - Subdivision of land - Income vs Capital
Date of advice: 21 February 2017
Published: August 2017
Ruling period: The year ended 30 June 20XX. | The year ending 30 June 20YY. | The year ending 30 June 20ZZ.
Date scheme commenced: 20XX.

Ruling: Q1: Will the profit on the sale of the properties be assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Will you be eligible for the discount capital gain if you hold all the properties for more than 12 months? | A2: Yes, however any capital gain from the capital gain tax (CGT) event will be reduced to the extent any profit is also assessable under section 6-5 of the ITAA 1997. Issue 2 | Q3: Will you be eligible to claim rental expenses while the existing dwelling is rented out during construction phase? | A3: Yes

Relevant facts and circumstances: You are spouses. You entered into a contract to purchase an old residential property (the property) as tenants in common in 20XX. Settlement occurred in soon after. The property was zoned as 'General Residential 1' at the time you acquired it and remains the same. A valuation report of the property provides the assessed land value in 20XX to be a particular amount. You intend to subdivide the property, leaving the existing dwelling and build an additional two units. You will renovate the existing dwelling's bathroom, kitchen and flooring. You have engaged the services of a surveyor in relation to the development. You have engaged the services of an architect in relation to the preparation of plans and planning applications. You will have water and telecommunication services connected. Subdivision costs including fees to council, contractors and service providers will be funded using equity from an existing dwelling. The construction of the project will be funded by bank loan. You have provided details of the associated construction costs. For the purposes of the subdivision and construction, you will undertake the activities yourself and engage subcontractors as necessary. You expect the new units to be completed in 20YY. You intend to sell the original unit and one of the two newly constructed units. You will retain one of the newly constructed units for some years, during which time it will be rented out. You expect the units to be available for sale later in 20YY. You have provided details of the projected values of each unit. You or any related entities have not been involved in subdivision activities or in the business of land development. You or any related entities have no specific intention to be involved in future subdivisions, but you may be involved again depending on the success of this project.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5. | Income Tax Assessment Act 1997 Section 8-1. | Income Tax Assessment Act 1997 Part 3-1. | Income Tax Assessment Act 1997 Part 3-3.

Reasons for decision: Summary: You are not carrying on a business of property development. However, any profit from the sale of the properties will still be accounted for on revenue account as an isolated commercial transaction. Any profit from the sale will be assessable as ordinary income under section 6-5 of the ITAA 1997 as an isolated transaction. Any capital gain you make will be reduced under 118-20 of the ITAA 1997 to the extent that the profit from the sale of the properties is otherwise included as assessable income including under section 6-5 of the ITAA 1997. If you hold the assets for at least 12 months, you can use the discount method to calculate any CGT that may be payable. | Detailed Reasoning - Detailed reasoning: Income vs Capital There are three ways profits from property sales can be treated for taxation purposes: 1. As ordinary income under section 6-5, on revenue account, as a result of carrying on a business of property development, involving the sale of land as trading stock; or 2. As ordinary income under section 6-5, on revenue account, as a result of an isolated business transaction entered into by a non-business taxpayer, or outside the ordinary course of business of a taxpayer carrying on a business, which is the commercial exploitation of an asset acquired for a profit making purpose; or 3. As statutory income under the capital gains tax legislation. Carrying on a business Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'. The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts. Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? provides the Commissioner's view of the factors used to determine if you are in business for tax purposes. In the Commissioner's view, the factors that are considered important in determining the question of business activity are: ● whether the activity has a significant commercial purpose or character ● whether the taxpayer has more than just an intention to engage in business ● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity ● whether there is regularity and repetition of the activity ● whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business ● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit ● the size, scale and permanency of the activity, and ● whether the activity is better described as a hobby, a form of recreation or sporting activity. No one factor is decisive. The indicator must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression. Application to your situation Applying the above factors to your circumstances, the overall view is that you are not carrying on a business as a property developer. Apart from this development, you are not currently involved in any land developments. You have not previously been involved in any land developments, although you may be involved in future developments, depending on the outcome of this development. There is a lack of regularity and repetition of the activity as there is no trading pattern of buying, developing and selling land. These facts indicate that you are not carrying on a business of property development, involving the sale of land as trading stock Isolated business transactions Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income discusses profits on isolated transactions and the application of the principles outlined in the decision of the Full High Court of Australia in FCT v. Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693. This ruling states that profits on isolated transactions may be income. Profit from an isolated transaction will be ordinary income where: ● the intention or purpose of a taxpayer in entering into the transaction was to make a profit or gain and ● the transaction was entered into, and the profit was made, in the course of carrying on a business operation or commercial transaction. ● TR 92/3 outlines that the relevant intention or purpose of the taxpayer, of making a profit or gain, is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case. Profits on the sale of subdivided land can therefore be income according to ordinary concepts within section 6-5 of the ITAA 1997 if the taxpayer's subdivisional activities have become a separate business operation or commercial transaction, or an isolated profit making venture. At paragraphs 56 and 57, TR 92/3 explains that a profit is income where it is made in any of the following situations: ● a taxpayer acquires property with a purpose of making a profit by whichever means prove most suitable and a profit is later obtained by any means which implements the initial profit-making purpose; or ● a taxpayer acquires property contemplating a number of different methods of making a profit and uses one of those methods in making a profit; or ● a taxpayer enters into a transaction or operation with a purpose of making a profit by one particular means but actually obtains the profit by a different means. Furthermore, Miscellaneous Taxation Ruling MT 2006/1 The New Tax System: the meaning of entity carrying on an enterprise for the purposes of entitlement to an Australian Business Number deals in part the taxation consequences of isolated transactions relating to the sale of land and states in paragraph 263: The issue to be decided is whether the activities are an enterprise in that they are of a revenue nature as they are considered to be activities of carrying on a business or an adventure or concern in the nature of trade (profit making undertaking or scheme) as opposed to the mere realisation of a capital asset. MT 2006/1 refers to the cases of Statham and Anor v. Federal Commissioner of Taxation (Statham) and Casimaty v. Federal Commissioner of Taxation (Casimaty) as cases that provide guidance on when activities to subdivide land may amount to a profit-making undertaking or scheme. In both cases, farm land was subdivided and sold and based on the facts of those cases, the courts held that the sales of the subdivided lots were a mere realisation of a capital asset. MT 2006/1 notes that from the Statham and Casimaty cases a list of factors can be ascertained that provide assistance in determining whether an activity is a profit-making undertaking or scheme. Those factors are: ● there is a change of purpose for which the land is held, ● additional land is acquired to be added to the original parcel of land, ● the parcel of land is brought into account as a business asset, ● there is a coherent plan for the subdivision of the land, ● there is a business organisation - for example a manager, office and letterhead, ● borrowed funds financed the acquisition or subdivision, ● interest on money borrowed to defray subdivisional costs was claimed as a business expense, ● there is a level of development of the land beyond that necessary to secure council approval for the subdivision, and ● buildings have been erected on the land. In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations. Application to your situation In your case, there was a demonstrated intention to profit and the transaction has been undertaken in a commercial manner with the property being purchased and settled in 20XX before steps were taken towards the development and subdivision of property soon after. You have previously not been involved in property development and subdivision activities but may consider future activities depending on the success of this project. This provides further evidence to your profit making intention, along with the construction of the additional units on the subdivided land. Based on the information provided, the Commissioner is satisfied that the proceeds from the sale of the properties will be those from an isolated transaction. Therefore, proceeds from the sale of the properties will constitute a profit from an isolated transaction under the guidelines of TR 92/3 as discussed above, and will be included as ordinary income under section 6-5. Capital gains tax The basic CGT provisions are contained in Part 3-1 of the ITAA 1997. Broadly, these provisions include in your assessable income any assessable gain made when a CGT event happens to a CGT asset that you own (to the extent they are not reduced by capital losses). A CGT asset is any kind of property or a legal or equitable right that is not property. CGT event A1 under section 104-10 happens if you dispose a CGT asset. You make a capital gain if your capital proceeds exceed the CGT asset's cost base. Section 118-20 contains anti-overlap provisions which operate to reduce capital gains by any amounts which are included in your assessable income under a provision of the ITAA outside of Part 3-1 of the ITAA 1997, for example, as ordinary income under section 6-5 of the ITAA 1997. Discount capital gain Under Division 115 of the ITAA 1997, you can use the discount method to calculate your capital gain from the disposal of your interests in the subdivided blocks if: (a) you are an individual, a trust or a complying superannuation entity (b) a CGT event happens to an asset you own (c) the CGT event happened after 11.45am (by legal time in the ACT) on 21 September 1999 (d) you acquired the asset at least 12 months before the CGT event and (e) you did not choose the indexation method. The discount method to calculate your capital gain can be used once you have held the properties for at least 12 months. The discount percentage for individuals is 50%. If you hold the assets for at least 12 months, you can use the discount method to calculate any CGT that may be payable after the application of section 118-20 of the ITAA. Application to your situation Accordingly, whilst CGT event A1 under section 104-10 of the ITAA 1997 will occur on the disposal of the property, the disposal will be viewed as an isolated transaction. Any capital gain arising from this CGT event will be reduced to the extent any profit is also assessable under section 6-5 of the ITAA 1997. | Summary: You are entitled to continue claiming deductions for the relevant portion of rental expenses incurred in gaining or producing assessable income, in relation to renting out the existing dwelling. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of capital, private or domestic nature, or relate to the earning of exempt income. Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put. Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings is about the relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings. Deductions for interest incurred on money borrowed to acquire negatively geared assets when the expenses incurred are in relation to bona fide investments, that is, investments that are expected to earn an overall profit, gain or cash flow in the longer term, will be accepted. Application to your situation In your case, you purchased and rented out the existing dwelling in a genuine manner for the purpose of gaining or producing assessable income. Where you have incurred expenses in funding the dwelling, you can claim the relevant portion of the expenses. Therefore, you are entitled to claim the relevant portion of rental expenses incurred in gaining or producing assessable income, even to the extent where negative gearing occurs as a deduction under section 8-1 of the ITAA 1997.