Get it clear from the start
It’s a property transaction so Capital Gains Tax (CGT) applies. A nice sweeping statement that most people (even many accountants I am afraid to admit) would maintain to be true.
The hard fact is CGT may not apply and worse, those who have found it so have applied CGT to their detriment in the shape of fines, penalties and taxes they were not factoring into their revenue calculations.
Let’s start with the basics – CGT is not a tax. It’s actually a piece of legislation that enables a taxpayer (you the property entrepreneur – notice I did not use the word investor here) to calculate how much income from an investment transaction should be included in their assessible income.
As an accountant who specialises in property transactions, I am likely to (and do) see all sorts. There are the traditional wealth accumulators, there are the developers, those seeking to use property as a nest egg builder, and those seeking to create an industry around creating dreams for others.
Lost already? In Australia taxpayers (investors, employees and business people alike) pay tax based on their taxable income. Taxable income is defined as assessible income less allowable deductions. Once a taxpayer has worked out their taxable income, tax is levied accordingly. As taxable incomes increase, the amount of tax per dollar we pay increases. This is called bracket creep or our marginal tax rate.
Tax to the ordinary person is complex and apparently endlessly ever changing. Here I am a few paragraphs in and we are talking concepts like CGT, marginal tax rates and taxable incomes. It can be and is a mine field for the ill-prepared.
Having said that, the complexity of the taxation system can actually work to our advantage. As some recent court decisions have shown, the ability to quarantine different income streams allows us to utilise structuring to limit the amount of tax we pay.
Let’s focus on the area you all love – property transactions. There are three basic types or scenarios:
- Buying and selling my home I live in
- Investing long term – being a landlord
- Short term ownership – treating property as a business
Now let’s consider each of these three scenarios in more detail.
Firstly, we should all realise if we buy a house and live in it, not using it for income producing activities, then under the current legislation no tax will apply when we sell it, notwithstanding the new non-residents withholding tax (but that’s a subject for another article). Tax normally comes into consideration if we decide to upgrade using the equity in our former home to buy another one.
I find there are huge misconceptions around what might be termed the six year rule when considering whether or not a home having been used as a Principal Place of Residence (PPoR) which is then rented and finally sold (again an article subject on its own). Generally speaking, although there are exceptions to the rule, in order to claim PPoR exemptions the property must be in the name or names of natural persons.
Secondly, moving to investment transactions where CGT might apply, natural persons under the current legislation include in their assessable income 50% of the capital gain on the sale of an investment. Looking at a property transaction, we buy a property, pay stamp duty and legal fees to own it, then hopefully rent it. Along the way we have included in our assessable income the rent less the direct expenses in relation to collection of that rent ie the interest on the borrowing, the rates and repairs etc.
When it comes time to sell the property we take the sale proceeds (less selling costs), deduct the purchase costs and from the resulting profit (assuming we have held the property for more than 12 months) we deduct the 50% CGT general exemption and include the other 50% in our tax returns and pay tax accordingly. Accountants talk about returning income on capital account when referring to these types of transactions.
Thirdly (and here the grey begins), we have those who seek to use property as the basis of their business. Developers are clearly in business, buying a piece of property, sometimes dividing it but generally creating new assets in the form of new dwellings where perhaps none previously existed.
On the other hand we have those who through sheer repetitiveness clearly are showing entrepreneurial attitudes to property by buying, upgrading and selling property on a regular basis. Then consider, can a one-off transaction be considered a business? Unfortunately the answer is yes. Recent court decisions have not only confirmed this but with the mixing of investment and business intentions or, as we accountants like to term them, revenue transactions.
A case in point – a taxpayer had, prior to the year in question, invested in long term rental properties and at the start of the year had what one might term a reasonable portfolio of properties, all deriving rents which they had been for some time. Hearing about the profits that could be made through short term turnaround of properties the taxpayer, after attending some targeted courses, embarked on a regime of sourcing, buying, renovating and selling them in a very short period – typically no more than a three month turnaround.
As well as the short-term transactions, the taxpayer also sold a longer-term hold property from the portfolio in the same year of income. When it came time to do a tax return the taxpayer, believing the short term transactions to be business in nature reported the profits accordingly and the profit from the gain of the longer term investment as a capital gain. Sounds logical?
Unfortunately the ATO (and then confirmed by the High Court) took the view that in the case of this taxpayer, it was obvious from the evidence there was always a business like intention to all the activities and included what had been returned as a capital gain with the other revenue profits and denied the taxpayer the 50% CGT general exemption – a very costly outcome!
So what should the taxpayer have done?
In cases like these, quarantining of activities can seek to mitigate this type of issue. Here, I am talking about using companies and trusts to segregate the income producing activities. In the case of the business like ventures, using a company would have segregated those activities away from the investments, good from an asset protection stand point, but also would have meant in the short term being able to access company marginal tax rates which for incomes less than $37,000 are less than personal rates (as high as 49%) leaving more cash for the next foray into the market.
Rather than using the taxpayer’s own name for investment, a discretionary trust might also have been considered. Whilst more expensive in property holding costs (discretionary trusts attract land tax in most states at much lower thresholds than individuals) the discretionary power of the trustee can allow for dissipation of capital gains on disposal to those in the family unit who may have lower margins to soak up. This would reduce the amount of total tax paid on a profit from disposal. Some even seek to use their Self Managed Superannuation Fund as a vehicle for longer term investment where, whilst in pension phase, the income of the Fund can be tax free but that is a discussion for taxpayers and their licenced financial planners.
Wait a minute
A word of warning, the ATO have this lovely piece of legislation called Part IVA. You may have heard this bandied around. It’s what we accountants (and the ATO) call the anti-avoidance legislation. Tax evasion and avoidance in this country is illegal. Taxation minimisation for the sake of it can be called tax avoidance and is covered under this legislation.
Basically if one enters into a transaction simply to reduce the amount of tax that might be paid it will run foul of Part IVA and the ATO will seek to remove the structure around it. But if the primary basis of a transaction is not tax avoidance but perhaps asset protection, either from creditors or the likelihood of confusion in the intention of transactions, then a prudent business person would seek to quarantine ‘dangerous’ activities away from any assets their hard work has accumulated.
Structures of another dimension
Structuring a property transaction needs to be carefully considered. It cannot be ‘fixed’ after the event. ‘Intention’ is also a very important word in taxation as is ‘evidence’. The two go hand in hand. We need to ensure the evidence conforms to the intention. If the mixed intentioned taxpayer had considered the transactions prior to undertaking them I suspect the final amount of tax paid could have been substantially lowered, if not at least deferred.
This is where the best value is made of your accountant. Proactively at the start not reactively at the end of the process. Your accountant should be one of your best friends when it comes to the planning of a transaction. The right advice can save you thousands in the longer term.
If there are two things you take away for this article it has to be the concept of quarantining your activities, and knowing your accountant is not there simply to record transactions and tell you what tax to pay. We’re here to help you through the planning process to save on one of the costs inevitable to profitable property trading – tax.
Jeff Banks is an Executive Officer at MW Lomax. MW Lomax is a financial services firm and have offices in Sydney , Melbourne and Brisbane offering Accounting, Taxation, Financial Planning, Mortgage Broking, Life Insurance, Superannuation and Business Advisory services.
Contact Jeff on (02) 8404 6700 or firstname.lastname@example.org
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