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 that 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. You might ask what is that, and why is it important?

Well, income recognition deals with the rules around the timing of recognising income from a property development project. It’s important because it will dictate which income year you must actually pay tax on as a development project proceeds, and this in turn drives provisional tax planning decisions and strategies.

So, starting with the basics, when you buy and begin a property development project the cost of land acquisition and development and construction of buildings are capitalised to the balance sheet as revenue account trading stock items. These costs are not necessarily deductible in the year they are incurred. Only holding costs like rates and 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 where 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 on 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 the 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.

So, let’s drill in on 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; the date it’s called unconditional; and the date it settles.

So, which of these dates determines the tax year in which you must recognise the income from the sale?

The answer lies in the finding from 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 binding agreements for the sale of land, the sales should only be recognised when settlement occurred. The courts agreed and found that it’s not until the agreed date of settlement passes that the vendor has the right to sue for the specific performance of the contract and this then determines the tax year in which the income should be recognised.

This means a sale settling after balance date will mean the income recognition is pushed 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 $1.3 million. Using the proceeds of this sale he then buys another property for $1.3 million in February, which remains unsold at March 31.

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 March 31 balance date?

Deal one has sold and settled before March 31, yielding a profit of $300,000. This income must be recognised in the year to March because settlement occurred within the tax year.

The next purchase 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 cashflow consequences of the income recognition rules for property development.

PFK Withers Tsang & Co specialise in advising on property-related transactions, valuation and restructure services, and tax planning. PKF Withers Tsang & Co Phone 09 376 8860, www.pfkwt.co.nz