For intrepid property investors thinking about making the leap into a property development project, there is a lot to learn and understand about how the tax system functions, which differs from what you will know about life on the investment side of the fence.
In this article, we are going to focus on the issues associated with income recognition for property developers.
What is that, and why is it important?
Well, income recognition deals with the rules around the timing of recognizing income from a property development project. It’s important because it dictates which income year you must actually pay tax on a development project’s proceeds. This, in turn, drives provisional tax planning decisions and strategies around minimizing use-of-money interest.
So, starting with the basics: When you buy and begin a property development project, the cost of land acquisition, development of that land, and construction of buildings are capitalized on the balance sheet as revenue account trading stock items of the development project. These costs are not necessarily deductible in the year they are incurred.
Only holding costs, like rates, interest, and overheads, are deductible in the year they are incurred.
Fair Allocation
The cost of the actual property development is claimed in the years when the land sales are accounted for, and these costs must be fairly allocated across the properties or lots being sold.
Fair allocation might be apportioned by lot size, floor size of a building development, or even specific cost allocation to a particular title if this is the most logical basis for allocation.
This is especially important when sales of titles may span several tax years, meaning careful attention needs to be placed on the fair and appropriate allocation of costs against the lots as they sell. This will drive the taxable profit in any given income year.
Let’s drill down into the actual process of selling the development. Typically, there will be three key milestones in the process: the date an agreement for sale is entered into, the date it becomes unconditional, and finally, the date it settles.
So, which of these dates determines the tax year in which you must recognize the income from the sale?
The answer lies in the finding from the Gasparin’s case, which was an Australian tax case that has been adopted as a common law precedent in New Zealand. Gasparin was a land developer who argued that, despite entering into binding agreements for the sale of land, the sales should only be recognized when settlement occurred. The courts agreed and found that it is not until the agreed date of settlement passes that the vendor has the right to sue for the specific performance of the contract. This determines the tax year in which the income should be recognised.
This means a sale settling after balance date will push the income recognition into the next tax year.
Balance Date
Let’s consider a simple example for a property trader. Our trader has a March balance date and buys a do-up for $800,000 in June. In July, he spends $200,000 on the property, and in August, he settles the sale of the property for $1,300,000. Using the proceeds of this sale, he then buys another property for $1,300,000 in February, which remains unsold at 31 March.
The question, given he has spent all the sale proceeds on another project that he still owns at balance date, is how much taxable profit will the trader have at his 31 March balance date?
Deal one has sold and settled before 31 March, yielding a profit of $300,000. This income must be recognized in the year to March because settlement occurred within the tax year.
The next purchase, though, was still unfinished and unsold at balance date. This purchase becomes a revenue account stock item on our developer’s balance sheet and offers no deduction against the profit from the previous project.
Accordingly, our developer must find the tax on $300,000 of profit despite spending all the sale proceeds on the next project.
Note to self: Budget the tax from a settled project before you sink everything into the next one!
Such is the importance of understanding the tax and cash flow consequences of the income recognition rules for property development.