Small-Scale Property Development (Part 1): Capital Gain or Taxable Income?

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You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Property development is a huge Australian pastime, whether it's big institutions developing big sites, or all the way down to mum and dad flipping their main residence.

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Today we're talking about revenue versus capital, and particularly the distinction between revenue and capital in the context of small-scale property developments.

To do so, I'm joined by Tom Warrington, who is an Associate in Velocity Legal's Tax team.

0:45

Welcome, Tom.

Thanks, Andrew.

Tom, let's start with some basics.

We talk about there being a line between revenue and capital in property development.

Why does that distinction matter?

1:03

What's at stake?

Yeah.

So, undertaking a property development in Australia and realising profits on the sale of that property, straight up you're thinking, okay, well, how am I going to assess this?

1:19

How's it going to be recorded to the ATO on my tax return? And the capital-revenue distinction really is a very tough and niche...

It is a tough and intricate kind of analysis as to which pile it sits under, but it's important because it completely determines what's available to you in respect of...

1:44

How much tax we're going to pay.

How much tax we're going to pay in the end, right.

So, if we're on capital, we might want that CGT discount. With a main residence, even, we might be looking at concessions.

There are these things that are specific to whether an asset is on capital account, and the determination of being on capital account is critical to getting access to any of those types of concessions.

2:07

If it's on revenue account, we're talking about ordinary income principles.

So we're looking at deductions and how you've treated the property throughout your development or building.

The distinction in determining whether something's on capital or revenue really is critical to seeing what the overall...

It's going to determine what's actually left at the end.

What money is left.

Yeah, exactly.

2:27

And that's where people can fall into traps because, with these small-scale developments in particular, I think we'll talk about this concept of mum and dad.

It could just be a couple who want to subdivide the back of their own property.

They may not be quite up to date or have an understanding of capital and revenue, and they may just think that all assets are capital assets, just like my shares and so on, and I get a 50% discount and away we go.

2:47

There's a lot of pub talk and myths and so forth.

Yeah, exactly.

And, like I said, it is a really difficult distinction in a lot of respects, and cases have been going on now for decades and decades discussing this distinction.

So it isn't easy, but it is critical when considering these developments.

Absolutely.

3:18

So, I guess, from a legal perspective, what are those categories?

Yeah.

So, I guess the first one I would say is capital account.

If something's on capital account, you're considered to be, I guess, merely selling a property. You're merely realising the value of a CGT asset.

3:37

And if it is on capital account, then we're under the CGT provisions.

Like we said, the CGT discount, main residence, maybe, those types of concepts. Then you're on capital account.

In terms of developments, there are two other categories it could fall under, both on revenue account.

3:57

The first is where it's considered a profit-making undertaking or scheme, or an isolated transaction, which has a kind of commercial nature to it and can be recorded on revenue account.

And the last one is trading stock.

4:15

And I don't think we'll talk too much about trading stock, but trading stock is more where you're in the business of property development.

So, I guess, it's often a little bit more clear-cut if you are a property developer.

Yeah, it's usually clear. I mean, not always, but it is usually clear whether or not someone's in a business.

4:34

Exactly.

And in this context of small-scale property development, we're focusing more on mum and dads doing developments, who are less likely to be in the actual business of property development.

And a lot of these will be one-offs as well, won't they?

Exactly, yeah.

And that's the concept, I guess, that people somewhat minimise. They think, oh, it's a one-off.

4:55

I've never done this before. Surely it's just capital account. Let's just move on.

I'm not in the business of property development. I just wanted to make some money on one transaction.

Surely we can just use the CGT discount, treat it on capital account and move on.

So, let's just construct a hypothetical garden, let's say, and we've got a fence going down the middle.

On one side, we've got capital account. We're just selling a capital asset.

And on the other side, we've got this profit-making undertaking or scheme, revenue account.

5:19

And assessing that fence, I guess, how wide is that fence?

How tall is it?

How do you even work out the difference, and how much grey and overlap could there be between those?

Yeah, and this is the difficulty people have because it is an incredibly fact-dependent analysis.

5:38

It really is a case-by-case assessment of what evidence you have to support your position.

Contemporaneous evidence is the strongest, but proving things like intention, what your intention was with the property, what evidence you have to support that intention and what steps you took along the way.

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All these things are taken into account.

And you could accidentally, just by the nature of how you've gone about this development, lean into a profit-making undertaking, where you could have just been looking to maximise the value of that property and sell it as a capital asset.

6:14

So it's incredibly grey because it really is a factual analysis.

Like I said, that's why we've had decades of cases dealing with this capital-revenue distinction, because it isn't clear-cut.

And thankfully, we have some guidance from the ATO and the Commissioner on the concept of a profit-making undertaking or scheme.

6:29

And I guess one thing to note is that, to fall within this category, you don't need to be carrying on a business.

It isn't as clear-cut as, oh, it's okay, I'm not carrying on a business of property development. That's fine.

It's enough that your development has a bit of a commercial nature or character to it, a bit of a smell, like a sniff of commerciality.

6:54

Why have you entered into this transaction?

Why have you purchased the property to start with?

A lot of people do purchase properties in Australia on a big block, with an older home at the front and, like I've said, a big bit of land out the back, thinking, well, I'm going to subdivide, build a property, sell that property and hopefully realise a profit.

7:17

And, yeah, what a great use of my land.

But doing that alone, having that intention from the start of, well, I'm actually going to realise a profit on this land, and very quickly going into a development contract with a builder, these things have a commercial nature.

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They have a bit of a smell of commerciality because you aren't just using it as a general piece of land and a long-term investment, like a lot of capital assets are.

You do have this idea of making a profit, and that can kind of be enough to fall within that profit-making undertaking or scheme.

8:00

And it's really hard to work out that distinction as well because you can come up with scenarios which are very clearly capital, and no one would dispute that, but you're still doing it to make money.

Let's say it's a house. You've lived in it for 40 years and you decide to sell it.

You say, all right, well, it would sell for a better price with a really nice kitchen in there, and some new floorboards.

Maybe we'll make the windows a bit bigger, and maybe it doesn't have central heating, so we're gonna put that in.

8:34

And, you know, you wouldn't say, well, those are just...

That just seems like renovations.

Yeah, it should, yeah.

But, you know, if you take that sort of commercial flavour to it, in one sense it is being done for...

It is.

To maximise price.

It is.

8:52

And I guess, yeah, we don't want to scare people off.

Most people try to maximise the value of a property they're selling, right?

They'll do some gardening, they will paint the exterior and they'll do improvements that maximise value.

And I guess that's very...

Difficult.

Yeah.

9:08

It's very difficult then to point to it and say, well, you've tried to make as much profit as possible. That's clearly a scheme to make profit.

I guess that's probably taking it a little bit too far.

So, like I said, it's incredibly fact-dependent.

9:27

It is the whole picture.

And that's where, I guess, for accountants out there or for taxpayers, it's having that evidence or having a look at what's happened and what you can point to and prove.

You may be doing a development or subdivision. You may be selling that back block.

9:42

But if it's just you and your wife doing it, you're funding it out of savings, you've built the property with one builder, and then you're obviously looking to sell, or you might be looking to rent and then sell later.

9:59

If it's a small quantity, a small sum of money, you know, a $400,000 or $500,000 build, small being relative.

If it's quite a simple, straightforward development, although I guess there could be an argument that you are looking to maximise profit by selling that land.

10:18

If we can point to the overall facts, where it's quite simple, there are low amounts of money and you haven't taken a real commercial approach, you might be handling the build yourself.

You might be doing some of the building yourself.

It could then lend itself more to being on capital account, just because you are potentially looking to maximise the value of a CGT asset that you own, being that land, with less of a commercial nature to it.

10:38

But, yeah, it's incredibly tricky and hard to balance sometimes.

Well, maybe that's a good point to discuss a case that's been going around the courts, and I understand it's on appeal now.

It's not, I guess, mum and dad in one sense, but it's definitely not small.

11:06

But I understand a lot of the principles from that case are highly relevant to this area.

So, yeah, let's discuss that case.

Yeah.

So it's the case of Morton, which I guess accountants and tax lawyers like ourselves have been quite interested in because, once again, it's dealing with the capital-revenue question in this situation, which is so common.

11:26

I think it's more and more common in places like Victoria and NSW, where these cities are continually growing outwards.

Land is being rezoned. Farming land, land that used to be used for individual farms, is being rezoned for residential, and people are developing on this land.

11:50

And that's what happened in Morton.

Mr Morton owned a very significant parcel of land out in the west of Melbourne.

He was a farmer there for decades.

Then his land got rezoned, I think, to residential.

12:13

Essentially, it meant that it brought his farming operations to a natural end.

So he thought, well, I might as well sell the land. I can no longer operate my farm.

And he entered into a development rights agreement with a significant developer to develop and build all the necessary infrastructure on the land.

12:29

So the roads, the sewerage and the water, split up the land and sell individual parcels.

Again, I think that's a relatively common scenario in these outer areas of the big cities.

There was an interesting arrangement where Mr Morton entered into this development rights agreement with the company.

There were a few steps along the way which might be different for certain taxpayers, and which the Court ended up finding quite interesting. Excuse me.

12:51

Mr Morton was very much taking a back seat in the development.

He obviously made his land available for development, but he wasn't very hands-on.

He didn't even use the land as security to finance the development, which I guess a lot of taxpayers would.

No, he didn't.

13:27

There were a few points where he didn't even try to maximise, I guess, the value of the land that he could have received from the eventual sale.

The Commissioner assessed him on revenue account for these sales.

13:45

So he said, no, look...

And I guess, like we've talked about, with all these factors, you probably would think at first glance, given what we've discussed, that it does have a commercial nature. Like, it's a big...

Big as well.

Huge.

14:01

Again, you have to build the entire infrastructure, roads and so on.

It isn't a mum and dad doing a small little subdivision in the back of the land. It's huge.

And often the scale of these developments lends itself more to it being a profit-making undertaking, really, doesn't it?

You're trying to maximise your profit on the land.

The Federal Court, in the end, actually found that it was on capital account and that Mr Morton was merely realising the value of his capital asset.

14:17

The Commissioner pointed to facts like: he had to do these massive construction works, he had to install the sewerage and do these earthworks, pass all these regulations, and take all these massive steps to get this development in play.

14:48

But the Court brought it back to a few concepts we've already talked about, such as, well, what was Mr Morton's initial intention when he purchased this block of land?

It wasn't to subdivide, develop and sell.

It was to run a farm, so he didn't have that profit-making intention when he first acquired the property.

15:06

Because it was so long ago, no one would even have known that it would ever be part of Melbourne.

Yeah, exactly.

I'm sure when he purchased it, no one had the idea that Melbourne would grow out to this level and that this farming land would suddenly be very valuable, because it was worth, I imagine, very little when Mr Morton purchased it.

15:26

They also said that Mr Morton didn't take much of a role in the development.

Like you say, he didn't even use his property as security, which most people would.

So he didn't even try to maximise his return.

And this development only came about because Mr Morton could no longer farm on the property.

15:42

So they held it to be on capital account, which was quite an interesting decision.

It was quite a careful analysis of the...

Terms of this development agreement between Mr Morton and the developer, and how its terms might affect that distinction.

16:02

Exactly.

And I guess that's one point where, going forward, it could be argued that the decision was very specific to this case.

The Commissioner, I'm sure, would argue that it was very specific to the facts and the wording of this development agreement.

16:19

And, like we said, it's a factual analysis.

So they'll probably always try to minimise it to the facts of Mr Morton.

And I note that the Commissioner has appealed this decision.

I think it's been heard by the Full Federal Court quite recently, so we'll see...

16:35

What the outcome is, yeah.

What it has to say.

But, like I said, this wasn't a mum-and-dad development. It was a very large-scale development.

Drawing parallels or things from this decision that can be applicable to a mum-and-dad-sized development...

16:51

Things like intention, that profit-making intention when you first acquire the land, were still relevant.

So your intention when you purchased a piece of land, how you can document that intention, or the evidence of what your intention was, is important.

And Morton has again gone back to that.

17:10

I think what will be interesting, and what might come out of the Full Federal Court decision, is perhaps a re-examination and maybe even some greater guidance on what this sort of commercial flavour actually requires.

Because it seems to me, and in practice, it's very hard to predict which way it's going to go.

17:29

Yes, okay, some situations are clearly one way, some are clearly the other.

But then there are all these ones in the middle.

Let's say you're mum and dad, and you build something and rent it out for two years and then sell it.

Well, okay, is that long enough? Who knows?

17:49

I mean, they're not going to be as prescriptive as that, but it would be nice to have a bit more guidance.

Yeah, because it's difficult for taxpayers to be certain of the treatment, or to have any type of confidence in these types of developments.

Obviously, you can get your accountant to give the sign-off.

18:04

But, yeah, I agree. This level of vagueness and greyness in this area would make it quite difficult for a lot of mum and dads or taxpayers looking into this type of small development.

So it'll be interesting to see what the Full Federal Court says and if it goes further than that.

Yeah.

18:21

I wanted to touch on one other area before we finish.

I wanted to touch on these situations where there's an initial purpose and maybe that changes in the future.

18:39

Maybe the original intention was to sell, but then the decision is made to keep.

And also the alternative, where the original decision was to keep and they decide to sell.

How do you work that revenue-capital distinction in those types of situations?

18:54

Yeah.

So I think, with these change-of-purpose or change-of-intention situations, we've got to remind our clients that the onus is on the taxpayer to prove whatever position they take in the end, whether that is a capital or revenue position.

Particularly if they're trying to make it a capital account sale, the proof is on the taxpayer.

19:14

So, with these changes of intention, if you have good factual evidence to support that change of intention, it might be a marriage breakdown.

It might be that circumstances in your family have changed, where you wanted to use it as a rental, for mum and dad, or to live in.

19:36

If the purpose of the property, or the reasoning behind why you've done this development or purchased the property, has changed along the way, then having, number one, as much evidence as possible to support that change of intention is really important.

19:53

That's because, as I said, you may be put to proof.

So documenting changes of intention will be really helpful if you do want to claim capital treatment for some reason down the track and you sell it.

Contemporaneous evidence to support that change of intention will be really helpful to support the view.

20:12

Obviously, there might be other tax outcomes.

You may have claimed input tax credits on the GST side because it was always intended to be on revenue account and a profit-making undertaking, so you've taken those necessary steps.

And then, actually, three years in, if you've decided to change and hold it long term, there might be some adjustments that need to be made to those GST lodgments.

20:32

But, yeah, I think the most important thing would be...

It's a good point you make about the evidence. That's critical.

The ones that we've seen probably the most are where some land is purchased, perhaps, and maybe a house is built or a duplex is built and, lo and behold, they're sold very quickly after the building.

20:58

But they say, well, no, really, we didn't...

That was sort of because of unforeseen circumstances. Interest rates changed, or someone died, or someone got divorced, or something like that.

It's a good point you make that you really need evidence.

21:20

Yeah, because that kind of quick purchase and sale, the ATO will be notified. They'll...

See the records.

They'll see the records from the land titles office.

A flag will go off. They've purchased and sold that property very quickly.

They'll check, okay, is the owner registered for GST?

21:36

Have they been lodging BAS, claiming credits?

What kind of GST treatment have they applied along the way?

Okay, well, they're not.

So if they're not registered for GST, and they've purchased and sold very quickly, questions would be raised.

21:54

They've purchased and sold that property very quickly, and they've sold for more money.

They've clearly made a profit.

Then, I guess, you're put to task. You're put to proof as a taxpayer.

So although it might be things like interest rates and other reasons as to why you've sold the property, if you struggle to come up with evidence to support those reasons, you might make it harder to really prove what that change of intention was and why you've chosen to sell the property so quickly.

22:14

So, yeah, documentation will certainly help you out if you do have circumstances where things have changed and brought about a quick sale.

I think that's a good takeaway message: the documentation and evidence.

We've been talking about this distinction, this divide between revenue and capital, why it matters and how to assess one category against another, with the acknowledgement that it is grey.

22:44

But what's in your control is the evidence.

Yeah, and making that clear.

But I appreciate it's a complicated area.

There are all sorts of different property development situations and all sorts of different circumstances.

23:03

If you are involved in a small-scale property development and you're wondering, is this really capital? Is this really revenue?

I'd strongly recommend reaching out to Tom for an initial discussion and seeing if we can assist.

23:20

Thanks again, Tom, for being part of this episode.

Cheers.

Thanks, Andrew.