Taking A Closer Look At Income Recognition
It pays to understand the drivers of income in the land division and property development game, writes Mark Withers.
1 March 2022
When it comes to tax, much of the focus is on minimisation, but of equal importance is understanding the process by which it becomes payable and falls due.
Ensuring the right amount of tax is paid at the right time minimises penalties and money interest charges that can add significantly to the overall tax burden.
The ever-increasing number of investors looking to develop intensive housing on rezoned land means that new understandings are needed in respect to when income from land division and property development must be recognised and managed.
So, let’s look at a few fundamentals and gain an understanding of the drivers of income in the land division and property development games.
Firstly, let’s explore the concept of “revenue account property”. Revenue account property is land that is held as part of the tradeable stock of a subdivider or developer. The disposal of revenue account property is always subject to tax, the key question is when?
Now to illustrate the complexity, let’s look at an example. Carlos is a new property developer. He acquires a section which he acknowledges will be held as part of his development activity, so it is revenue account property held for disposal. He buys the site for $500,000 and during the tax year he builds a dwelling on it for $500,000, so the property has a cost of $1 million. He then sells the property for $1.2 million.
Watch Out For Mistakes
Almost immediately he buys his next property for $1.2 million, using the proceeds from the first sale, and at the tax year end balance date he still owns this second property and has no surplus cash.
Now, how much taxable profit has Carlos made in his first tax year?
If you think none, because all the surplus from deal one funded deal two, you won’t be alone. Carlos has made $200,000 taxable profit that must have tax paid on it in this tax year. The fact he has purchased another property with this money doesn’t help him because he gets no deduction for the cost of the new unsold property against the profit from the first. The cost of the new property is essentially a stock item, an asset. His deduction for this property is only available in the year he sells it.
This demonstrates what is known as the matching concept, the notion of having to match the revenue from a sale with the costs associated with gaining it.
Now let’s take the income recognition issue a step further. When Carlos sells the property there are three key dates. The date he signed his sale and purchase agreement, the date the contract was called unconditional, and finally the settlement date.
Which date is the date that determines which tax year the profit from the deal must be accounted for?
The answer came as a result of an Australian tax example known as Gasparins case.
Gasparin was a land developer. He accounted for his sales on the settlement date, but the Australian tax office said he must account for his profit based on the date the contract became unconditional. The judgment in this case was that Gasparin did not have the right to sue his purchaser for specific performance of the unconditional contract until after the agreed settlement date had passed.
As such he won his case and this decision has formed the basis for income recognition in land transactions since.
The time of supply rules for GST are different and depend on a number of factors including the registration basis of the developer, so don’t assume GST is only payable on settlement date.
Being alert to the tax year end when agreeing settlement dates can therefore have a significant bearing on the timing of tax payments given it dictates which tax year the income must actually be recognised in. This is difficult when settlement dates are determined by issuance of code of compliance certificates as it isn’t always possible to be sure which tax year this will occur in.
Finally, just a note for those doing land subdivision: The allocation of “cost” to particular lots can be problematic when lots are of differing size and in some cases have different costs of development.
The accepted approach to allocation of cost to land parcels is to apportion it on the basis of size. Having said that, size does not always offer a sensible or realistic basis for cost allocation. If some alternative basis offers a more practical outcome, it is generally acceptable to adopt it. Taxpayers must keep records of how cost is allocated across lots and be ready to defend the basis of allocation of cost to individual lots. As with all things tax, seek professional tax advice before taking a tax position.
Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. Withers Tsang & Co Phone 09 376 8860, www.wt.co.nz