Many people would assume that a gain made on the sale of a rental property held for nearly 10 years would be a capital gain eligible for the 50% general discount. However, in a recent decision by the Full Federal Court, the length of time a rental property had been owned was deemed less significant than other factors in deciding the tax outcomes. Rather, the court looked at the original intent of the taxpayer and determined the gain on sale to be ordinary income (not a capital gain) to which no capital gains tax discounts could be applied.
Capital gains vs Ordinary income
An asset will generally fall into one of three categories:
A capital asset
A capital asset is generally acquired for the purpose of deriving an ongoing stream of income from the use of the asset (even though a gain may be made on the eventual sale of the asset). The disposal of a capital asset will give rise to a capital gain or capital loss.
The term trading stock applies to any assets traded in the ordinary course of business. Proceeds from the sale of trading stock will be assessable on revenue account.
An asset used in a profit making scheme
These assets are generally acquired with the intention of deriving income or profit from the sale of the asset. Gains or losses on disposal will be assessed on revenue account.
The distinction between each of these categories is crucial in determining the tax outcomes arising on sale. A capital asset may be eligible for discounts or concessions which reduce the assessable amount of any gain on the eventual sale. Where a resident individual or trust has held a capital asset for greater than 12 months, they will generally be eligible to reduce the assessable amount of any gain on disposal by 50%.
Conversely, the sale of trading stock or an asset used in a profit making scheme will be on revenue account as the intention is to derive income or profit from the sale of the asset. Generally the entire amount of a revenue gain will be assessable.
The August case – Why intent is important
The recent August case1 highlights the importance of the taxpayer’s intent in determining the categorisation of assets and their tax treatment.
In the August case, a small strip of shops was acquired in the late 1990’s. Shortly after acquiring the properties some of the shops were leased to a supermarket operator, a hairdresser and a butcher on five year leases with options to extend the lease. Prior to leasing the properties some renovations and extensions to the properties were required.
During the early 2000’s, surrounding land including land previously used for car-parking, was acquired by the taxpayer. Additional shops were constructed on these properties and were leased to restaurants on five year leases (with options to extend the lease).
Shortly after the last of the shops was tenanted, the taxpayer entered into discussions with a real estate agent regarding the best way to dispose of the properties. After a lengthy process, the properties were finally sold in early 2007.
Although the shops had been held for a significant period of time, the Commissioner of Taxation (and ultimately the judges in the Full Federal Court) was not satisfied that the shops had been acquired as long term capital assets.
Instead, they found that it was more likely that the properties had been acquired as part of a profit-making scheme with the principal intention being to develop, tenant and sell them for a profit. Accordingly the sale was not deemed to give rise to a capital gain and therefore not eligible for a 50% discount.
In coming to their conclusion, the judges considered two factors as being crucial:
- Prior to acquiring the properties the taxpayer had sought considerable advice and assistance from a friend who was a successful property developer. The friend explained in detail how he had been successful in buying, developing, leasing and then selling property. The court believed that the taxpayer was looking to emulate this approach; and
- The value and sale of the shops was investigated in detail once the last of the shops was tenanted. The judges felt the most plausible explanation for this was that it was part of a profit making scheme of purchasing, developing, securing long term tenants and then selling the property.
How does this case impact on taxpayers?
The August case provides an important reminder to advisors and their clients that care needs to be taken when classifying an asset as being on capital account or revenue account. Ultimately, the taxpayer has the burden of proof in demonstrating their position is correct. Where possible, detailed advice on the likely tax treatment should be sought prior to acquiring an asset.
While holding an asset for a considerable period of time may seem to indicate that it is a long term capital asset, the intention of the taxpayer at the time of acquisition (and throughout the ownership period) is the more crucial aspect.
Documenting the intent and purpose prior to the acquisition and throughout the holding period is important if the matter is challenged by the Commissioner of Taxation. Factors to address include:
- How is revenue or profit to be generated from the asset?
- What is the likely holding period and do the surrounding facts support this intention?
- What does the loan documentation say? Arguing that an asset is held on capital account if your mortgage documentation suggests that the property is being held for a shorter term property development is likely to be a challenge.
- How much development or redevelopment of the property is required and how close to the time of sale will this occur?
- When did you first engage the services of a real estate agent in relation to the proposed sale of the property? Even though a sale may not take place until years after first contact with an agent, the engagement of a selling agent may be sufficient to indicate the intention of the taxpayer.
- Consistency of accounting treatment. Where a taxpayer changes the treatment of an asset from being on revenue account to capital account in the years leading up to sale, the change would need to be consistent with the surrounding factors and intentions.
Should you require assistance in determining the tax treatment of an asset sale, please contact your local William Buck advisor.
On revenue or capital account? Subdivision of land
Ms A set up a trust called ABC trust. The trust bought farm land with an old house on it for $600,000 in 1997. The size of the land was 1,300 Acres. In 2012, Ms A applied to the council and land titles to subdivide the land into three pieces as follows:
- 200 acres with a new house to be built
- 1,000 acres vacant farm land
- 100 acres with an old house
Ms A built a new house on the 200 acres land in 2012 and sold it in 2013 financial year. The subdivision costs were $35,000. The ABC trust had $100,000 of losses carried forward from the prior year and $20,000 of losses in the 2013 financial year (losses totalled $120,000). Let’s say that Ms A made $250,000 profit on the sale of the 200 acres with the new house.
- Could Ms A claim the subdivision cost of $35,000 as a part of the cost base of the 200 acres and the new house?
- Could Ms A use the losses of $120,000 to offset the capital gain ($250,000 – $120,000 = $130,000)?
- Based on the information provided there is a risk that the sale of the house would be taxed on revenue account rather than capital account. The key issue is whether the subdivision of the property followed by the construction of the house and its subsequent sale would be treated as the mere realisation of a capital asset or a profit making undertaking.
If the client’s intention was to construct the house and hold it for the long term as a private residence or rental property then it may be possible to argue that the sale was the mere realisation of a capital asset. Unless the client can demonstrate sufficient reasons for selling the house within a relatively short period of time (e.g., sudden change in financial circumstances) there is a significant risk that the ATO would treat the activity as a profit making undertaking in which case the profit on sale would be taxed on revenue account and is likely to trigger a GST liability.
You might want to take a look at paragraphs 262 to 302 of MT 2006/1 which discusses whether isolated property transactions are enterprises for GST purposes. If so, the transaction should also be taxed on revenue account.
- If the sale is on capital account it should be possible to include a reasonable portion of the subdivision costs in the cost base of the property. You would need to apportion the costs between all of the subdivided blocks of land.
If the sale is on revenue account then it should also be possible to include a reasonable portion of the subdivision costs when calculating the net profit made on sale of the property.
- A trust can generally deduct prior year or current year losses against other income if the trust loss rules are passed. If the trust has made a family trust election then it would only need to pass a modified version of the income injection test.
If the trust has not made a family trust election then it would need to pass the normal trust loss rules. If the trust is a discretionary trust then it would need to pass the 50% stake test, control test, pattern of distributions test and income injection test