Whether you are carrying on a property development business or undertaking a one-off property development project, taxation has a significant impact on your return on capital. Having a good understanding of the taxation rules that may apply to your property project upfront is an essential step to planning your cash flow and maximising your project return.
Here are some of the key taxation issues to consider if you are running a property development project:
You should get the structure right during the planning stage of the development project and, in particular, before you buy the site. This is because once a structure starts owning assets and becomes valuable, it may get expensive to restructure to achieve a better commercial and/or taxation outcome due to the potential application of stamp duty, capital gains tax, etc. Therefore, it is always better to ‘put the horse before the cart’ with structuring being the ‘horse’.
Structuring is ultimately about creating a permutation of entities that is fit for purpose, which should involve considering a multitude of factors, including asset protection, the number of parties involved, the legal and regulatory environment, taxation, exit strategy, succession planning, and establishment and ongoing costs, etc. Sometimes a structure cannot optimise all these factors, so it is about prioritising the most important ones and coming up with a structure that may provide the best outcomes on balance.
For instance, if you are partnering with a landowner to develop a site, you may enter into a development agreement with the landowner, rather than having the landowner transfer the land to a separate entity in which you and the landowner both have an interest. As there will not be any actual transfer of land, you will save stamp duty and the potential tax liability that would otherwise be crystallised.
On another project, you may be developing a site for a few private investors, who will be chipping in money to fund the project. You may negotiate a ‘free carry’ arrangement with them under which you will be issued a predetermined percentage interest for nominal consideration in the entity that will be acquiring the property before the investors contribute their funds. Such an arrangement may give you an interest in the entity without entailing any taxation consequences.
There are many more examples of how you could potentially minimise your tax liability simply by structuring the deal correctly and a tax adviser who specialises in property is your best friend in getting this step right.
At the outset, there is this demarcation between the concepts of ‘revenue’ and ‘capital’, which give rise to different tax outcomes. For instance, if you acquire a property with the intention of developing and selling it for a profit, the gain you make on the deal will be treated as revenue; on the other hand, if you buy a property for the purpose of earning rental income and you subsequently sell it and make a gain, the gain will generally be treated as capital.
The reason why it is important to differentiate between revenue and capital is that the tax system currently favours capital gains, provided that the property has been held for at least 12 months before sale. If the property is so held and is in the name of an individual or a trust, the gain will qualify for the 50% CGT (capital gains tax) discount, which has the effect of halving the tax that would otherwise be payable had the gain been treated as revenue!In reality, property projects are, more often than not, that clear cut. You may have bought a property for rent and later decide to venture it into a property development project for sale in return for a profit. You may even have a dual purpose when you first bought the property, not knowing exactly what you are going to do with it. All these intentions (which may be difficult to prove) could add another level of complication to your tax characterisation and calculations.
Then there is the issue of the manner in which the gain on a property project is taxed if you are carrying on a recurring property development business as opposed to undertaking a one-off property development project. The former requires you to treat the property (or parts of the property you are selling off such as strata titles) as trading stock and the sale proceeds are treated as assessable income. The latter requires you to return the profit on sale as assessable income. The deductibility of expenses may also be different between these arrangements from a timing perspective.
Therefore, unless you know the tax law well and know exactly what you are doing, calculating your tax liability is definitely not for the faint-hearted.
Goods and Services Tax
The Goods and Services Tax (GST) was meant to be a simple indirect tax that imposes tax on a ‘supplier’ for ‘taxable supplies’ it makes, including property developers who sell properties. However, there are a number of rules and exceptions that could render a relatively simple tax a compliance minefield.
By way of an example, if you have developed new residential premises but rented some of them out because you have trouble selling them, even though you continue to market them for sale, the GST issues may take a complicated turn.
As a general rule, if you incur expenditure in the course making a taxable supply (eg, selling new residential premises), you are allowed to claim back the GST included in such expenditure. However, if the expenditure is incurred in the course of you making an input taxed supply (eg, leasing residential premises), you are not allowed to claim back the GST included in the expenditure.
In the example, given that you are both selling new residential premises (ie, making taxable supplies) and renting out residential premises (ie, making input taxed supplies), you will need to apportion your GST claims on expenditure incurred to bring the premises into existence and in the course of making these supplies, eg, construction costs. The apportionment calculation may not be straightforward, especially given that you effectively have to guess the sale price of the premises to do the apportionment.
Then there are issues in relation to whether the purchase or sale of a property may qualify for GST-free treatment, eg, as a supply of a going concern or farmland. If the supply of the property does qualify for GST-free treatment, contractual protection will need to be considered and negotiated such that if the Commissioner of Taxation subsequently rules that the supply should have been taxable, you need to ensure that the property contract does not leave you out of pocket.
Further, if you buy a property under a sale that is characterised as a supply of a going concern but you wish to on-sell the property under the ‘margin scheme’, another set of convoluted rules apply, which may require you to find out how much the original seller who sold you the property paid for the property or obtain an approved valuation just to calculate the ‘margin’.
Meanwhile, if you have calculated the GST liability incorrectly, which is subsequently discovered by the tax office, you may find yourself confronted with penalties and General Interest Charge.
The above has highlighted some of the tax issues you may face when you undertake a property development project. From experience, even what appear to be the most simple projects may entail some curly and mind-numbing tax issues. In that regard, a property savvy tax adviser is perhaps one of your most valuable secret weapons.
Eddie Chung is a Partner, Tax & Advisory Private Clients for BDO, one of Australia’s largest associations of independently owned accounting practices, with offices in Adelaide, Brisbane, Cairns, Darwin, Hobart, Melbourne, Perth, Sunshine Coast, and Sydney.