Eddie Chung examines the different ways you can invest in property, and how the tax office treats these activities
The income tax rules in Australia are applied in different ways to different categories of property owners. Generally, if you buy a property, your intent for the acquisition and subsequent use of the property will dictate how you are treated for tax purposes. Broadly, property ownership can be classified in the following five categories:
One-off profit-making undertaking
Property development business
When it comes to tax time, you will need to characterise your property ownership under one of these categories. Incorrect characterisation may give rise to incorrect tax treatment, which may, in turn, invite grief from the tax office.
How the tax office treats these activities
The following summarises the points of differentiation between these activities and their general income tax treatment:
1. Property Investment
This is perhaps the most ‘vanilla’ case of property ownership. The owner buys a property with the intention of holding it for the medium to long term in return for rental income. Often the property is negatively geared because any net rental income from the property (ie gross rent less expenses) will be taxable as ordinary revenue in the owner’s hands. By negatively gearing the property, the annual net rental income and therefore the associated tax liability is minimised and, unless the property is sold, no capital gains tax (CGT) will be payable.
If the property is sold and the property is owned by an individual, a trust or a complying superannuation fund (not in pension mode), and the property has been held for at least 12 months before it is sold, the CGT discount will apply. The discount applicable to an individual or a trust is 50%, while the discount for a complying superannuation fund is 33.33%.
The owner may also be entitled to claim the capital works deduction, which is based on the original construction expenditure of any improvement on land (building, for example).
2. Property-leasing business
While this is similar to property investment, in that the owner buys each property with the intention of holding it over the medium to long term in return for rental income, the number of properties owned by the owner and the way the owner conducts the activities may turn it into a business.
For the leasing activities to be considered a business, the owner must own a multitude of properties and the activities will exhibit one or more of the following characteristics:
they have a significant commercial purpose or character
they are conducted with a profit motive and there is a prospect of profit
they are repetitious and regular
they are planned, organised, and carried on in a business-like manner that is directed at making a profit
they are of a sufficient size, scale, and permanency and the owner has more than just an intention to engage in business
The tax treatment of a property-leasing business is not significantly different from property investment. Any net rent will be taxed as ordinary income, and CGT will apply upon the sale of each property.
A notable income tax difference pertains to tax deductions that are specifically available to businesses and that would otherwise not be available to investors. For instance, the blackhole expenditure provisions allow an entity carrying on a business to claim over five years’ expenditure that is of a capital nature and not included in the cost base of any asset.
By way of an example, if an owner incurred expenditure with a view to purchasing a property but the acquisition never eventuated, they would not be entitled to claim a tax deduction because the expenditure was not incurred in the course of producing assessable income and was capital in nature. In contrast, a leasing business could claim this capital expenditure under the blackhole expenditure provisions over five years as the expenditure could not be included in the cost base of any asset because the property was never purchased.
However, the owner might be entitled to claim the capital works deduction as the property would still be considered a capital asset.
3. Property-trading business
This involves a property owner buying a property (or a number of properties) and selling it for a profit, which is commonly known as ‘flipping’. In many ways, the activities resemble those of a share trader, who buys and sells shares regularly to realise a quick profit.
While the lead time in property trading is longer (ie the contract may have a cooling-off period and settlement usually happens sometime after the contract is signed), the taxation principles are the same –the property will be treated as ‘trading stock’ of the owner and any profit made on its acquisition and subsequent sale will be assessed as ordinary income, rather than a capital gain. It follows that the gain on sale will not qualify for the CGT discount, even if the property has been held for at least 12 months by an eligible entity.
If the owner has a property that is not sold by the end of an income year, the cost of the property, which is reflected in the ‘closing stock’ figure, will not effectively be tax deductible until the property is sold in a later income year. Interestingly, the trading stock rules allow the owner to value the closing stock at cost, market value, or replacement value, which means that the owner may choose to crystallise some of the gain or loss on the property if the market has moved and the value of the property no longer approximates its original cost. However, the closing stock value adopted must be used as the opening stock value at the start of the following year.
Further, as the owner is carrying on a business, they will be entitled to claim specific business related tax deductions that are not generally available to non-business property owners. However, as the property will be a revenue asset, rather than a capital asset, the owner will not be able to claim the capital works deduction.
4. One-off profit-making undertaking
Rather than being a continuous series of activities, a one-off profit-making undertaking pertains to a property owner buying a property as an isolated transaction with a view to profit.
For instance, rather than regularly buying and selling properties, the owner buys a specific property on a one-off basis with the intention ofselling it in the short term for a profit; alternatively, the owner may buy the property but improve it first by way of development before the property is sold at a profit.
However, it should be noted that if the activities are of considerable size, scale, and magnitude, a single acquisition of land for the purpose of development, subdivision, and sale may be treated as the commencement of a business, rather than an isolated one-off profit-making undertaking. Accordingly, it is sometimes difficult to draw a line between a one-off profit-making undertaking and a property development business.
For income tax purposes, a one-off profit-making undertaking will be treated as a revenue transaction. Again, this effectively means that even if the property has been held by an eligible entity for at least 12 months before it is sold, the CGT discount will not apply.
Unlike the case of a property-trading or property development business, in which the sale price of the property is essentially brought to account as assessable income and the original cost of the property is claimed as a tax deduction in the same financial year under the trading stock rules (unless the owner chooses to value closing stock other than at cost), it is the ‘net profit’ from the one-off profit-making undertaking that is treated as assessable income.
The net profit amount is calculated by subtracting the total development costs from the sale proceeds, which generally include all the costs to acquire the property or bring an improvement on the land into existence –for example, development approval costs, architect fees, site clearing costs, construction costs, etc.
Unlike the case of a property-trading business or property development business, in which indirect costs such as interest, rates, land tax, etc, that are specifically related to the development are tax deductible as they are incurred, the tax office’s approach appears to require all such costs to be included in the net profit figure as assessable income for a one-off profit-making undertaking, ie these costs are only tax deductible in the income year in which the net profit for the undertaking can be determined, which is when the property is sold.
Further, as a one-off profit-making undertaking is not a business, the owner will not be able to claim specific business-related deductions, such as the blackhole expenditure deduction. Also, as the property will be a revenue asset, no capital works deduction can be claimed.
5. Property development business
A property development business is usually a continuous going concern and carries on its business activities on a regular and repetitive basis. The income tax treatment for a property development business will essentially be the same as for a property-trading business; that is, the proceeds on the sale of a property will be treated as assessable income, while a tax deduction for the original cost of the property will effectively be claimed under the trading stock provisions. Again, there is room for the owner to revalue the closing stock figure each year, which must be carried forward to become the opening stock value in the following year.
Perhaps the more tricky issue in terms of determining the cost of the property sold is apportionment when the property is subdivided into a number of lots. Common apportionment methodologies may be based on the proportionate expected sale price or the land area of each lot. In any case, the method adopted must be reasonable, having regard to the specific circumstances of the development.
As a business, any indirect costs that are incurred in the course of carrying on the business will be tax deductible as they are incurred, unlike the treatment under a one-off profit-making undertaking in which such costs are required to be included in the net profit figure that forms the assessable amount after the property is sold. The business may also be eligible to claim business-related deductions that are otherwise not available in a one-off profit-making undertaking or property investment, but the capital works deduction cannot be claimed.
The above describes the most common scenarios associated with property ownership, but circumstances are seldom that clean-cut in real life. For instance, a property owner may commit a part of their main residence to a development project, which adds extra complications to the arrangement. What about the reverse scenario in which a property developer decides to keep one of the lots they developed as a private asset? All these scenarios will require further analysis to determine the exact taxation consequences that are specific to a given set of facts.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.