Property Development Tax Treatment – Capital Gains (50% Taxable) or Ordinary Income (100% Taxable) ?

Property development tax treatment is complicated due to the number of potential taxes as well as the breadth of factors that impact how each is applied.  And unfortunately for the compliant majority, property developers (and the related construction industry) have always been high on the ATO’s hit list due to a long and recurring history of non-compliance by a small minority.
Worryingly, the ATO have recently reported they have found a “growing number of property developers that were misusing trusts and treating a property under development as a capital asset” incorrectly.  Accordingly the ATO have issued Taxpayer Alert TA 2014/1 which describes an arrangement where property developers use trusts to return the proceeds from property development as capital gains instead of as ordinary income.

The Mischief

The arrangement described in the alert involves an entity with some experience in either developing or selling property, or involved in some way in the property and construction industry, that establishes a new trust and acquires property through the trust. The stated purpose of the trust is to hold the developed property as a capital asset to generate rental income.
However, activity is then undertaken in a manner which is at odds with the stated purpose.  For example:

• Documents prepared in connection with obtaining finance for the development may indicate that the dwellings constructed on the land are to be sold within a certain time frame and that the proceeds are to be used to repay the loan.
• Communication with local government authorities overseeing building approvals may describe the activity as being the development of property for sale.
• Real estate agents may be engaged early in the development process, and advertising to the general public may indicate that the dwellings/subdivided blocks of land are available to be purchased well in advance of the project’s completion, including sales off the plan.
• The property is sold soon after completion of the development, where the underlying property may have been held for as little as 13 months. The trustee treats the sale proceeds as being on capital account, and because the trustee acquired the underlying property more than 12 months before the sale, it claims the general 50% CGT discount.

The Issue

The ATO considers that arrangements of this type give rise to various issues relevant to taxation laws, including whether:

• the underlying property constitutes trading stock on the basis that the trustee is carrying on a business of property development; and
• the gross proceeds from sale constitute ordinary income on the basis that the trustee is carrying on a business of property development; or
• the net profit from sale is ordinary income on the basis that, although the trustee is not carrying on a business of property development, it is nevertheless involved in a profit-making undertaking.

Although this Alert only refers to special purpose trusts and applies to the specific facts described, there is no doubt the ATO is continuing to look at other property transactions to ensure they are being treated correctly.  The data matching now available to the ATO (including details of all property purchases and sales via each State’s land registry authorities) means they are better equipped than ever and they are clearly focusing their efforts on the distinction between ordinary income and capital gains.
This is demonstrated by a recent court case, August v FCT [2013] FCAFC 85.  In this case, the Federal Court held that income the taxpayers received as beneficiaries of a number of trusts was income according to ordinary concepts and not income of a capital nature because of the existence of a profit making intention on resale (accordingly the 50% CGT Discount could not apply).  This is despite of the properties being held for a number of years and deriving rental income during the ownership period.
If you are considering property development activity or intend to sell a property that you acquired in order to make a profit on its sale, we highly recommend you invest in specific advice from us, tailored to your unique circumstances, to ensure you fully understand the tax implications of your activities.