Property development in your SMSF – Yes or No?

From a tax perspective, your self-managed superannuation fund (SMSF) is a good place to make property development profits, provided you won’t need to access the money until retirement.

The downside is that it also involves cutting a path through a jungle of complex tax and legal regulations, all at the risk of being penalised or taxed into ruin if you breach the regulations.

Simply getting property into your SMSF can be a challenge. Your SMSF deed must permit the proposed activities, after which you need to take into account the relevant property market risks along with the costs of complying with SMSF regulations. Then, if you are allowed to borrow, the potential lenders will need to understand and be comfortable with your proposed arrangements.

Your SMSF must be run for the sole purpose of providing superannuation benefits for its members, based on a rational investment strategy. For this reason, the following activities are not permitted:

  • Lending money or provide financial assistance to a member or relative.
  • Intentionally acquiring assets from related parties (though there are some exceptions, such as property that is used wholly or exclusively in a business and where the in-house asset test is satisfied).
  • Borrowing money (except for Limited Recourse Borrowing Arrangements, which are used solely for the acquisition of a single asset, being a commercial or residential property).
  • Charging benefits or assets.
  • Undertaking transactions that are not at an arm’s length. An arm’s length transaction is one in which the parties are acting independently and have no relationship to each other. Therefore, transactions that are not at an arm’s length are those where you’re dealing with related parties.

One thing that isn’t restricted is the ability of your SMSF to carry on a business. However, you cannot run a business that contravenes the requirement that a SMSF can only be operated to provide retirement benefits. As a simple example, this requirement would be breached if a SMSF fund member dipped into the fund to get cash to prop up his or her struggling business activities.

The benefits of using your SMSF for property development include:

  • If you hold the property until retirement and you go into the pension phase, you will pay no tax on either the capital gain if you sell or the rent if you continue to hold your investment.
  • Prior to retirement, the capital gains from selling your investment and any rent you earn from the investment is taxed at 15 per cent. There is an added bonus, from a capital gains point of view, if you have held the investment for more than 12 months, whereby the tax reduces further, down to as low as ten per cent for the capital gain.
  • The ability to borrow to invest in direct property enables you to access high-growth assets without the need to pay for them upfront (remembering that if you are looking to develop the property, you will need to do so with clear funds in the SMSF).
  • Investing in direct property in your SMSF gives you control of your investments and a real understanding of where your money is invested, as opposed to managed share schemes in traditional investment strategies.
  • The long-term benefits of holding property with significant growth in value will supplement other investments within the SMSF. If borrowed funds are used to acquire these properties initially, it provides you with the opportunity to hold and develop those properties once the borrowing is cleared. That will accelerate the value growth in your SMSF far greater than cash or other traditional investments.

If you would like to discuss property and your SMSF, please contact us and we’ll be more than happy to have a chat.

Development agreements vs Joint Venture?

A development agreement is a contractual arrangement between the builder and land owner for which there is a fee for the development of the land.

This arrangement differs from a typical JV where the result is a sharing of the final product (the completed houses, units or apartments), as the development arrangement will be a sharing of the profits by the land owner paying the builder a fee for the development of the land.

These agreements are best structured as to equalise the profits as best is possible.

The two main types of agreements are to either:

  1. Structure a development agreement for a fee for costs plus a percentage of profit on sale of the units.
  2. Structure a fixed fee that has a contingency based on the success of the project. In other words, the fee could be reduced if the expected return was not achieved.

These agreements have the benefit of eliminating any stamp duty that would be paid by transferring the ownership of the land from the original land owner to the newly created entity that would run the development (a significant cost, depending on the value of the original land used in the development).

If you would like to discuss your next development or even your current one, don’t hesitate to contact us.

Alternative Joint Venture (JV) structures

Are there alternative joint venture (JV) structures?

Indeed there are.

What if you decided to use a company or unit trust as the JV vehicle?

The key difference between the partnership JV and company or unit trust from a structuring point of view is the issue of losses.

In a partnership JV, the losses on a current year basis are able to be claimed by each of the parties in their respective entities and can therefore help to offset other income and potentially reduce their tax liability.

When it comes to a company and/or unit trust structure, unfortunately, the losses are quarantined against future profits and as such you are unable to offset these losses on a current year basis against other income you may be generating.

Entering into a development agreement or construction contract between the entity developing the land (building company) and the entity holding the land (land owner) is one alternative that would allow the building company to take up the costs of the development as they are incurred on a year-by-year basis.

It is important to understand what structure best suits you and your business and that depending on the type of development and who you may partner with, it could be a different structure each time.

We would be happy to discuss your options with you, preferably, before you commence your next development.

A joint venture (JV) vs a partnership – Be careful

The benefits of an unincorporated JV include that there is no joint and several liability. In other words, each of the parties in the joint venture is responsible for their own tax consequences and one cannot impinge on the other. The real-life problems that arise if you have created an accidental partnership are shown in the following example.

Consider two friends, Mark and Brian, who formed a JV for their property development, making a point of documenting that the arrangement was not a partnership in their initial agreement.

To obtain finance to complete the project, Brian needed to put up his family home as collateral. Because of this, Mark and Brian formed a new agreement, which contained the following clause:

‘The parties have agreed that, notwithstanding their co-registered proprietor shares of the property, they will have equal shares in the property as tenants-in-common and will share equally all costs, liabilities, mortgages and proceeds derived from any sale arising from the property.’

So Mark and Brian agreed that they would have equal shares in the property, that they would share all costs equally, and that they would share all proceeds (or profits) equally. As previously discussed in an earlier blog, one of the defining features of a partnership is that the partners receive an equal share of the profits, while in a JV each party is entitled to an output of the undertaking. Consequently, this new clause meant Mark and Brian were now considered to be a tax partnership, even though it may not have been their intention.

Upon completion of the development, the properties were sold and the GST liability, as issued by the ATO, was $508,962. Brian paid his share of the GST liability ($254,481), believing that the Mark would also pay his share. Unfortunately, Mark did not. The ATO then pursued Brian for Mark’s share on the basis that they were a partnership (I think you know where this is going).

The ATO was successful and Brian was liable for the full GST liability – $508,962.

The key issue for consideration was whether there was in fact a JV in place. It was concluded that while the first agreement was a JV, the subsequent agreement changed the entitlements from sharing the properties developed (a feature of a JV) to a share of ‘joint or collective’ profits (a feature of a partnership).

Consequently, Brian, as a partner in the partnership created by the subsequent agreement, was jointly and severally liable for the full amount of the GST owing. If it was found that there was a genuine JV in place, he would have only been liable for his half of the GST liability.

As you can see, care needs to be taken in any JV development.

If you would like to discuss an upcoming development or one you have already begun, we’d be happy to have a chat – absolutely no obligation.

What is a joint venture?

Property development arrangements have been on the ATO’s radar for a very long time and we are currently seeing audit activity looking at the GST treatment of joint venture (JV) arrangements.

One of the problems with understanding JVs is that the term itself is used in a number of different ways. Let’s explore that.

An Incorporated JV can simply be an arrangement between parties that they will undertake a commercial activity through a company which may own the relevant property. So you could have two or more shareholders in that company.

An Unincorporated JV is a different beast – it is a contractual arrangement between two or more parties to undertake a particular commercial activity and commonly involves some parties contributing property (or the use of property) which they remain the owners of.

A common question that comes up at this point is, if a JV is an arrangement between two or more parties, how is it different to a partnership?

A partnership is where two or more people are in business together with a view to sharing profit. Tax law states that two or more people in receipt of income jointly will constitute a partnership for tax purposes. A common example of a partnership for tax purposes is where two or more people jointly hold a rental property. They are in receipt of rental income jointly from the property they own and therefore they constitute a partnership for tax purposes.

In a JV, on the other hand, the participants don’t share profits – they each have an entitlement to the output of the undertaking. For example, a land owner might contribute vacant land to a joint venture together with preliminary work performed to seek approval for a development, while a builder then obtains further approvals and builds properties on the land. The finished properties are then distributed equally to each of the participants of the JV to do with as they wish. They might choose to live in the completed properties, rent them or sell them.

From a tax perspective, each participant accounts for their tax treatment separately, given that the (unincorporated) JV is not a separate taxpayer. In other words, there are two or more separate entities, not one combined entity (like a company) with shareholders.

JVs can also simplify the way they account for GST externally and internally where revenue is connected to the JV activity by establishing a GST JV. According to the ATO’s GST regulations, GST JV purposes include ‘the design, or building, or maintenance of residential or commercial premises’. This does not include land subdivision.

JVs, if structured correctly, have a number of benefits over other structures, such as partnerships. The parties in a JV can adopt their own tax treatment for their participation in a JV and they are not jointly and severally liable. If the JV is structured so that there is no need to transfer property, duty and tax costs may be avoided or deferred.

The possibility of CGT, stamp duty and other tax costs at the completion of the project needs to be carefully considered. As a general rule, if you are dealing with real property and accept that a true JV requires a sharing of output, rather than profit, this may require a change in ownership interests in the property that can trigger tax costs. The structure and documentation of a JV of this type will likely determine the timing of these costs.

For instance, because transferring land will trigger stamp duty to the buyer and CGT to the seller, it may be beneficial to trigger the transfer at the beginning of the project where the value of land may be at its lowest point to minimise both stamp duty and CGT. Conversely, it may work as well at the end of the project once all development costs have been factored into the project. The key here is to plan the project carefully and in detail from the outset so you can make any land transfers necessary at the most advantageous time of the development.

The income tax treatment of the JV by the parties will depend on the actual arrangements entered into and the extent of the property development being undertaken.

If you are considering a JV for your property development and are unsure what best suits you, please get in touch for a complimentary chat.

What is a special purpose vehicle (SPV)?

A special purpose vehicle (SPV) is a separate formal structure (either a company or a trust) that brings together separate parties, such as a developer and an investor, for the purpose of a property development.

These property developments usually exist for a defined time period and are generally born from the developer having the idea for a project and the investor, liking the idea, investing in the project. At the completion of the project, each party then goes their own way.

SPVs can be a beneficial structure when you would like the return from a development to be classified as the realisation of a capital asset, rather than a revenue-generating activity. However, in order to access the CGT concessions, the SPV would need to be in a trust structure, as companies cannot access the CGT concessions.

The reason for this is that an SPV would be legally separate from any other revenue-generating property development activities being carried on. Therefore, it could be argued that the new SPV is a clean slate, unaffected by previous property developments and demonstrating the intention to realise a capital asset from day one.

If external factors cause you to sell the development much earlier than the build-and-hold strategy anticipated then, unless the ATO can prove otherwise, the initial capital intention may still hold up, even if the property has only been held for a relatively short period of time (remembering that you would need to hold the asset for a period of 12 months to access the 50 per cent CGT discount).

The factors that the ATO would look to investigate in order to prove a revenue-generating development, rather than one on capital account are:

  • The parties have experience in property development, selling property and construction and the underlying purpose may be for development and sale.
  • Finance documents for the development may indicate the dwellings, once complete, will be sold within a certain time period in order to repay part or all of the loan.
  • Communication with local authorities granting building approvals may describe the activity as being a development of property for sale.
  • Real estate agents may be engaged early in the development process, along with advertising being undertaken.
  • The property/s are sold very soon after the 12-month CGT concession period.

All the above factors may provide the ATO with enough evidence to suggest that the intention from the outset of the development was a profit-making venture or scheme, and therefore taxable on revenue account with no access to the 50 per cent CGT concession.

However, keep in mind that this is a complex area and should be discussed with your accountant or financial adviser. The ATO has made clear its intention to audit developers to determine if they are accounting for their transactions in accordance with tax law, with penalties of up to 75 per cent of the tax avoided, in addition to the requirement to pay the avoided tax, for deliberate avoidance cases.

In these cases, the ATO is saying that the correct tax treatment is to tax profits as revenue and not as capital, and that an SPV arrangement is a contrived attempt to use trusts (in particular) as vehicles to access the CGT discount.

In other words, the ATO may believe that the trust is set up to try and isolate what might otherwise be a natural part of the other commercial property transactions you undertake.

The ATO may also believe that you justify capital account treatment on the strength of your claimed intentions to build and hold for income-generation purposes, and that subsequent transactions that appear more consistent with build and sell strategies are explained as being driven by changed circumstances.

The commercial reality is that there will be activities that start out as being capital in nature and then require a change for various reasons. These could be due to cash flow issues or changed market conditions. The change itself is not necessarily the problem if there is a genuine commercial explanation which has contributed to it.

In any case, if you set out your intention in SPV documents, it is likely to be a good starting point. Be as prepared as you possibly can.

If you would like to discuss a potential property development and what may best suit your circumstances, please get in contact with us for an initial chat.

Structuring your property development – what’s best for you?

If you are considering getting into property development, you could structure the development as a sole trader, partnership, company or trust.

As with your main business, many developers will protect themselves by using a separate entity (a company or trust) for each development.

However, the ownership of the land on which the development is to occur often determines the development entity, so it is important to get this right so you don’t run the risk of paying additional stamp duty by having to transfer ownership.

Whatever entity and development arrangement you adopt, it is vital that you clearly identify and document the identity and role played by each party.

Beyond the structures, there are some additional legal structures common in the property development space that are worth considering – special purpose vehicles, joint ventures and self-managed superannuation funds.

Understanding your options and which would best suit your specific development, is paramount.

A special purpose vehicle (SPV) is a separate formal structure (either a company or a trust) that brings together separate parties, such as a developer and an investor, for the purpose of a property development.

A joint venture (JV) is simply an agreement between two or more parties that they will undertake a commercial activity. It can be incorporated (company) or unincorporated.

A self-managed superannuation fund (SMSF) is self explanatory but what some people are not clear on is the ability to undertake development activities, albeit within very strict guidelines.

Which would best suit you?

Whilst your personal and business situation is likely to differ from others, you would likely fall into one of the above structures with any development you wish to undertake.

If you would like to discuss a development project with us and what make best suit you, please get in touch for an obligation free chat.

What happens when your property development changes?

The basic tax position for a property development is:

  • A capital asset is something that you acquire with the intention of holding it and generating a return from
  • Activities you undertake in respect to the property may amount to the carrying on of a business, or an isolated profit-making
  • If you dispose of a capital asset, then CGT provisions
  • Merely claiming a capital intention may not be sufficient to meeting the approval of the ATO or the courts.
  • If you enhance the value of a capital asset in order to increase the return when it is sold (for example: you obtain development approval for a farm) you may still be ‘merely realising’ the capital asset, or maybe not, depending on the degree of enhancement and all the factors considered in farm
  • If your activities with a capital asset become more than mere realisation (or an initial capital intention cannot be established), you cannot access CGT concessions and you will then need to consider the income tax
  • Your intention in relation to a capital asset can

The final point here is key – your intention in relation to a capital asset can change.

A capital asset may turn into a profit-making transaction or business. The land may not have been originally purchased with a profit-making intention, however, due to changing circumstances, it may then venture into a business or profit-making transaction.

Let’s explore this issue with an example.

Mr Beach purchased ten acres of land in 2002 in a fairly remote seaside location so he and his family could enjoy the benefits of holidaying at the beach. In 2010, following discussions with friends and colleagues, some of which had experience in property development, he decided to subdivide and develop the land. The predominate reason was the significant increase in land value at this now rather popular seaside location. As a secondary issue, the family were no longer using the land for their recreation as they once were. Mr Beach embarked on a significant development with 50 residential lots. The subdivided land was then sold at a significant profit.

In this scenario, the profit on the development would be considered on revenue account. Once Mr Beach decided to develop due to the significant increase in land value and the interest in property in the area, the land transformed from one which was held for ‘domestic purposes’ for the owner to one that was purely driven to engage in a commercial venture to make a profit. The transformation turned the development from a ‘mere realisation’ to an assessable transaction. Mr Beach had ‘ventured into’ a profit-making scheme and the land was no longer held on capital account.

While this particular scenario may be rare, the fact remains that the ATO and the courts will closely examine the facts of any scenario and will look to clarify whether the intention and/or purpose has changed from one that would be considered capital to a business or profit-making scheme and therefore on revenue account.

There have been many legal cases in this area, particularly ones involving farmers looking to undertake subdivision activities themselves, rather than simply offloading the farm to a property developer.

The theme that developed from these farming cases was that if the farmer didn’t look too much like they were actively doing things a developer would do, the transactions would be considered a mere realisation of a capital asset to maximise the return to the farmer on the disposal of the family farm. If there is a rule of thumb, it is that the greater the direct involvement of the farmer in the subdivision activities, the more likely they would have stepped over the line into the business of property development, where the profits are then subject to tax on revenue account.

Similarly, in the example above with Mr Beach, if he simply decided to seek a subdivision and sell without any development, it may well have been considered a mere realisation of a capital asset.

The law in this area is not just about mere realisations becoming development activities, or how long an asset has been held; it also looks at profit-making intention and isolated profit-making transactions amounting to something less than a business.

Without wanting to generalise, the test with isolated profit-making transactions or one-off ventures is whether you intend to make a profit from entering into the transaction.

There have been many cases that have looked closely at this issue of intention and purpose. What they tell us is that you must prove you didn’t have a profit-making intention in order for the transactions to be taxed as a capital gain.

In a perfect world, you, as the property developer, will get tax advice when you are considering any developments and ensure that there is documentary evidence of your intention at the appropriate time. (Hopefully you’re reading this before your first development!)

In the real world, though, there are often conflicts between your stated intentions and the activities you actually undertake, including documents and plans provided to financiers and others.

While the ATO talks about wrongful and inappropriate claims and exploitation of the system, litigation about the distinction between capital and revenue has been happening ever since there were different tax outcomes depending on how profits were categorised, and there is no one size fits all tax treatment for property development.

There will always be commercial activities that start out as capital, and which require a change of plans for a host of reasons, including liquidity and changed market conditions. Such a change is not, on its own, a problem from a tax point of view.

At the end of the day it all boils down to the facts and circumstances of each particular case, and how much appetite you have for engaging in potentially lengthy and costly disputes with the ATO.

The ATO is willing to take on clever arguments about developments on capital account. However, it may not be the clever argument that lets you down, it’s all about the stuff that lawyers always get excited about, evidence. Consequently, you must document your intentions at the time of acquisition and monitor changes of use while you hold the development.

If you are planning a development or even commenced one, don’t hesitate to get in touch if you’d like some advice.

What is a profit-making transaction when it comes to property?

Unlike a mere realisation of an asset’s value, a profit-making transaction is one where an asset was purchased with the intent of selling it for profit. This transaction is considered revenue, rather than capital (even if it’s an isolated or one-off transaction), which means that the net profit from the transaction will be included in the tax return of the entity that holds the asset.

In other words, if you were to make a profit of $200,000 and you held the asset in your individual name or a trust, you would declare the full $200,000 as net income in your tax return and pay tax at your marginal rate (individual) or the marginal rates of the respective beneficiaries (trust). The highest rate of tax you would pay is currently 49 per cent (inclusive of Medicare levy) or $98,000. If the entity was a company, you would pay 30 per cent of the profit in tax ($60,000) or 27.5 per cent ($55,000), depending on whether your company qualifies as a small business entity with turnover of $10 million or less.

As previously mentioned in an earlier blog, the key distinction between a mere realisation and a profit-making transaction is your intention when you purchase the asset.

There have been many cases that have been before the courts on this issue of capital vs revenue and whether property was purchased with the intention to sell for a profit or hold for rental purposes.

In what may seem an extreme case, a property developer had held a parcel of land for 20 years and due to her history and the fact that the land was ‘ripe for subdivision’ and she was aware of this, it was held that the land was purchased for resale at a profit.

In other cases, townhouses were developed and never offered for rent and as such were considered to be developed for the purpose of sale at a profit.

An example of a property sale considered to be on revenue account is as follows:

Mr Veritas purchased a property as his primary residence and lived in that property for a few years. He then subdivided and developed the property with two units at the rear of the property. At completion, the properties were listed with a real estate agent for sale. The properties were successfully sold shortly after completion.

The profits derived from the development and sale of properties that were not offered or held for rent are income. In determining whether there is a purpose of profit-making, the actions of Mr Veritas in subdividing and developing the property to make profits from the sale of property indicate that the purpose was profit-making. The sale of the properties was considered to be on revenue account and assessed accordingly.

Just from these couple of examples above, you can see that what might seem on the surface to be a mere realisation (capital) is in fact considered as a profit-making transaction (revenue) and therefore taxed accordingly, which is in most cases higher than if it were to be considered capital.

Make sure you consider your intention and also your actions when you purchase and the things you do from the beginning (i.e purchase) through to sale.

If you would like some assistance or even just a second opinion, do not hesitate to contact us.

Is your property development considered an income-generating business?

When would you be considered to be operating a business of property development? What difference does it make?

Your property development is considered to be a business where you have a history of property development. If you are considering investing in your first property development, that is most likely to be considered a mere realisation or a profit-making transaction, as discussed in my previous blog. However, if you are planning your third or fourth development, it is more likely to be seen as a regular business activity. As a result, you will be required to account for transactions relating to your property development on the revenue account.

In these circumstances, the land involved in these business transactions will be considered trading stock, not unlike coffee supplies for a café or clothing for a clothing retailer. For example, the café business sold $100,000 in coffee to its customers and the cost of the coffee for those sales was $25,000. The $25,000 of cost is a deductible expense. The same applies to land. If you sold land for $500,000 and the cost of that land was $400,000, the cost is deductible as an expense of trading stock in the financial year that the sale takes place.

So how can you know whether an isolated transaction would be considered a business operation or commercial transaction for a profit-making purpose? The ATO will consider the following factors:

  • The nature of the entity undertaking the operation or
  • The nature and scale of other activities undertaken by the taxpayer.
  • The amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained.
  • The nature, scale and complexity of the operation or transaction.
  • The manner in which the operation or transaction was entered into or carried out.
  • The nature of any connection between the relevant taxpayer and any other party to the operation or transaction.
  • If the transaction involves the acquisition and disposal of property, the nature of that property.
  • The timing of the transaction or the various steps in the transaction.

What does this mean for you and your property development?

If the ATO considers you to be conducting a business of property development, then your profit from such activities will be taxed on the revenue account, in the same way as profit-making transactions (as explained earlier). Your profit will be included in the tax return of the entity that is conducting the business and taxed accordingly.

Why is  this an issue?

It is an issue because it means that the ATO will not allow you access to any CGT concessions and the current CGT concessions can be significant.

Whilst that might not be ideal for you, the important thing to consider is understanding how your property development will be treated and planning for that accordingly. Too many developers have believed that they will end up with a nice “pot of gold” at the end of the project, only to find out that the ATO takes a big chunk of the gold.

If you are about to undertake a development or have already commenced one and would like to understand the implications better, do not hesitate to contact us.