Development Profits - Capital Gain vs Ordinary Income

If we decide to re-develop our property that was purchased several years ago (this was not the intention at the time of purchase), given the prevailing case law and scale of the re-development contemplated, this activity could be more than a mere realisation of a capital asset. On this basis (please accept this as is – I understand there are many private binding rulings that can go either way), if the intention is to sell all lots in the re-development:

1. Once the decision has been made to re-develop for sale, the property becomes a revenue asset / trading stock, a CGT event is triggered and CGT is payable;
2. Once the re-developed properties are sold, Income tax would be payable on the development profit
3. Interest on development funding would be deductible

However, if the intention is for lots in the re-development to be retained for rental for, say, 10 years

1. Interest on funding during the development would be capitalised;
   
2. At the time the development for rental decision is made, does the property become a revenue asset/trading stock and trigger the CGT event ? or,
3. Does the land continue to be a capital asset and re-development subject to CGT once a lot(s) is(are) sold in the future?

What happens if circumstances change, and some, or all of the development is sold shortly after completion? (Note, the issue of GST on new residential premises is not the subject of this query)

Will the development profits be treated as capital gains, or income?

If income, would prior income tax returns be amended to reflect a transfer of the land to trading stock, thereby paying the CGT on that transfer, and reducing the development profits that are treated as ordinary income. And would the interest costs during development be included in the amended returns as deduction, rather than be capitalised and add to the cost base?

What steps / evidence would be required to ensure that the profits on sale are treated as capital gains, rather than income?

 

There is a specific CGT event which may allow you to realise some profit as a cap gain. However it comes with a catch. It is triggered when the land becomes trading stock so a cashflow timing issue with the CGT event generally arises. This CGT event allows you to choose cost or market value !! Thus you can trigger a discounted capital gain when the land is first held as trading stock. That timing may require advice as it can be earlier than some taxpayers may like.

If your intention changes back to rental another CGT event may occur. But you can't undo your choice for the earlier CGT event. This can affect the costbase thereafter. The ATO also generally don't accept a person can commence a enterprise intending to profit then change their mind towards the end and hold on for a few years and use CGT. They may still consider the intention was to generate ordinary income. Important that intent is clear and matches advice.Many people choose the cost method for the CGT event where they are definitely or fairly well committed to holding some/ most / all to produce rent. In some cases the CGT value method is good where a substantial cap gain is expected but the trade off can be in timing.

There are a large number of tax issues in this issue including GST, margin scheme, how and when to claim GST and how to apportion costs on each "unit" as well as CGT choices and timing of deductions.

Tip : If intent is to build and hold for rents then GST may be avoided after 5 years (but none claimed on build) and interest during the build can be claimed - Not capitalised.

You will need a property focussed accountant to guide all this to avoid big errors in planning and implementation.

 

Thanks Paul

Indeed, it may be nice to have a capital gains (with the 50% discount) maximised to increase the value of the trading stock and reduce the profit subject to ordinary income. However, isn't this CGT event only relevant when the intention was always to develop for sale and the land become trading stock? Or are you suggesting that this CGT event will occur irrespective of whether the original intention of the development is for immediate sale (trading stock and ordinary income), or build and hold (capital asset).

The OP was questioning the impact of changing an intention to build and hold, to sell one or more (most likely shortly after completion) on the treatment of trading stock, capital gains and ordinary income profits. (And agree the other tax issues such as GST, margin scheme, and adjustments would also come into play)

Not sure if your comments regarding an enterprise and ordinary income apply to this scenario.

Although this is getting slightly off topic, your comment that interest during the build is not capitalised is curious, as it appears to conflict with advice I have received. That advice was for the proposed development entity structure (not discussed in these posts), if the properties were retained as rentals, interest during development would be capitalised, and interest after development, deductible. In contrast to a development for sale, where the interest during development is deductible, and after development, deducible to the extent that sale proceeds do not cover the level of borrowings relating to the development. Maybe there are some other conditions for this to apply that are different to the scenerio you are contemplating.

 

Steele's decision is the basis and the ATO views on that High Court decision are contained in TR 2000/17. I would have concerns that the advice given may not be coming from a property focussed tax adviser. Take care with GST then.

If less than 100% rentals after build then you may need a private ruling to ensure you comply with Steels and can apportion etc

CGT event K4 Summary of CGT events | Australian Taxation Office. The issue with K4 is determining when the asset commences to be held as trading stock v's CGT. Demolition of a rented structure can trigger this as an example.
But if its going to continue to be held for rental post build K4 isnt triggered.K4 doesnt occur if the intent is to build and hold