Capital Or Revenue? The Tax Question That Decides What You Keep

YOUR TAX TREATMENT CHANGES WHAT YOU KEEP.Confirm capital or revenue treatment before trusting net profit.

A development site that produces a $400,000 gross profit can leave the developer with very different amounts depending on one question asked long before the sale: is that profit ordinary income or a capital gain? It is not a technicality that belongs with your accountant in the last month of the project. It belongs in your feasibility from the day you start testing the site, because it changes the after-tax number the whole deal rests on.

Here is the practical version. Your purpose and your conduct decide the answer, the Australian Taxation Office looks at both objectively, and a first project is not automatically a capital one.

The deal question: what am I actually being taxed on?

The Australian Taxation Office's guidance on tax consequences on sales of property, including small-scale land subdivisions, starts from a blunt proposition: property sales, including subdivided land, that are part of a property development business are treated as ordinary income. It then explains that your purpose when you enter into an arrangement to purchase, develop or sell the property determines whether gains or losses are a capital gain or ordinary income, and that your purpose can change across the years you own it.

That is the hinge. If it is ordinary income, the capital gains tax discount is not available on that profit and the money is brought into your assessable income, which is why the ATO's guidance notes that the tax outcome depends on whether the disposal was a mere realisation of a capital asset or a disposal undertaken as part of a business or a profit-making undertaking.

Three outcomes, not two

Reading a property tax discussion as a simple choice between income and capital misses the middle option, and the middle option is where most small developers actually sit. The Australian Taxation Office's own records set out the three pathways: ordinary income because you are carrying on a business of property development, with the land as trading stock; ordinary income because of an isolated business or commercial transaction undertaken with a purpose of profit; or a capital gain on the mere realisation of a capital asset.

In the third pathway the ATO set out a case in which a taxpayer subdivided and sold land and the proceeds were not ordinary income. The indicators that supported that outcome were informative: minimal works to meet council requirements, the landowner's minimal involvement in the subdivision, land that was not purchased with an intention to resell at a profit, small scale and low complexity, and no experience or history of property development. In that case the ATO's published factors include minimal works to meet council requirements and the landowner's minimal degree of involvement in the subdivision.

Turn those indicators around and you can see how a small project quickly lands in the second pathway. Engage a surveyor, a planner and a builder, fund it with a loan, and sell two completed dwellings, and the ATO's view in its own worked record was that the arrangement is an isolated commercial transaction undertaken for the purpose of making a profit, assessable as ordinary income.

The factors that get weighed

Taxation Ruling TR 92/3, which the ATO still applies, describes an isolated transaction as one outside the ordinary course of business, or one entered into by a person not carrying on a business. Paragraph 35 of that ruling sets out the two elements: the taxpayer's intention or purpose in entering the transaction was to make a profit or gain, and the transaction was entered into, and the profit made, in carrying out a business operation or commercial transaction. The ruling is explicit that the test is objective, not a matter of what the taxpayer says they intended.

In practice the facts that carry weight are the ones you can still see years later in documents: what the acquisition documents and the loan application said the property would be used for, whether you took steps to change planning controls or obtain approvals, how much work was actually done to the land, the amount of financial risk you carried, the cost of the development relative to the value of the land, your history of similar activity, and how businesslike the whole exercise was.

What it does to your feasibility

Two numbers have to be modelled, not one. Ordinary income means the profit is assessed at the owner's marginal or company rate with no CGT discount; capital means the discount may be available to individuals and trusts, subject to the rules that apply to the specific asset. GST is a separate question again. The ATO's subdividing guidance notes that where the gain is ordinary income the sale is part of an enterprise for GST purposes, included in calculating your turnover for GST registration purposes and subject to GST if you exceed the registration threshold or are already registered, and the ATO's guidance on GST at settlement explains that from 1 July 2018 most purchasers of new residential premises or potential residential land pay a withheld amount of GST direct to the ATO at settlement and the balance to the supplier.

The practical consequence is that a deal which looks strong on a gross margin can be marginal after tax. If your feasibility only carries the gross number, you are not testing the deal, you are testing an assumption about the deal.

The trap: assuming a first project is automatically capital

The most common and most expensive mistake is believing that because you have never developed before, the result must be a capital gain. The ATO's examples are built precisely on the opposite proposition. A one-off development can be a profit-making undertaking with the net profit assessable as ordinary income even if you are not carrying on a business.

The second trap is timing. Purpose at acquisition matters, but later conduct matters too. The ATO's guidance is that purpose may change through your ownership period, and that if property is purchased as a capital asset and the intention later changes, the ultimate overall gain may need to be split between a capital gain and ordinary income. A site you bought as an investment and later committed to a development is exactly the situation this describes.

The checks a capable student would run

1. Write down your purpose before you sign anything. What the acquisition documents, loan application and your own file say about intended use is evidence.
2. Model two after-tax outcomes in the feasibility, one on revenue account and one on capital account, and see whether the deal survives the worse one.
3. Decide the entity before the contract, not after, because the entity affects the rate and the characterisation weight.
4. Ask about trading stock early. If the land is stock, the profit is recognised as lots sell, and the accounting follows the sales.
5. Test GST as its own line item rather than assuming it away, including whether a withholding amount may be payable at settlement.
6. Keep a project file from day one with the acquisition intent, the advice received, the approvals applied for and the works done, dated and sourced.

The Think Property Club lesson

A development is a business plan with a tax outcome attached. The students who do well are not the ones who know the most tax law, they are the ones who identify the question early enough for a specialist to answer it while the decision is still open. You do not need to resolve the characterisation question yourself. You do need to book it into the feasibility and brief your accountant with the facts of your own project rather than a general query.

Your next actions

• Add a line to your feasibility template for the characterisation assumption and the tax rate applied.
• Ask your accountant to confirm, in writing, the likely treatment of your facts before you exchange.
• Confirm whether GST registration and GST at settlement are likely to apply, and price it.
• Start the project file now, with the acquisition documents, advice, approvals and works evidence in it.
• Have your finance broker confirm what the lender needs to see on the tax treatment before it will fund the project.

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Photo: Peterdownunder, CC BY-SA 4.0, via Wikimedia Commons.