Property flippers face uncertainty amid tax law changes and court rulings

Christmas might be the time of giving but this year it is a time of great uncertainty for property investors – particularly those who follow the old renovate and flip model.

For a long time, many property flippers expertly navigated their way through the minefield of tax regulations to make sure not too much of their flipping profits end up being lost to tax.

Until now they have been extremely lucky in this regard with the capital gains tax rules allowing for no taxation on properties that are regarded as your principal place of residence at the time of sale and even for a halving of any capital gains tax due if the property is held for more than a year, even if it is not subject to the concessionary principal place of residence treatment.

Now, due to an unusual and unexpected court decision, flippers and other property investors such as those who subdivide their home have had a great deal of uncertainty thrown their way and will have to wait and see how the tax rules end up being interpreted.

Could renovation profits be taxed like normal income?

Flipping tactics and techniques that may have worked just fine in the past in a taxation sense are no longer a sure thing and many tax accountants have been quick to warn about the potential changes and issues.

At the worst interpretation, some flippers could end up paying tax at their marginal tax rate – potentially as high as 47% – on their relatively quick renovation profits.

The key to the change is that the CGT concession could be lost on any transaction that could be interpreted as a commercial transaction – an interpretation that could double the CGT payable for repeat flippers even if they have obeyed the previous rules and held on to the property for more than a year.

The challenge to the popular CGT discount happened in an unlikely way when the Administrative Appeal Tribunal (AAT) ruled that an 86-year-old self-funded retiree should be allowed to offset losses on the sale of her downsizer apartment against other income because it was considered to be a commercial transaction.

Losses on a downsizer apartment offset against other income

The AAT case involved Sydney-based Jenifer Bowerman’s successful application to have losses on her downsizer apartment offset against other income because it was purchased with the intention of selling it for a profit.

Bowerman was described in the ruling as a “savvy and entrepreneurial” businesswoman who managed her own investment portfolio of shares, managed investment trusts and rental property investments.

In 2015, she bought an off-the-plan apartment in a complex at Foreshore Boulevard, Woolooware Bay, about 20 kilometres from Sydney’s central business district, for about $1.5 million.

Two years later she purchased another in Dune Walk at the same complex for $1.2 million where she intended to live until the first apartment was completed.

The tribunal was told Bowerman expected to sell Dune Walk and move into Foreshore Boulevard after the sale of her main residence, and that she had sold her family home to fund the deals.

COVID sale leads to losses

She sold Dune Walk in early April 2020 at a loss of $185,000 because property prices had dropped during COVID-19.

AAT senior member Gina Lazanas found the sale of Dune Walk was tax-deductible under 8-1(1) of the Income Tax Assessment Act 1997, which allows an individual to deduct a loss or outgoing “if it is incurred in gaining or producing assessable income”.

Bowerman relied on a Federal Court decision that the profit from an isolated transaction involving the sale of a property would be assessable if the taxpayer bought the property to make a profit and its acquisition and sale “took place in the context of a business operation or commercial transaction”. A loss incurred in such a scenario would therefore be deductible.

Lazanas told the tribunal that she “placed considerable weight on the incontrovertible fact” that Bowerman intended to re-sell the Dune Walk apartment for a profit instead of holding on to it for a long-term investment.

“The result in this case is unusual,” she ruled. “It is especially unusual because a loss was made on a recent re-sale of Australian property when property has mostly appreciated in value. However, there is no rule in Australian income tax law that a profit or gain made on the sale of one’s residence, in circumstances where there is a profit-making intention, cannot give rise to a profit that is taxable as ordinary income,” she ruled.

“It follows, that a taxpayer whose intention was to make a profit in a commercial dealing but who ultimately incurred a loss is allowed to claim a deduction for that loss.”

Finding not binding on tax authorities

The decision brings about a lot of uncertainty because tax authorities do not have to follow the Bowerman ruling because the decision was made by a tribunal.

However, that leaves tax professionals uncertain on how to advise their clients about their legal position on the CGT discount and also the family home CGT exemption in a variety of circumstances.

An ATO spokesman said it “is considering the implications of the decision of the Tribunal including whether any appeal may be appropriate”.

Wide range of property activities on the line

Lawyers claim the AAT decision could affect the tax treatment of a wide range of property investment activities involving the family home – such as subdividing properties for development or “flipping” property with the primary intention of selling it for a profit rather than viewing it as a long-term home.

Some of these circumstances could lead to someone losing the family home CGT exemption and instead paying tax on any profit at their marginal rate.

As Edward Hennebry, a senior associate with law firm Sladen Legal, recently told the Australian Financial Review: “This decision puts taxpayers on notice that CGT exemption of the family home is under closer scrutiny. The difference between someone paying income and capital gains on a property sale is potentially very substantial.”

In the interim, some property investment advisers have even warned that it may be a better proposition to turn shorter term renovations into a longer-term plan to renovate and rent out properties, to ensure a more forgiving or at least more spread-out tax treatment, complete with handy depreciation.

It is a tough area to make decisions about and the tax law has just got harder to interpret and plan for.

So, property renovators, flippers and home sub-dividers are on notice to be particularly careful until further case law clarifies the situation for those who intend to profit through buying, renovating and selling property.