By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)
The choice of structure adopted for a property development project often has a key bearing on the tax implications and commercial viability of that particular property development project.
In this article we consider property development structure options for:
- Landowners that have held land for investment (e.g. farm, lifestyle property or family home) now suitable for development;
- Property developers.
In particular, the following special advantages will be achieved with proper documentation of the property development arrangements:
- Landowners – ensure the unrealised gain at commencement is taxed as a capital gain (which may be eligible for concessions including the exemption for pre-CGT assets and the CGT discount for post-CGT assets) rather than as ordinary income, without incurring tax restructure costs.
- Property developers – offsetting the profit of one project against expenditure of the next project (providing a tax effective deferral).
Landowners
The circumstances we are dealing with is where a landowner has held a property on capital account (for example, a farming property or family home) which is now suitable for property development.
A simple sale of the property may be eligible for CGT concessions including the CGT discount and small business concessions.
If the landowner undertakes a property development activity, the activity will usually comprise the carrying on of a business or a profit-making undertaking in respect of which the profit will be taxed as ordinary income (not as capital gains).
To avoid this result, the usual recommendation is to transfer the property to a developing entity. This incurs a liability for stamp duty and also triggers a taxing event for income tax purposes. Both stamp duty and income tax will be payable notwithstanding no cash being received for realisation of the property. In addition, the restructure will occur before commencement of development, which reduces the capital gain component and therefore the tax advantage. For these reasons, we don’t consider this standard recommendation as tax effective.
A better alternative is to implement the property development through an appropriate form of contractual arrangement. Under such a structure, there is no transfer of property to the property developer (therefore avoiding the imposition of stamp duty) while at the same time the landowner is considered to hold the property on capital account, and therefore retaining the CGT advantages. In addition, the landowner’s share under the contractual arrangement can be maximised, therefore maximising the CGT concessions. A very tax effective structure.
Property Developers
A key issue for property developers is that where they purchase the land and undertake property development works on the land, the land is considered trading stock. Development expenses are therefore included in the value of trading stock which has the effect of reversing the deduction for property development expenses until sale of the individual lots which generates a taxable profit.
Importantly, the trading stock provisions only apply where the developing entity is the holder of land.
On the other hand, where the land is held by a separate entity which enters into a suitable form of Development Arrangement with the developer, the developer will not be the holder of the land and therefore will not hold trading stock. The result is the property development expenses are deductible in the year they are incurred (and not offset by the trading stock provisions). The advantage is that the profit resulting from the first project can be offset against property development expenses incurred in the same year on the second project or other projects.
This view is supported by an ATO Public Ruling.
Example
In 2016 a property developer sells all of the lots in the first project which creates a profit of $1.2 million, the property developer would ordinarily be liable on tax of $1.2 million (tax at company tax rates is $360,000). This is the case even if the property developer had incurred property development expenses of $600,000 on the next project because of the application of the trading stock provisions.
If instead the property developer adopted the Development Arrangement structure, the developer’s profit in 2016 would be $500,000 and therefore the tax liability on company tax rates would be reduced to $150,000 – a saving of in excess of $200,000.