When can new rental IPs be sold without losing CGT Discount & Paying GST?

Background Situation:

We purchased a house in Brisbane on a block suitable for subdivision, removed the house, subdivided 1 into 2 lots and built two new houses (one on each). The property was purchased in our own names (married couple). The the intent was to;
- create new low maintenance rental properties with depreciation benefits that would be positively geared on completion, and
- to add value, with a view to borrowing against equity created to pursue further investments in the future.

The IPs were immediately rented on completion as planned. The project was successful in that the properties are in an inner Brisbane suburb, significant value has been added and they are significantly positively geared. We have owned the property for about 3 years and construction of the new houses was completed 1.5 to 2 years ago. Depreciation is claimed each financial year.

We have purchased and sold IPs on capital account in the past, but never been engaged in development activities (not even small subdivision projects prior to this one), flipping or alike. We used professionals to buy the site and project manage construction. The rental of these IPs is managed by a rental manager.

The change in circumstances:

We have lived in rental properties long term to preference property investments. With a number of school age children the insecurity and scarcity of appropriate rental properties in our area of Sydney has led us to preference purchasing a PPOR. Our next project is now planned to be the purchase of a PPOR to live in. To fund the PPOR purchase and related construction we may have to sell at least one of the IPs. We have refinanced to release equity which will be used to fund our next purchase with a view to delaying sale of one or both of the existing IPs as long as possible, but a sale is reasonably likely to be necessary to fund / free up borrowing capacity for construction of a new PPOR.

There are two main reasons we'd sell one or both IPs inside 5 years of construction completion;

1) If it is confirmed by our Mortgage Broker as necessary to fund construction of the new house (PPOR), and/or

2) If our financial advice indicates that on completion of the PPOR purchase / construction we'd be better off to sell the IPs to release the equity and pay down the PPOR loan - leaving less non-deductible debt and equity within the PPOR to draw out to fund future property investment projects.

As we are not developers (not engaging in a profit making enterprise), I'd hope that the sooner than expected sale of one or both of our IPs in these circumstances would still be treated as on capital account with the CGT discount applicable and not be subject of GST. I understand however that the ATO may look closely at these sales and there is a risk of audit. We've got nothing to hide in that regard, the circumstances described are truthful and accurate, but if the ATO didn't accept our reasoning the tax consequences could be significant. If for some reason our reasoning was not likely to be accepted by the ATO we'd need to completely reassess our capacity to purchase a PPOR in the short term (the tax implications may be too costly). Particularly if we weren't allowed the CGT Discount.

I'd also expect that as we aren't developers if the sale was accepted as on capital account and CGT Discount allowed, but GST deemed to apply independently as the properties are new, any application of GST would not involve the Margin Scheme. So the GST bill would also be at the higher end (with initial land purchase costs of about 850k, construction and related costs of about 1.2 mil, a total cost base of a bit under 2.1 mil and total sale proceeds of about 2.8 mil based on recent bank valuations). 280k GST on sale proceeds, minus 120k GST paid on construction related costs = 160k. Perhaps with some reduction for time the IPs were held?

Key Questions re tax implications:

Q1 - If the sale of new property inside 5 years is deemed by the ATO to be subject of GST, can the sale still be on capital account (can the CGT discount still apply to the sale) or does the application of GST to the sale automatically classify the sale as on revenue account (automatically exclude the CGT discount)?

Q2 - What do the ATO accept as a satisfactory reason to depart from a genuine plan to hold a newly constructed rental IP for 5 years or more and sell early - such that they allow the sale as on capital account and/or don't apply GST?

Examples of conceivable reasons that might motivate an earlier than planned sale of a rental IP;
a) Medical / health issues that will be costly,
b) Loss of job / change in employment that reduces income,
c) A change personal circumstances that requires access to equity / borrowing capacity tied up in existing IPs, like the decision to purchase of a PPOR, the need to fund the purchase of a new family car, and/or meet education expenses for children etc.
d) The review of an investment property portfolio which determined better long term gains could be achieved elsewhere. Eg - an assessment consistent with expert opinion / advice that capital growth prospects in other areas were better than in the existing IP's location, and therefore a decision to sell and reinvest elsewhere was made. (This would not seem dissimilar selling shares in one company and investigating in another the investor thought had better growth/income prospects).
e) Financial Advice indicating the sale was preferable in the interests of overall wealth creation for the couple / individual. Eg - To pay down non-deductible debt, invest in a different asset class, to facilitate additional voluntary contributions to super etc.
f) Would less investment focussed / lifestyle choices be acceptable reasons - eg. planning a substantial family holiday that funds needed to be accessed to pay for?

Are there other reasons generally accepted by the ATO in this regard?

I am seeking specific tax advice on this, but am interested in the experiences / thoughts of others.

MF35

 

Too long to read on my phone but gst only applies if you are registered or required to be registered for gst and you are conducting an enterprise. But this could include a one off sale
CGT only applies if on capital account. Intending to hold long term for rent basically
Otherwise income taxed if an isolated profit making intention or trading stock

get some specific advice

 

There is a rebuttal presumption you are up for CGT and GST. Get proper tax advice from someone who is qualified.
I would include the margin scheme in any contract for sale on an “if required” basis to cover you here.

I think you are within the timeframe to claim GST paid on construction to offset against the sale.

 

In such circumstances I would generally recommend the facts are presented to the ATO and binding private ruling (BPR) given as any tax advice is mere opinion based on what you disclose and the manner in which you do that. I would be exploring many issues and would give my opinion but that is not as reliable as that of the Commissioner however if the tax issues are quite evident it could be a waste of time and BPRs can be costly.

There are many elements that suggest profit making intentions were and are evident. Profit making includes selling to discharge loans as much as it also may involve release of equity etc. The fact you subdivided and constructed two dwellings at the outset has signs of profit making and the reinvestment plan does you no favours as it appears a further element of a broader enterprise. Selling "for the first time" is a taxable supply where there is an enterprise. If GST applies then there is no CGT but the profits would be taxed as ordinary income.

I do see a issue in the post and wonder why you have referred to "selling in 5 years" several times. This suggests a intention to construct and sell to bypass GST on sale perhaps as this is one of the most misunderstood rules in GST law and when I see it used it rings a alarm bell. This doesnt unwind the enterprise issue and may in fact merely reinforce a concern. A sale AFTER 5 continuous years of ONLY renting merely means the sale is not subject to GST. It doesnt change the tax outcomes. It is one of the warnings I give all people who develop land.

The ability to use the margin scheme will come down to how the land was acquired. In addition, you may be able to claim some of the GST on the build PROVIDED you have retained the correct records.

 

It does sound like the facts are trying to be massaged to make it look like capital account.

The ATO could take the view that this is revenue account and you were just holding off on the sale to wait for the market peak.

This isn't financial advice, as defined under the corporations act anyway, and it may not even be good advice as the tax you would pay would eat into decades of any potential interest savings.

 

Thanks Paul,

If we did need to sell the IPs I would seek a private ruling if my accountant thought it necessary. His opinion is that the sale should be on capital account and GST should not apply, but notes the ATO take an interest in the sale of 'new property' inside 5 years - looking for developers carrying out profit making enterprises under the guise of rental IPs. The ATO are no doubt as suspicious as you guys seem to be, so I'm researching to make sure we're on solid ground if we need to sell. This is an after the fact consideration of the potential implications of needing to sell the IPS. If we had intended to develop and sell, we would have purchased in a Company/Trust structure, not in our own names.

My reference to the Margins Scheme is made only because my accountant says that would be the preferred method to apply IF GST was applicable, but I'm speculating that if the ATO decided GST did apply for some reason, we would not qualify for the Margin Scheme as we are not developers / not required to be registered for GST and the other more expensive method of calculating GST would probably apply.

My reference to the 5 years term is simply because GST only applies to new property less than 5 years old. Only a fool wouldn't take into account the potential costs of selling, and the application of GST by the ATO is one of those costs IF it is applicable now that sale could become necessary, that's all it is.

What 'reinvestment plan' are you talking about? Planning to add value and improve rental return, hold the rental IPs and borrow against their equity to reinvest without selling the original IP isn't a 'profit making enterprise' surely. If it was most buy and hold property investors would not qualify for the CGT discount.

And the 'possibility' circumstances might at some point in the future dictate the sale of an IP is necessary surely couldn't mean the original purchase / construction is deemed a profit making enterprise. Every owner knows their circumstances could possibly change in such a way that required the sale of an IP (for personal or overall wealth creation reasons like getting rid of an underperforming asset when you reach the limit of your borrowing capacity), If that was the rule nobody would ever be able to apply the CGT discount as everyone knows their circumstances can change.

Paul your own definition of the features of an 'Investor' as opposed to a 'Developer' indicates you are behaving like an 'Investor' if:

- You acquire land with view to earning assessable income from rent. DONE
- You seek to maximise yield, although capital appreciation concerns can guide this. DONE
- You develop land you intend to hold. DONE

AND features like these exist;
- You acquire the property with expectations of rent, cashflow and negative / positive gearing tax issues. DONE
- You are likely to buy and hold IPs. Noting that holding can include refinancing to access the IPs equity to buy more IPs. And that your actions may even enhance yield be adding dual or multiple income sources. DONE
- You seek to repeat with concerns about LVR and servicing over time. DONE / INTENDED.
- You keep 'simple records', presumably meaning it's not run like you're a business or profession. DONE.
- You generally seek capital appreciating property with capital base stability. DONE - the IPs are in inner Brisbane.

We are mum and dad self educated property investors. We both have full time jobs in occupations completely unrelated to the property industry. The subdivision was completed with the assistance of property professionals to produce IPs that would be positively geared and create equity to facilitate further investment, without selling. Ideally the rental return will at some stage replace work related income. Instead of being negatively geared and praying for CG, these IPs are significantly positively geared and they have valued with significant equity. If we didn't need to sell them we wouldn't.

I'm interested to know, given the circumstances, on what basis you think 'There are many elements that suggest profit making intentions were and are evident' ? I can understand why the ATO would have a look (because they are 'new' properties), but I can't see how we would fit the definition of a profit making enterprise etc on any of the examples provided by accounts or the ATO. That said, the reason I posted was to test this view.

 

Hi Terry,

There is no 'massaging' of the facts here. I appreciate your opinions / input on the forum, but you're jumping to unsafe conclusions not based in fact with that statement. The facts and intentions are as described.

Whether the ATO consider a sale of new property in those circumstances to be on revenue or capital account and whether GST is relevant to such a sale is what I'm asking about. I understand you would deal with people who are trying to hide property development for profit activities by pretending to be 'investors' when they are really 'developers', but I'm not. Trying to deceive the ATO is a fools game as far as I'm concerned. IF I decided that developing for profit was the appropriate course for me I'd set up the appropriate ownership structures and sell off IPs immediately with no concern about rental return, and repeat.

When I said 'financial advice' I was talking about the advice of a Financial Planner regarding overall wealth creation, insurance, retirement planning and tax effectiveness. I've had a financial planner indicate that if we purchased a PPOR we may be better off selling our IPs, paying down the non-deductible debt and investing by using the equity within the PPOR. I think I've read some of your Debt Recycling articles that are along similar lines. If that continues to be the advice we receive, it may be financially prudent to sell the IPs after buying a PPOR.

What about it would make it bad advice to sell and pay down non-deductible debt on a PPOR? What interest savings would we be eating into if selling these IPs allowed us to half our non-deductible PPOR debt and facilitated reinvestment by pulling equity for future investments?

Note that the reason we have now decided to prioritise a PPOR is personal. We can't readily obtain appropriate rental properties in our area, we have three children attending schools in the area and security of residence in school catchment areas is of significance, and when considering affordability / benefits of a PPOR v Rental Property now, buying a PPOR is more personally and financially appealing than it was 5 years ago.

I understand there could be reasons why the ATO would scrutinise such a sale, but as I said to Paul, I'm interested in opinions based on the circumstances and intentions outlined at face value (with a presumption of innocence / truthfulness applied ).

 

The ATO view on property as ordinary income has no time limits. If they said 5 years I think they gave poor advice.

 

I am just commenting on bits of a post that I haven’t read if full so don’t take it as advice

sometimes it is best not to apply for a pbr

 

Sometimes a BPR is worthless too. eg It contains a error or misstatement. They tend to be poor for confirmation of matters of intention as intention is a state of mind in the past. One of the best ways to support intention is a record of old advice when the intentions are being formed. I think thats invaluable and we go to lengths to ensure this is on file. Likewise adviser advice can be misguided too by a less than honest or incomplete client disclosure. As a tax adviser I always consider risks from new client mis-statements given to me to shop for advice outcomes. eg They may want me to tell them what they want to hear. In reality I hope I can tell them good news but must be open to truth. Most tax and legal advice is based on listening. Filtering the key facts from the information being shared. I actually dont want clients to send a lengthy email and tend to ignore it. I want a good conversation and will seek to ask many questions.

I suspect the "financial"advice obtained may work to support or harm your views. I have seen it work both ways. One had a "spruikers plan "to new build and enhance equity which would assist them to buy in 5 years time to buy their own home with minimal debt. The plan even said to sell aftre 5 years to avoid paying GST so the deferral of a sale was specific and contemplated. ie profit making. ATO considered the advice to support the notion of intention to profit and sell. Another constructed 4 x T/houses without intention to sell at all. Then after 4 years he sought to depart Austtralia when parents became ill overseas and he as unsure if he would return and to avoid loss of the CGT discount he sold all of them. That was a CGT event. I have records where he said "No intention to sell in 3, 5 or 25 years if at all possible" in a diary record on file back when he proposed to buy land etc.