Partitioning real property – what is it and what are the tax implications?
This article is relevant for developers, investors and even those looking to break into the first-home buyer’s market at a discount to market value.
In relation to the latter, even at historically low interest rates, many people are simply shut out of the property market as the cost of entry is beyond their financial reach. For some, the problem is exacerbated in boom times where the market may increase in value well beyond the rate of their capacity to save.
Increasingly, as a means of entering the market, friends and family members are pooling their financial resources. Commonly, this involves the straightforward purchase of an existing dwelling to live in or rent out, however, an increasingly popular option is to undertake small-scale development projects, such as a duplex.
Such projects can be attractive in a variety of circumstances, including:
- parents seeking to acquire an investment property and adult children wanting to enter the first-home buyer’s market (parents take one dwelling and the children take the other(s));
- parents seeking to down-size and adult children wanting an investment property (parents live in one dwelling and adult children rent out the other(s)); or
- siblings and/or friends seeking a first-home and/or investment property (one party takes one dwelling and the other party takes the other).
There is no denying that such projects give rise to complexities, however, provided that participants carefully consider all the relevant issues and weigh the particular risks prior to entering into any arrangement, they can be very worthwhile.
Increasingly, project home builders have standardised duplex/triplex/townhouse designs available so as streamline the construction process (and although participants pay a premium for the service compared to project managing themselves, in the writer’s experience, project home building is a very competitive industry with very reasonable base prices and if you can source options and extras from external sources rather than the project builder, there are considerable savings to be made).
For present purposes, assume that by pooling their resources, two parties are able to save $100,000 each, that is, an attached duplex which would cost $850,000 on market costs $750,000 to develop. This may not only be the difference between buying in a preferred suburb or elsewhere, but over the life of the loan this will save a very significant amount of interest.
From a planning perspective, individuals need to be aware of the rules governing the development of a potential property before purchasing. Unfortunately, each local government area is different so it will be a matter of participants either:
- sifting through the relevant provisions of the applicable Local Environmental Plan, Development Control Plan and any statutory overlays personally; or
- engaging the services of an experienced town planner in their local government area, who for a small fee will summarise precisely what can and cannot be done with the property prior to you moving forward.
In the writer’s experience, wherever possible, going down the path of ‘complying development’, that is, purchasing a property that is effectively ‘pre-approved’ by the local government authority for the desired project (subject to meeting designated criteria such as minimum lot frontage, minimum lot area, maximum height and maximum floor-space-ratio) effectively eliminates the risk of not getting approval. However, there are also other risks to carefully consider before deciding to proceed, including finance risk and construction risk.
From a tax perspective, these projects give rise to issues as to:
- the income/capital distinction;
- income tax;
- capital gains tax (“CGT”);
- goods and services tax (“GST”);
- stamp duty; and
- the availability of any relevant concessions/exemptions.
Interaction between planning regulations and finance
One critical issue to consider is finance, which is in part a function of valuation. Generally, ordinary residential mortgage lenders will lend 80% of the valuation of the end product without mortgage insurance.
The potential problem with this is that in relation to attached duplexes and triplexes, local council regulations generally dictate that subdivision (whereby a single legal lot is split into two or more separate legal titles) is the very last step in the entire construction process. Therefore, ordinary residential mortgage lenders will often only lend on the value of the amalgamated (un-subdivided) property. Consider the following:
Annabelle and William are siblings and wish to construct two, three-bedroom attached duplexes. Based on comparable sales, the end value of each duplex post-subdivision will be $850,000 ($1,700,000 in total). However, the lender can only value the existing, un-subdivided block based on the plans provided as a single, six bedroom home valued at $1,200,000. Therefore, Annabelle and William can borrow 80% of $1,200,000 ($960,000) without mortgage insurance, not 80% of $1,700,000 ($1,360,000).
Some participants may simply accept that mortgage insurance is the cost of getting started and of course, there may be better financing options out there, although in the writer’s experience, borrowing on the anticipated end value of a project (post-subdivision) involves commercial forms of finance which is generally more expensive. Ultimately, if the numbers work, perhaps commercial forms of finance is the answer to get the project off the ground before re-financing to an ordinary residential mortgage on completion (a finance broker should be able to assist you in this regard).
What happens on subdivision?
If two participants acquire a property as tenants-in-common in equal shares and intend to construct a duplex, whether as developers, investors or a private arrangement with the duplexes to serve as their respective main residences, then returning to the example above, on subdivision:
- Annabelle owns 50% of Lot A and 50% Lot B; and
- William owns 50% of Lot A and 50% Lot B.
The purpose of the project is to ensure that Annabelle owns 100% of Lot A and William owns 100% of Lot B. This is critical as to the extent that one party wishes to use their dwelling as their main residence, they must hold 100% of the property in order to claim the full main residence CGT exemption on disposal. Separately, a partition is critical if the parties are seeking to carry out a joint venture as opposed to a partnership (and therefore avoid joint and several liability), as the hallmark of a joint venture is the sharing of product rather than profit.
Returning to the example above, if Annabelle treated Lot A as her main residence and there was no partition, the eventual disposal of Lot A would only be exempt as to 50%, with the remaining 50% assessed in the usual manner in the hands of William (who will be ineligible to claim the main residence CGT exemption in relation to Lot A as his main residence is Lot B).
In order to achieve the desired result:
- Annabelle will need to transfer her 50% share of Lot B to William; and
- William will need to transfer his 50% share of Lot A to Annabelle.
This is known as a ‘partition’.
As outlined below, depending on whether the relevant participant holds their interest on capital account, trading stock or otherwise on revenue account, various tax consequences arise on partition.
Tax issues for participants
The income/capital distinction
Participants must consider their intention or purpose in entering into the project. If participants intend to live in their dwelling as their main residence, or to rent out one of the dwellings, they are likely to be taken to hold the property as a capital asset. Conversely, if a participant is entering into the project to sell one or more of the dwellings, they will be taken to hold the relevant “for sale” dwelling(s) as trading stock (or otherwise on revenue account).
So what is the difference?
If a participant holds the property on capital account, they will be subject to the CGT regime. Capital assets give rise to capital gains or losses and for individuals (or individual beneficiaries of a trust), the maximum tax payable on a long-term capital gain (a gain on an asset held for at last 12 months) is 22.5% (excluding levies).
This is known as the “50% CGT discount”.
Further, in the present context, special exemptions may apply in the context of partitions (see below).
If participants hold the property as trading stock (or otherwise on revenue account), they will be subject to tax at their ordinary marginal tax rates on disposal (currently up to 45% excluding levies).
Note, the income/capital distinction can be a very grey area and the ATO is certainly alive to the pointy practice of taxpayers purporting to hold assets on capital account rather than as trading stock (or otherwise on revenue account) and claiming the 50% CGT discount on disposal soon after the 12 month holding period ticks over.
In the context of an ATO review, it is insufficient to highlight the taxpayer’s subjective intention or purpose in entering into the project unless such intention is corroborated by objective evidence and as recent case law highlights, this extends to evidence as to:
- what participants told their lender(s) when seeking finance as to their purpose;
- what participants told any real estate(s) agent as to their purpose and whether they were engaged to generate pre-sales;
- what participants told the local government area as to their purpose in seeking approvals (if applicable); and
- whether and how the property/ies were marketed (i.e. for sale, for rent or ‘for sale or rent’).
At the risk of over-simplifying, all objective evidence must support the taxpayer’s stated subjective purpose and participants can expect that, in the absence of specific circumstances (such as serious illness, unexpected relocation etc), the shorter the time period between completion of the project and disposal, the higher the scrutiny they are likely to come under from the ATO in seeking to claim discount CGT treatment.
This article assumes that participants are on capital account.
A partition gives rise to a partial disposal, that is, returning to the example above, Annabelle disposes of her 50% interest in Lot B to William as consideration for the transfer of William’s 50% interest in Lot A.
The disposal of a CGT asset generally gives rise to a capital gain or loss. However, a special exemption applies where:
- you own land on which there is a building; and
- you subdivide the building into stratum units; and
- you transfer each unit to the entity who had the right to occupy it just before the subdivision,
a capital gain or loss you make from transferring the unit is disregarded.
There is a corresponding CGT exemption for the receipt of the relevant strata unit in these circumstances. However, specific advice should be sought and the relevant partition agreement between the parties must be appropriately documented so as to ensure that each participant has a right to occupy a particular dwelling so as to fall within the particular exemptions.
Note that this only applies to strata title properties and does not apply to other forms of land title, including Torrens title.
In relation to Torrens title land (and other forms of land title), the ATO takes the view that a partition agreement, even if entered into at the very outset between the relevant parties, will trigger an ordinary disposal for CGT purposes.
Some commentators take the view that if the relevant parties enter into an arrangement at the outset whereby Annabelle acquires half of her 50% legal interest in the property as trustee for William and vice versa that the subsequent transfers of those shares by the respective trustees on partition are ignored for CGT purposes under the absolute entitlement rules.
However, the ATO takes the view (in a draft Taxation Ruling that has remained in draft form for near 12 years now) that two or more individuals cannot be absolutely entitled to a single parcel of real property and therefore, the absolute entitlement rules do not apply to prevent triggering CGT in these circumstances.
At the very least, this differential treatment for Torrens title versus strata title property appears to infringe the principle of horizontal equity, in so far as taxpayers with similar assets (although clearly legally distinct) being subject to different tax rules, that is, partitions of Torrens title property triggers liability to CGT whilst partitions of strata title property being disregarded for CGT purposes. However, the CGT concession for strata title property has its genesis in the conversion of older systems of title to strata title following its introduction. The question remains, however, as to why there is not a broad-based CGT rollover for partitions of all real property, regardless of its system of title as it only serves to trigger liability to tax in the absence of the actual receipt of funds with which to pay it (unless the relevant asset is liquidated).
Stamp duty issues
Ordinarily, transfers pursuant to a partition would trigger liability to duty. However, in NSW (and other States/Territories), special concessions may apply to limit duty to the extent of any ‘overs’. Returning to the example above, in NSW, if Annabelle and William have an interest in the post subdivision (pre-partition) dwellings worth $850,000 each, and post-partition they each hold 100% of a single property worth $850,000, concessional duty of only $50 is payable.
However, if the post subdivision (pre-partition) value was $850,000 each, but Lot A was worth $900,000 based on superior fixtures, fittings and aspect, then Annabelle, as transferee, would be subject to duty on her $50,000 up-interest, or approximately $765.
Please note that other States/Territories offer various partition concessions however, they can operate differently to the NSW provisions and specific advice should be sought in this regard.
Generally, the supply of residential premises is input taxed, meaning that the supplier (vendor) does not charge GST on the supply and cannot claim any GST credits on expenses in relation to the property.
There is an exception to the general rule, however, in relation to the supply of ‘new residential premises’. Broadly, new residential premises are residential premises that:
- have not previously been sold as residential premises (other than commercial residential premises) or the subject of a long-term lease (generally 50 years);
- have been credited through substantial renovations; or
- have been built, or contain a building that has been built, to replace demolished premises on the same land).
New residential premises are subject to GST if all the relevant conditions of a ‘taxable supply’ are met.
An entity makes a taxable supply where, among other things, they carry on an ‘enterprise’ and they are registered, or required to be registered for GST.
The term, ‘enterprise’ is broader than that of ‘business’ and includes, for example, an enterprise of leasing residential property. However, activities of a private or domestic nature fall outside the scope of an enterprise.
Broadly, if a participant is seeking to construct a dwelling to act as their main residence, it will be considered private or domestic and therefore, they will not be required to be registered for GST (and if they are registered for required to be registered for other reasons, for example, they are a sole trader, then these activities would fall outside the scope of their enterprise).
However, if a participant is seeking to rent out their dwelling, they will be carrying on an enterprise of residential leasing and therefore, they will be required to be registered if they will have turnover of more than $75,000.
Returning to the example above, if Annabelle intended to use Lot A as her main residence and William wanted to rent out Lot B, then as the value of William’s supply of 50% of Lot A to Annabelle on partition will exceed the $75,000 registration threshold, William will be subject to GST on the partial disposal of new residential premises.
Conversely, this means that William will be entitled to GST input tax credits equal to 50% of the GST component of his eligible input costs in carrying out the project. In this regard, specific advice should be sought as to the availability of the margin scheme.
Partitioning is common amongst developers engaged in joint ventures (whether between arm’s length third parties or ‘internal’ joint ventures between a company [intending to sell] and a trust [intending to hold for investment] within a single family group).
Increasingly, partitioning is being used by family and friends to break into the property market or deliver an instant ‘equity boost’ to the participant’s respective property portfolios.
Of course, there are myriad issues to consider and costs to factor in in conducting a feasibility study so as to determine whether it is worthwhile and what participants can expect to save compared to buying equivalent end-product ‘on market’.
Any feasibility study must include as relevant expenses the tax, duty and GST implications of the proposed transaction so as to get an accurate idea of the relevant savings, which will ultimately assist in determining whether the project is worth the effort.
Again, specific advice is absolutely critical in this regard as generalisations are apt to mislead, however, as a rough ‘ready reckoner’, please see the table below:
|Purpose||Main Residence||Investment Property|
|Duty on acquisition||Yes||Yes|
|GST credits on (non-land) costs||No||Yes (as apportioned)|
|GST payable on partition||No||Yes|
|Will margin scheme apply?||N/A||Yes (if conditions satisfied)|
|NSW duty on partition||Concessional (unless ‘overs’ arise)||Concessional (unless ‘overs’ arise)|
|CGT on partition||Yes (unless strata exemption applies)||Yes (unless strata exemption applies)|
Many people are surprised by the fact that tax and GST issues can arise on partition as they are not ‘cashing out’ but rather, taking a preliminary step in putting the properties in the individual names of the relevant participants so as to facilitate, for example, access to the CGT main residence exemption on eventual disposal. However, in the absence of any specific concession, the general tax rules apply to assess participants as outlined above (except insofar as a specific concession or exemption applies) and these costs must be factored into any meaningful feasibility study.
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Disclaimer – this article does not constitute specific advice and cannot be relied upon as such.