Tax treatment of Vendor Financing in Australia

In this section, the capital gains tax implications on two forms of vendor finance is examined –

1. Capital Gains Tax and Instalment Contracts; and
2. Capital Gains Tax and Options.

At the end, there is a guide on calculating your capital gains tax.

1. the right to the use and enjoyment of a CGT asset you own passes to the other entity; and
2. title in the asset will or may pass to the other entity at or before the end of the agreement.

The provision contemplates the existence of only one agreement for it to operate.
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The ATO Interpretation of CGT event B1

Entering into a terms contract

CGT event B1 happens to real estate if you enter into an agreement where the new owner is entitled to possession of the land or the receipt of rents and profits before becoming entitled to a transfer or conveyance of the land.

Where this happens under a contract, it is known as a terms contract and the new owner usually completes the purchase by paying the balance of the purchase price and receiving the instrument of transfer and title deeds.
 
It may also happen where an agreement is made with a relative or other party to use and enjoy the property for a specified period after which title to the property passes to them. It will not happen where, under an arrangement, title to a property may pass at an unspecified time in the future.

CGT event B1 happens when use and enjoyment of the land is first obtained by the new owner. Use and enjoyment of the land from a practical point of view takes place at the time the new owner gets possession of the land or the date the new owner becomes entitled to the receipt of rents and profits.

If the agreement falls through before completion and title to the land does not pass to the acquirer, you may be entitled to amend your assessment for the year in which CGT event B1 happened.
Source
http://www.ato.gov.au/individuals/content.aspx?doc=/content/36904.htm&pc=001/001/038/002/002&mnu=0&mfp=&st=&cy=
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Commentary

This view applies to one-off transactions, but does not apply to vendors who are carrying on a business. For vendors carrying on a business, the ATO takes the view that the trading stock provisions of the ITAA apply, rather than the capital gains provisions. One consequence is that the capital component of the instalments of capital received is counted in the income of the vendor in the tax year of its receipt, rather than as a capital gain.

This is the ATO interpretation found in Interpretative Decision 2004/27 –
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ATO Interpretative Decision 2004/27

Income Tax
Derivation of income: residential properties instalment sales contracts - carrying on a business

FOI status: may be released
Status of this decision: Decision Current

Issue

For a taxpayer carrying on a business, are payments received from the sale of residential properties under instalment sales contracts included in assessable income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year in which the contract is entered into?

Decision

No. The payments will not be included in the assessable income of the taxpayer under subsection 6-5(1) of the ITAA 1997 in the income year in which the contract is entered into, as the income has not yet been derived.

Facts

The taxpayer carries on a business of buying and selling residential properties. The properties are sold under instalment sales contracts with vendor finance.

The instalment sales contract has the following features:

• the sale price represents a profit over the investor's purchase price
• the purchaser will pay the investor a deposit
• vendor finance is provided to the purchaser with interest charged at a premium above the rate of interest paid by the investor on their mortgage on the property
• payment of the balance of the price, plus interest, is by instalments over a substantial period such as 25 years
• the deposit and instalments are not refundable
• the purchaser is licensed to occupy and entitled to possession of the property during the term of the instalment contract
• the contract states that this occupation or possession is not by way of lease
• the purchaser is required to reimburse the investor for the rates and taxes on the property
• the purchaser is required to keep the property in good condition and repair
• the investor retains title to the property until the final instalment is paid and the contract is completed
• if the purchaser defaults on the contract the deposit and instalments paid are forfeited to the investor

It is common ground that the interest is included in assessable income in the year it is received.
 
The taxpayer did not use the properties for any other purpose prior to sale. The properties were sold for an amount that was in excess of the amount paid by the taxpayer to acquire the property. Each property was sold within six months of it being acquired by the taxpayer.

The properties are trading stock for the purposes of subdivision 70-C of the ITAA 1997.
 
For detailed reasons, go to the ID -
http://law.ato.gov.au/atolaw/view.htm?rank=find&criteria=AND~instalment~basic~exact&target=J JA&style=html&sdocid=AID/AID200427/00001&recStart=1&PiT=99991231235958&recnum=22&
tot=66&pn=ALL:::J
 

Capital Gains Tax (“CGT”) and Options

Commentary

There are two distinct stages in an option.

The first stage is the grant of the Option where the option fee is paid up front, and where an ongoing option fee might be specified. The questions are -

• What capital gains tax is payable by the owner (the grantor) on the option fees?
• What is the status of the option fees paid for capital gains tax purposes by the purchaser (the grantee)?

Because the purchaser has an option to purchase, rather than being contractually bound to purchase, under a standard option (a call option), the capital gains tax that will be payable if the option becomes a contract (i.e. the option is exercised) does not arise at this stage.

The ATO calls the first stage a CGT event D2.

The second stage is the exercise of the Option, which is where a legally binding Contract for the Sale of the Property is entered into. The question is –

• Starting with the Contract price, what deductions are able to be made to arrive at the capital gain, which is subject to the capital gains tax?

The ATO calls the second stage a CGT event B1 (see above).

Here is the ATO commentary on Capital Gains Tax for Options –
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The ATO Interpretation of CGT event D2

Granting an option

CGT event D2 happens if you grant an option to a person or an entity, or renew or extend an option that you had granted.

The amount of your capital gain or capital loss from CGT event D2 is the difference between what you receive for granting the right and any expenditure you incurred on it. The CGT discount does not apply to CGT event D2.

Example

Granting of an option (stage 1)
You were approached by Colleen who was interested in buying your land. On 30 June 2009, you granted her an option to purchase your land within 12 months for $200,000. Colleen pays you $10,000 for the grant of the option. You incur legal fees of $500. You made a capital gain in the 2008-09 income year of $9,500.

Exercise of an option

If the option you granted is later exercised, you ignore any capital gain or capital loss you made from the grant, renewal or extension. You may have to amend your income tax assessment for an earlier income year.

Similarly, any capital gain or capital loss that the grantee would otherwise make from the exercise of the option is disregarded.

The effect of the exercise of an option depends on whether the option was a call option or a put option. A call option is one that binds the grantor to dispose of an asset. A put option binds the grantor to acquire an asset.

Example

Granting of an option (stage 2):
On 1 February 2010, Colleen exercises the option. You disregard the capital gain that you made in the 2008-09 income year and you request an amendment of your income tax assessment to exclude that amount. The $10,000 you received for the grant of the option is considered to be part of the capital proceeds for the sale of your property in the 2009-10 income year. Your capital gain or capital loss from the property is the difference between its cost base/reduced cost base and $210,000.

Source:
http://www.ato.gov.au/individuals/content.aspx?doc=/content/36904.htm&pc=001/001/038/002/002&mnu=0&mfp=&st=&cy=
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Commentary

In the Example (stage 1) you will notice that the option is granted for less than 12 months. If the Option goes beyond 12 months, so that more than a year passes, then when you reach stage 2, the property will have been owned for more than 12 months and so only 50% of the capital gain will be subject to tax.

Here is the ATO commentary on how to calculate capital gains tax, with modifications by me –
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Calculating your capital gain or loss

Basic method

Description of method - Basic method of subtracting the cost base from the capital proceeds.

When to use the method - Use when the discount method does not apply (for example, if you have bought and sold an asset within 12 months).

How to calculate your capital gain using the method - Subtract the cost base (or the amount specified by the relevant CGT event) from the capital proceeds.

Example

Property purchased and sold within 12 months

Marie-Anne bought a property for $250,000 under a contract dated 24 June 2009. The contract provided for the payment of a deposit of $25,000 on that date, with the balance of $225,000 to be paid on settlement on 4 August 2009.

Marie-Anne paid stamp duty of $5,000 on 20 July 2009. On 4 August 2009, she received an account for solicitor's fees of $2,000 which she paid as part of the settlement process.

Marie-Anne sold the property on 16 October 2009 (the day the contracts were exchanged) for $315,000. She incurred costs of $1,500 in solicitor's fees and $4,000 in agent's commission.
 
As she bought and sold her property within 12 months, Marie-Anne must use the 'other' method to calculate her capital gain.

Deposit                                                                  $25,000+
Balance                                                               $225,000+
Stamp duty $5,000+
Solicitor's fees for purchase of property                      $2,000+
Solicitor's fees for sale of property                             $1,500+
Agent's commission                                                 $4,000+
Cost base (total)                                                  $262,500

Marie-Anne works out her capital gain as follows:
Capital proceeds                                                   $315,000
less cost base                                                     ($262,500)
Capital gain calculated using the 'other' method $52,500

Assuming Marie-Anne has not made any other capital losses or capital gains in the 2009-10 income year, and does not have any unapplied net capital losses from earlier years, the net capital gain to be included on her tax return is $52,500.

Discount method – use if property held for 12 months

Description of method - Allows you to discount your capital gain (by 50% for individuals and trusts, and 33 1/3% for complying superannuation funds).

When to use the method - Use for an asset held for 12 months (between date of entry of Contract for purchase and date of entry of Contract for sale)

How to calculate your capital gain using the method - Subtract the cost base from the capital proceeds, deduct any capital losses, then reduce by the relevant discount percentage. Apply this to the Example, the Capital gain calculated of $52,500 is halved to $26,250 and that amount is included in Marie-Anne’s tax return.

Source:
http://www.ato.gov.au/individuals/content.aspx?doc=/content/36581.htm
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Commentary

The sale price that appears on the Contract for Sale invariably represents more than the owner is to receive from the sale of the property.

Simple costs such as real estate agents commission and conveyancing costs on the sale will need to be deducted from the sale price that appears on the Contract, to arrive at what the ATO describes as capital proceeds, which is the starting point for the calculation of a capital gain.

In more complex transactions, the deductions from the price that appears on the Contract for Sale might include purchaser expenses that a seller agrees to pay out of the price, and the profit ‘uplift’ between what a seller has agreed to accept on the sale, and the amount a buyer has agreed to pay, which represents a transaction engineer’s profit such as is found in a Sandwich Lease Option.

The seller’s tax position is that the seller has to include in the capital gains tax calculation, what they receive (the capital proceeds), not the price that appears on the Contract for Sale.

This is how the ATO puts the position –

What are capital proceeds?

Whatever you receive as a result of a CGT event is referred to as your ‘capital proceeds’. For most CGT events, your capital proceeds are an amount of money or the value of any property you:

• receive, or
• are entitled to receive.

Source:
http://www.ato.gov.au/individuals/content.aspx?doc=/content/36556.htm

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