Structures For Property Development
The choice of structures adopted for any property development project often has a key bearing on the tax implications and commercial viability of that particular project. Capital gains tax (CGT) is an important consideration for investment property or development projects in Australia, as is the relationship between property development and company tax rates.
In this article we consider structure options for:
1. landowners that have held land for investment (e.g. farm, lifestyle property or family home) now suitable for development
2. property developers.
In particular, the following special advantages will be achieved with proper documentation of the development arrangements:
1. 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.
2. Property developers – offsetting the profit of one project against expenditure of the next project (providing a tax deferral).
Advantageous structures for landowners
The circumstance 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 development.
A simple sale of the property may be eligible for capital gains tax concessions in Australia, including the CGT discount and small business concessions.
If the landowner undertakes a 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.
A better alternative is to implement the development through an appropriate form of joint venture. There are many documents called joint ventures that aren’t in the required format, hence the need for an ‘appropriate’ form of joint venture. Under such a structure, there is no transfer of property to the developer, therefore avoiding the imposition of stamp duty. At the same time, the landowner is considered to hold the property on capital account, therefore retaining the CGT advantages. In addition, the share of the joint venture that may be enjoyed by the landowner can be maximised, therefore maximising the CGT concessions.
Advantageous structures for property developers
A key issue for property developers is that where they purchase the land and undertake development works on the land, the land is considered trading stock. Development expenses are therefore included in the value of trading stock. This has the effect of reversing the deduction for 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 that enters into a suitable form of Development Agreement with the developer, the developer will not be the holder of the land and therefore will not hold trading stock. The result is that the 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 development expenses incurred in the same year on the second project or other projects.
This view is supported by an ATO Public Ruling.
Structures for property development in action
Consider this example of different structures for property development at work.
In 2016 a developer sells all of the lots in the first project, creating a profit of $1.2 million. The developer would ordinarily be liable on tax of $1.2 million (tax at a company tax rate is $360,000). This is the case even if the developer had incurred development expenses of $600,000 on the next project because of the application of the trading stock provisions.
If instead the developer adopted the Development Agreement structure, the developer’s profit in 2016 would be $500,000. Therefore the tax liability on company tax rates would be reduced to $150,000 – a saving of in excess of $200,000.
Investment property tax liabilities and capital gains tax are complex matters for developers in Australia. If you are in any doubt about the best structures for your next property development project, speak to a property law expert.