What tax implications are there when I demolish my main residence, build two townhouses and sell them ?

A common question I get asked is what the tax implications are when I have lived in a property for a long time and then decide later to demolish the main residence, build two townhouses, and sell them. 

Many people think that because it was their main residence that the profits on sale will be entirely tax free.  Beware however as this is a trap!

This can be a complex calculation and not only does the person need to consider tax implications but also the potential GST implications.

The intentions on purchase are extremely important as this will also determine the tax implications on sale.  This will be a discussion for another blog but in this example, we are going to assume that the intention was to purchase the property as use it as their main residence, and they have done so for many years, and only due to zoning law changes have they decided to now build two townhouses and sell them.

Tax Implications

This type of transaction is generally considered to have been disposed as part of a profit from an isolated transaction.

Because the property was originally held as a capital asset then the person will need to calculate the tax implications under both the capital gains tax regime as well as the revenue regime.

Sounds confusing right.  Well, it is.

Unfortunately when the main residence is demolished the main residence exemption is also lost.

The main residence exemption for a dwelling occurs for a CGT Event which happens to a CGT asset under Section 118-110 of the ITAA 1997.

The meaning of dwelling includes a unit of accommodation and any land immediately under the accommodation under Section 118-115 ITAA 1997.

However the main residence exemption does not apply to an event in relation to the land if that event (CGT Event A1) does not also happen in relation to the dwelling (the demolition (C1 Event)) under Section 118-165 ITAA 1997.

It’s a 3-step process and the calculation is best illustrated using an example which we will go through below.

Step One

Calculate the net profit under Section 6-5 in the year in which the contract is settled.

Step Two

Calculate the capital gain under the CGT provisions in the year in which the contract was executed.

Step Three

Reduce the capital gain calculated in Step Two by the net profit calculated in Step One.

 EXAMPLE

Pauline, who is an Australian tax resident, purchased her main residence in July 2002 for $500,000

She lived in the property until July 2020 and at that point demolished the main residence and built two townhouses.

The market value of the land at the time was $ 1,000,000

She incurred development costs of $ 750,000 and interest on her development loan was $ 50,000

She sold the two townhouses in April 2022 for $ 3,000,000 and settled in June 2022.

 Step One Calculation – Net Profit

Sale Proceeds                                       $ 3,000,000

Less : Market Value of Land                $ 1,000,000

Less : Development Costs                    $   750,000

Less :  Interest on Loan                         $     50,000

Net Profit under Section 6-5              $ 1,200,000

Step Two Calculation – Capital Gain

Sale Proceeds                                        $ 3,000,000

Less : Cost of Land                               $    500,000

Less : Development Costs                    $   750,000

Less : Interest on Loan                         $      50,000

Capital Gain                                          $ 1,700,000

Step Three Calculation – Reduce capital gain by net profit

Capital Gain                                             $ 1,700,000

Less ; Net Profit                                       $ 1,200.000

Capital Gain reduced by net profit         $   500,000

Less : 50% CGT Discount                        $   250,000

Assessable Capital Gain                        $   250,000

 Pauline will also need to consider GST as part of her calculations which haven’t been included in this example.