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Rosemary buys a vacant block of land for $50,000 on 20 October 1997. On 20 May 1999 she builds a house (assume that this is the date of either contracting for or commencing construction) on the land at a cost of $100,000 and occupies it as her main residence.
As a member of a firm of tax advisors you are required to advise her of:
1. the capital gains tax implications of her selling the property on 1 June of the current year for $300,000;
2. what difference would it make if the land had been purchased on 20 October 1984; and
3. what difference would it make if, in the original situation, the house had been built on:
a. 20 May 2003; and
b. 20 May 2017.


Your advice should be supported by reference to the applicable section(s) within the income taxation act(s) and any cases that may apply.

In the context of the preceding question, advise whether the Commissioner of Taxation has expressed an opinion about the way in which the income tax legislation applies to dwellings that are built on land acquired before the advent of capital gains tax. If such an opinion has been expressed, prepare a report that explains the Commissioner’s
position which could assist other members of your firm in the future when providing similar advice to their clients. 

Normal Condition

Rosemary had bought a vacant land, worth $50,000, on 20th October 1997 and build a house on that land on 20th May, 1999. She intends to sell the property for $300000 on 1st June,2017. She likes to know the tax consequences for selling the property.

The report is prepared to provide advice to Rosemary on the capital gain tax consequences under the said scenario and, also, for some alternative situation.

Tax Consequences for Normal Condition:

Rosemary had acquired the land and build the house after 20th September, 1985. Hence, it cannot be considered as pre-CGT asset. She is liable to pay tax on sale of the property. However, as Rosemary is an individual taxpayer and the acquisition dates of both the assets are before 21st September, 1999, both the reduction method and indexation method can be applicable for computing the capital gain for taxation purpose. It is advised to Rosemary that she should select the method, which would cause lower capital gain tax, between the two methods for tax return purpose (Barkoczy 2017).

To measure the outcomes of the two methods, the capital gains under the two methods are calculated below:

Particulars

Discount Method

Indexation Method

Proceeding from Sale

$300,000

$300,000

Cost of Land

$50,000

$51,422

Cost of Building

$100,000

$100,881

Total Cost of Property

$150,000

$152,303

Capital Gain from Sale of Property

$150,000

$147,697

Less: 50% Discount

$75,000

$0

Net Capital Gain on Sale

$75,000

$147,697

As per the reduction method, the accumulated value of original purchase price of the land and building cost of the building is considered as the cost base of the property. Moreover, the individual taxpayer can apply for 50% discount on the total capital gain if the individual possessed the capital assets for more than 12 months. Rosemary has held the ownership of both the land and building for more than 12 months and hence, she is eligible to get 50% discount on the total capital gain. The table exhibits that the net capital gain of Rosemary under reduction method would be $75,000 (Miller. and Oats 2016). Under Income Tax Assessment Act 1997, Division 115, Subdivision 115-A, and Section 115-15, directly mentions about using the discounted capital gains method, which could only be used for capital gains conducted after CGT (Ato.gov.au 2017).

In indexation method, the original costs of the assets are indexed in accordance to the consumer price index. It causes increase in the cost base of the property and helps to reduce the capital gain. However, if the costs are indexed then the taxpayer cannot apply for 50% discount. In accordance to the above table, the net capital gain of Rosemary under indexation method would be $147,697. Under Income Tax Assessment Act 1997, Division 960-General, Subdivision 960-M, and Section 960-275, directly mentions about using the indexation method, which could only be used for capital gains conducted before the augmentation of CGT (Ato.gov.au 2017).

As the capital gain under reduction method is lower than indexation method, Rosemary would have to pay tax on the capital gain, amounted to $75,000.

Tax Consequences for Pre-CGT Assets:

It is assumed that the land had been purchased on 20th October, 1984. However, the building was built on the actual date. In such case, the building would be considered as major capital improvement on the pre-CGT asset. The sale proceedings are also divided between the pre-CGT asset and the post-CGT capital improvement. Taxpayers are liable to pay tax on the capital gain, derived from the sale of post-CGT capital improvement only. Capital gain from the pre-CGT asset would be exempted for the taxation purpose (Saad 2014). The implication of GST is mentioned under Division 100 and Section 100-45 directly states about the treatment of asset post GST (Ato.gov.au 2017).

Tax Consequences for Pre-CGT Assets

Rosemary would like to sell the whole property for $300000. The current market value or the present value of the land is not stated in the case study. However, the total cost of the property is $150000 and the proportion of the land value and building value in the total cost are 33% and 67% respectively. Hence, the 33% of the selling price would be deducted from the total sales consideration for the association of the pre-CGT asset. Rosemary would have to pay tax on the 67% of the total sales value only. Moreover, as the building had been built on 20th May 1999 and held it for more than 12 months, she can again select any of the reduction method and indexation method for determining the capital gain on building (Yinger et al. 2016).

As per the discussion, capital gain on the sale of the property for this situation, is calculated in the following table:

Particulars

Discount Method

Indexation Method

Proceeding from Sale

$300,000

$300,000

Less: Sale Value of Land

$100,000

$100,000

Net Selling Price of Building

$200,000

$200,000

Less: Cost of Building

$100,000

$100,881

Capital Gain from Sale of Property

$100,000

$99,119

Less: 50% Discount

$50,000

$0

Net Capital Gain on Sale

$50,000

$99,119

The table depicts that Rosemary would not have to pay any tax for the proportionate sale of land. However, she is liable to pay tax on $50000 under discount method, as the capital gain under indexation method would be higher than the discount method.

Tax Consequences for Building the Home on 20th May 2003:

If the home would be built on 20th May, 2003, then it would not be considered for indexation method. However, as the house would be under the possession of Rosemary for more than 12 months, she can apply for 50% discount. On the other hand, as the acquisition date of the land, is before 21st September, 1999, she can select any of the two stated methods for capital gain determination (Taylor and Richardson 2013). Tax ruling of GSTR 2003/3 mainly indicates the measures that need to be taken into consideration before calculating the CGT of an asset (Ato.gov.au 2017).  

Particulars

Discount Method

Indexation Method

Selling Price of Land

$100,000

$100,000

Less: Cost of Land

$50,000

$51,422

Capital Gain on Land

$50,000

$48,578

Net Capital Gain on Land

$25,000

$48,578

Selling Price of Building

$200,000

$200,000

Less: Cost of Building

$100,000

$100,000

Capital Gain on Building

$100,000

$100,000

Net Capital Gain on Land

$50,000

$100,000

Total Capital Gain on Property

$75,000

$148,578

The table implies that for this situation also discount method would result in lower capital gain than the indexation method. Hence, under the discount method, Rosemary has to pay tax on the capital gain of $75000.

Tax Consequences for Building the Home on 20th May 2017:

If the building is built on 20th May, 2017 and Rosemary plans to sell it in June,2017, then the building would be under possession for less than 12 months. Therefore, she would not be eligible to get any discount on the capital gain on the sale of building or reduce it by increasing the cost base through indexation me thod (Faccio and Xu 2015). However, as the land had been purchased on 20th October, 1997, both the discount method or indexation method for determining the proportionate capital gain on the sale of the land. The calculations are shown below.

Particulars

Discount Method

Indexation Method

Selling Price of Land

$100,000

$100,000

Less: Cost of Land

$50,000

$51,422

Capital Gain on Land

$50,000

$48,578

Net Capital Gain on Land

$25,000

$48,578

Selling Price of Building

$200,000

$200,000

Less: Cost of Building

$100,000

$100,000

Capital Gain on Building

$100,000

$100,000

Total Capital Gain on Property

$125,000

$148,578

As per the calculations, if discount method is applied to determine the capital gain on land, then the total capital gain on the property would be $125000. Under indexation method, the capital gain would be $148,578. Hence, Rosemary has to pay $125,000 tax on the capital gain if the building had been built on 20th May,2017. Under Capital gains tax 2017 relevant calculation of CGT obligations could be identified (Ato.gov.au 2017).

Tax Consequences for Building the Home on 20th May 2003

Conclusion:

It should be noted that Rosemary has used the property for her main residence. Therefore, she would get full exemption on the capital gain, generated from the sale of property irrespective of any difference in the acquisition dates.

This report is prepared to advice whether the Commissioner of Taxation had expressed an opinion on matters relating to income tax legislation. The main emphasis had been given on land that is acquired before the advent of capital gains tax.

Income tax legislations applicable for dwellings built on pre-CGT assets:

From the previous question, it is understood that capital gains implications differs largely before the advent of capital gains tax and after the advent of capital gains tax. From the case study, Rosemary purchased a vacant block of land for $50,000 on 20th of October 1997. The year 1997 is after the advent of capital gains tax, so the amount is subject to Capital Gains tax.

In the next part, a situation arises when the land was purchased on 20th of October 1984. The year 1984 is before the advent of capital gains tax and this is the condition where the amount is not subject to Capital Gains Tax. If the taxpayer sells the land later, then the capital gain on such event is generally exempted from tax.

However, in many cases, it has been observed that many taxpayers had increased the value of the pre-CGT assets through major capital important after the advent of capital gain tax. If such properties or assets are sold later, then the capital gain would include gains from the both the pre-CGT assets and post-CGT capital improvements. According to Taxation determination of TD 97/3, Income Tax Assessment Act 1997 Part 3-1 and Part 3-3 directly suggest the consideration of capital gain before CGT (Ato.gov.au 2017).

For such instances, the tax authority suggests that in any case, capital gain from pre-CGT assets are tax exempted and capital gain from post-CGT assets or major capital improvements are taxable. Hence, if the selling price of the post-CGT asset cannot be identified separately from the sale price of the property, then it is advised to take the current market value of the pre-CGT assets as its selling price.

If the current market value is not available, then the selling price of the whole property should be divided proportionately between the post-CGT and pre-CGT assets in accordance to the proportions of the original costs of the assets. After determination of the current value of the pre-CGT asset, it should be deducted from the total selling price to obtain individual selling price of the post-CGT capital improvement for ascertaining the capital gain (Barkoczy 2016). Under Income Tax Assessment Act 1997, Division 100-A, and Section 100-25, capital gains conducted after CGT is mentioned (Ato.gov.au 2017).

Conclusion:

Construction of any dwelling on the land, acquired before the advent of the capital gain, is a form of major capital improvement. Therefore, it should be treated in the same method, as discussed above, for capital gain taxation purpose. However, it has been noticed that the taxpayer often face issues to determine the current market value of the pre-CXGT assets. Moreover, the proportionate distribution of the selling price is also not appropriate, as the index values before the advent of capital gain tax and after the advent of capital gain differs highly with each other (Tanzi 2014).

References:

Ato.gov.au. (2017). Legal Database. [online] Available at: https://www.ato.gov.au/law/view/document?docid=PAC/19970038/115-15 [Accessed 6 Sep. 2017].

Barkoczy, S., 2016. Foundations of Taxation Law 2016. OUP Catalogue

Barkoczy, S., 2017. Core Tax Legislation and Study Guide. OUP Catalogue

Faccio, M. and Xu, J., 2015. Taxes and capital structure. Journal of Financial and Quantitative Analysis, 50(3), pp.277-300

Miller, A. and Oats, L., 2016. Principles of international taxation. Bloomsbury Publishing.

Saad, N., 2014. Tax knowledge, tax complexity and tax compliance: Taxpayers’ view. Procedia-Social and Behavioral Sciences, 109, pp.1069-1075

Tanzi, V., 2014. Inflation, indexation and interest income taxation. PSL Quarterly Review, 29(116)

Taylor, G. and Richardson, G., 2013. The determinants of thinly capitalized tax avoidance structures: Evidence from Australian firms. Journal of International Accounting, Auditing and Taxation, 22(1), pp.12-25

Yinger, J., Bloom, H.S. and Boersch-Supan, A., 2016. Property taxes and house values: The theory and estimation of intrajurisdictional property tax capitalization. Elsevier.

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