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Breeding Properties & Taxation - July 2004


BREEDING PROPERTIES & TAXATION


Our office can’t help but notice just how much investing in property has grown in the past five or so years. Sure, the market has “corrected” recently, but there are still many of you who bought at the “right” time of the cycle and are sitting on significant “unrealised’ property gains.

Against this background, this article is going to focus on the significant taxation issues that those of you who own, or intend owning, breeding properties should be aware of - in terms of holding or selling all or part of the property. With the increased number of property owners we have also noticed the extra demand for tax consultancy in relation to property, so I’m sure many of you will find this a worthwhile topic. Be warned, it is a complex area and I doubt whether any of my articles have been, or will be, as complex as this.

To ensure that we cover the main horse industry ownership scenarios, I am going to focus on those of you who live on the breeding property and those that hold it as a secondary investment and use it for your breeding activities.

Though we are well known for our expertise in bloodstock taxation, property taxation has always been a favourite of mine, a fact that CPA Australia kindly acknowledged in 2001 when I was selected to represent them at the ANZ sponsored “Buying a Home” seminars - free public seminars that focus on the tax and financial issues associated with owning a family home or rental property. I’d like to think that I can share a few property tax “tricks” that I have picked up over the years that I’ve been presenting these seminars.

Living on the Breeding Property - tax issues

This will relate to those of you who mainly live in regional Australia and also run a breeding operation/stud farm from the same property.

So, what are the major issues for you in terms of:

  • Capital Gains Tax (“CGT”); and 
  • GST.


1. CAPITAL GAINS TAX (“CGT”)

For CGT purposes, this breeding property that you also live on is your “sole or principal residence” (“SPR”).

The SPR, where owned by an individual, is ordinarily fully exempt from CGT when sold. However, this total CGT exemption does not ordinarily relate to a breeding property, acquired after 19 September 1985, where the family home is also part of the property.

What is not well known is that the maximum area of the breeding property covered by the CGT exemption (including the area of land on which the family home is built) is only two hectares. Thus, the property outside this two hectares in not exempt from CGT when sold. Consider the following example, albeit complex, as to how a capital gain on a breeding property is calculated in these circumstances.

Example 1 - 2 hectares exempt from CGT

Fred owns a 10-hectare breeding property and he uses 4 hectares primarily for private or domestic purposes in association with his family home dwelling. Fred sells the farm for $1,000,000, which includes $200,000 for the farmhouse. The original acquisition price (ie. CGT cost base) of the entire farm is $600,000, including $160,000 for the farmhouse. Therefore, the cost base attributable to the 10 hectares of land (which includes the land on which the farmhouse is located) is $440,000 ($600,000 less $160,000).

NB. At the time of buying the property, Fred should obtain a valuation that indicates how much of the $600,000 purchase price can be allocated to the farmhouse only. In the above example, $160,000 was allocated to the farmhouse.

Fred's total capital gain on the property sale is $400,000, being $1,000,000 less $600,000 (ignoring indexation). The cost base attributable to 2 hectares of the land is $88,000, being two-tenths of the total cost base of the land. The sale price attributable to 2 hectares of adjacent land are $160,000, being two-tenths of the sale price attributable to the land ($800,000). Therefore, the capital gain in respect of the 2 hectares is $72,000, being $160,000 less $88,000.

The capital gain on the farmhouse is $40,000, being $200,000 less $160,000.

Fred may disregard his capital gains of $72,000 (for the 2 hectares of land) and of $40,000 (for the farmhouse) under the main residence exemption provisions. Therefore, Fred includes in his assessable income a capital gain of $288,000, being the total gain of $400,000 less $72,000 less $40,000.

Note:

  • if the property was acquired before 20 September 1985, no CGT would be applicable as it is an exempt asset;
  • if the property is held in a trust or company, which is often done for asset protection purposes, the CGT exemption for “sole or principal” residence does not apply;
  • If the property has been held for over 12 months, a 50% CGT discount will apply. NB. This exemption does not relate to companies; and
  • Fred can choose which two hectares the main residence exemption is to apply. A 1997 ATO determination confirmed this and applying it might save you significant taxation.


BREEDING PROPERTIES & TAXATION


2. GST

Assuming Fred was registered for GST in relation to his horse breeding activities, he will have to consider the GST implications of holding and selling his property.

a) Holding the property

Simple enough. A registered person, such as Fred, can only claim back GST on his property expenses to the extent that they are related to a “creditable purpose”. For instance, expenses such as insurance on farm buildings, farm vehicle petrol, farm repairs, fencing, fertilisers, and dam construction generally attract a 100% GST credit.

However, there are many expenses incurred, such as electricity, where the GST can only be claimed to the extent that it is used for the breeding business. For example, the portion of the electricity bill relating to the farmhouse should not be claimed as a tax deduction, nor should the GST be claimed. Though, if part of the farmhouse is a legitimate home office, the GST can be claimed back for that portion.

The general rule is that when you acquire something partly for a creditable purpose, you will need to apportion the input tax credit. This means that you divide the input tax credit between the purpose that relates to the breeding business and the purpose that does not relate to the breeding business

b) Selling the property

Ordinarily, the sale of such a property would not attract GST due to the following:

  • The farmhouse is not subject to GST as it is a “residential premises”; and
  • The rest of the property normally attracts the “GST free” exemption relating to sale of farm land.

When is sale of Farm Land “GST free”?

Firstly, the farm land will never attract GST if is sold as a “going concern”. To constitute a “supply of a going concern”, the sale must be under an arrangement under which the seller supplies all of the things that are “necessary” (eg. plant and business name) for the continued operation of the business.

If the farm land is not sold as a “going concern”, it can still be GST-free if:

  • a farming business has been carried on the land for at least the period of five years before the sale; and
  • the purchaser intends that a “farming business” will be carried on the land after the supply of the land is complete.

Some points to note about this rule:

  1. “Farming business” does not include a business of strictly agisting horses; and
  2. This rule clearly requires that there be no break in the use of the land for a farming business. There must have been a farming business on the land for at least the five years prior to the sale to be GST-free under this rule.
 

BREEDING PROPERTIES & TAXATION

Not living on the Breeding Property - tax issues

As noted above, this discussion relates to those of you who hold a breeding property as a secondary investment. Typically, you will live in the city and run a breeding activity from this other property. Many of you will have full time managers on this property.

1. CAPITAL GAINS TAX

This property is not your “sole or principal” residence, thus it is fully subject to CGT when sold. The “2 hectare” exemption does not apply. Of course, this assumes that you acquired the property after 19 September 1985.

As noted above, the only consoling fact is that the property may attract the 50% CGT discount if owned for greater than 12 months

Can I reduce or defer the CGT on this property?

Yes, as a person conducting a small business, you may be able to access the new “Small Business CGT concessions”. We have used these concessions very effectively for clients who have made large capital gains on the sale of a breeding property.

Before you even consider using these concessions, you must be able to fulfil some important “qualifying” conditions, the two most significant being:

  • Your total net assets must not exceed $5 million dollars. This also includes assets of “connected” entities. Many wealthy taxpayers fail this test;
  • The property must be an “active asset”.

Broadly, if your breeding business has not ceased and the property has been owned for less than 15 years, the property must be an active asset just before its sale and for at least half of the period of ownership.

If the property has been owned for more than 15 years, it needs to be an active asset for at least half of the 15-year period ending at the time of sale (or when your business ceased, if earlier).

A CGT asset is an “active asset” if it is owned by you and is used in the course of carrying on a business. Note - rental properties are excluded.

 

What are the CGT “Small Business” concessions?

The concessions that may be potentially available to you are:

  1. The 15 year asset exemption - if you owned the property for greater than 15 years, you are over 55 years when you sell it and you are going to retire, there will be no CGT on the sale of the property;
  2. 50% active asset reduction - the CGT on the property is reduced by 50%;
  3. Retirement exemption - up to $500,000 of the property gain can be alleviated by contributing it to a superannuation fund; and
  4. “Rollover” relief into another asset - if any of the gain is left after applying the above, it can be “rolled-over” to a replacement asset and deferred until that asset is sold.

2. GST

Refer my comments above re selling a breeding property that you also live on. The same comments apply. Though, I will add that if you knock down the old farmhouse and build a new one, it may also be subject to GST on sale on the basis of it being “new residential” premises.


BREEDING PROPERTIES & TAXATION

“Subdividing” the farm - tax issues

Talk about a topic by popular demand!

With the boom in property values, we have provided a large amount of advice recently in relation to the taxation issues surrounding “one-off” subdividing and selling of all or part of a breeding property. Accordingly, I’ll take you through the major tax issues in this area.

a) Income tax issues

The sale of the subdivision maybe taxed as “income” or a “capital gain”. The key issue is whether the taxpayer merely realised the asset in the most enterprising way (ie. taxed as a “capital gain” on sale) or whether the taxpayer entered into a “business venture” (ie. taxed as “income” on sale). As a general rule, it is better to have the development taxed as a “capital gain”, due to the availability of the 50% CGT discount for land held for greater than 12 months. If it caught under the “income” sale category, the calculation is far more complex and the tax generally a little higher.

If land is a pre-CGT asset?

Please be aware that improvements/building works made to land acquired pre-CGT does not ordinarily attract CGT when sold. Hence, the whole of the sub-division would not attract CGT. However, this will not always be the case, as sometimes the capital works put into the development are so substantial (eg. the building works exceed 5% of the sale price) as to make them subject to CGT - though the land portion still remains exempt from CGT.

Is the development of an “income” or “capital” nature?

Whether or not the sale of the sub-divided land is subject to income tax or capital gains tax depends on the facts of each case. To help you with this decision, I provide a special checklist of the major factors that the ATO would consider as relevant to this question. You will note that the more sophisticated the sale and developing process is, the more likely that the disposal would be taxed as an income (“business venture”) sale.

BREEDING PROPERTIES & TAXATION


Checklist of relevant factors

1. The purpose the taxpayer originally acquired the land. If it was for the purposes of farming or some other non-sale related purpose, such as to rent, this indicates capital.

2. The magnitude of the development. The larger the area of land subdivided and the greater the number of lots the more likely it will be treated as a business venture.

3. What is the reason the taxpayer is selling the land? If it is simply to make a profit on its sale then this indicates income.

4. Did the taxpayer try and sell the land as broad acres before subdividing it? If so this indicates capital.

5. Whether the taxpayer had subdivided and developed other properties in the past. If so this indicates a business venture.

6. The taxpayer's occupation. If it is in some way connected with land development such as a real estate agent or builder, then this will indicate a business venture.

7. The amount of borrowing to finance the development. The greater the borrowing, the more it indicates a business venture.

8. The number of stages in the development. The development should be done in as few stages as possible. Stage developments indicate a business.

9. The amount of actual work done in developing the land. Limited clearing and earth works indicates capital.

10. Was a site office or any other building erected on the land? If so, it indicates a business venture.

11. The taxpayer's involvement in the actual development. The more the taxpayer is involved, the more it indicates a business venture.

12. The number of contractors engaged by the taxpayer. The more contractors the taxpayer engages and organises, the more it indicates a business venture.

13. The whole business organisation of the taxpayer. If there is no business organisation, no manager, no office, no secretary and no letterhead this indicates it is not a business venture.

14. The length of time the land has been owned. The longer the land has been owned, the more likely that it is capital.

Tax Tip

To minimise the chance of the development being considered as income, taxpayers should carry out the absolute minimum development that is required by the council and their personal involvement should be minimal.


BREEDING PROPERTIES & TAXATION


b) GST issues

In the above scenario, we assume that the taxpayer is GST registered in relation to the breeding business conducted on the property, hence the sale of the development would be subject to GST. .

“Margin Scheme” available to reduce GST

It is also worth noting that if you acquired the property and did not claim an input tax credit, the “margin scheme” for calculating GST can be utilised on all of the property sales I have noted above. Using the scheme reduces GST on the sale of a property as GST is levied on the profit margin, not the gross sales proceeds. If the property was acquired pre 1 July 2000, you must obtain a valuation of the property as at that date to apply the scheme. It is a complex area, and I’ll leave a more detailed discussion for another day.


PAUL CARRAZZO CPA
CARRAZZO CONSULTING CPAs
22 BLACKWOOD ST, NORTH MELBOURNE VIC 3051
PH: (03) 9329 7044
FAX: (03) 9329 8355
MOB: (0417) 549 347
Email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it


DISCLAIMER
Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information’s applicability to their particular circumstances with an accountant specialising in this area.

Reproduced with permission from the Australian Bloodhorse Review © Copyright 2004

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