When selling real estate, there are three possible tax outcomes:
income - from a business of real estate development;
income - from a one-off profit-making undertaking; and
capital - from the mere realisation of a capital asset.
Broadly speaking, under the first two categories, the seller of land is generally assessed for tax on all of the profit arising out of the project (i.e. the land is said to be held on revenue account) whereas under the third category, for landowners who are individuals or trusts, a 50% discount is often available to halve the capital profits on which tax will be assessed from the sale (i.e. the land is said to be held on capital account). For Mum and Dad or trust landowners, the third category often delivers the best tax outcome.
Which category a landowner will fall into is in no small part, a result of the “purpose” they had when the land was bought. In rare but not uncommon circumstances, a purpose can also be treated as having changed during ownership. Whereas the lines are often much more clearly drawn between the first and third category, it is the distinction between each, and the second category, that creates the most confusion. This is particularly so, when working out whether a capital holding (i.e. the last category) slips into one-off profit making (losing its 50% discount) because the property has been significantly developed for sale, rather than sold ‘as is’. Over the years, the Courts have had opportunity from time to time to reduce this confusion but, as with much law clarified through dispute resolution, the answers are confined to and coloured by the facts involved. One thing that is emphasised throughout, is the importance of purpose.
McCarthy v FCT and the importance of purpose
The recent decision of McCarthy v FCT [2021] AATA 1511 is a case in point. The facts concerned the 2016 purchase by both husband and wife of residential land in Western Australia which had a long-term residential tenant. The taxpayer (Mrs. McCarthy) claimed that the purpose of the acquisition was “to rent the Property long-term with the option to potentially sub-divide the block some years in the future, should they decide to do so.” Prior to the purchase, the taxpayer was advised of local subsidence issues and that Council approvals for subdivision had been denied for that same issue in the past. It was for that reason and “to keep their options open” that the taxpayer quickly lodged a subdivision application some 2-3 months after purchase in November 2016.
This application was approved, and the taxpayer decided to proceed to subdivide the block in mid-2017, with the lots sold in 2017 and January 2018. They sought no tax advice and had no prior experience in subdivision or property development but enough nous to seek a private binding ruling from the Commissioner on whether the proceeds were realised on capital account. Unsurprisingly on the facts, the ruling was unfavourable. The Commissioner determined that the profits were on revenue account “being an isolated transaction carried out for profit and commercial in nature.”
In the proceedings, much was made by the taxpayer (through her accountant who represented her) that the transactions, being in their view very poor financial decisions, were decidedly uncommercial in nature. However, the Tribunal found that the test was “not whether the transaction was carried out in an efficient or business-like manner” but whether the “transaction is of the sort that a person in business would undertake.” One could argue that the act of buying and selling property and nothing more, would fit that description. Not surprisingly, the Tribunal decided that the act of purchase, subdivision and sale were above that very low bar. Perhaps the overreliance of the taxpayer on this point was a fixation on arguing the principles of the Commissioner’s ruling (in TR 92/3) rather than the case law. Aside from that issue, what may surprise many is the comment that, for the purpose to be seen as profit-making purpose, it did not need to be the sole or overriding purpose in order to attract the characterisation of revenue, but only a “not insignificant purpose” in the transaction. It is instructive to remember however, that although this is an established principle (in FCT v Cooling [1990] FCA 29), it is never applied in a vacuum. Instead, it is at its most forceful in the context of a profit-making undertaking that was contemplated by the parties from the outset in circumstances where the taxpayer ends up pursuing the profit-making purpose. The point is that in these circumstances, it offers little defence to say that it was not a dominant purpose at the outset. So what are potential ‘Mum and Dad developers’ to make of this, who find themselves looking to realise real estate legitimately acquired as capital, for its highest and best use?
Structuring to maintain a capital (mere realisation) purpose
Mum and Dad should ensure they never engage in an undertaking that might be considered “an isolated transaction carried out for profit”. It is often recommend that, for sound commercial reasons, to protect Mum and Dad (and other assets they may own) a company be established to carry out that work, even if the work of that company is not to turn soil, but limited to project management and engaging others to carry out the works. In terms of structuring, this work is often ideally suited to a joint venture agreement. A true joint venture does not have its own status as a legal entity and is not a partnership of its venturers. In its simplest form, it is a project that, in order to achieve completion, each party comes together to carry out clearly defined and separate roles, for their own respective benefit. For Mum and Dad, a properly structured joint venture agreement (and there are many that are not) is crucial to separate risk and to separate roles. Most importantly in the context of this discussion, the agreement ensures any activity that might be described as an “isolated transaction carried out for profit”, is carried out by the company and not by Mum and Dad. The actual development is certainly not the type of risk-laden activity that Mum and Dad should be undertaking personally. With proper structuring, the value of the land before commencement of the project ought to be capped as the return to Mum and Dad which, absent any profit from the project, introduces the compelling argument that their proceeds are a mere realisation or liberation of that capital value. What is profit comes in to the developer, quarantined from Mum and Dad under the terms of a competently drafted joint venture agreement, paying particular attention to critical commercial and taxation law outcomes.
Particular issues with main residences
Where the land is a capital gains tax (CGT) exempt main residence, it may be more cost effective to pay the duty and trigger the CGT free gain at or before commencement of the project, by selling the land to a company before any work starts, as opposed to joint venturing with it. This will bring forward the CGT consequences to a time where the main residence exemption still covers all of the land or 2 hectares, whichever is less. For the CGT exemption to apply, the land needs to be a residence at the time of the CGT event. Once the land is subdivided, it is most likely that this exemption will shrink to the subdivided lot on which the residence sits or none at all, if the residence is demolished. If a disposal is triggered before this occurs, only proceeds received from the project above the new tax cost, should be subject to tax.
At the earliest time possible, it is essential to obtain structuring advice that can balance the often-competing issues of commerciality, protection, revenue v capital and GST, to arrive at the best solution in the particular circumstances.
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