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Deferring tax can make a big difference to total returns

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By Jason Huljich

No one likes giving the tax man more of their money than they need to. And when personal tax rates range from a third to a half of your income, finding ways of reducing the burden is definitely time well spent. Negatively gearing residential property, or investing in companies which pay a franked dividend, for example, are two well-used solutions to the problem of reducing and/or deferring tax liabilities over time.
 
What some investors may not realise is that the income, and potentially the capital gains, on commercial property can also be significantly tax-advantaged. The reason is that the ATO allows for certain deductions and allowances on commercial property, which can serve to reduce assessable income and defer tax liabilities for the period the property is owned.
 
Furthermore, these tax benefits are available to investors regardless of the structure in which their property asset is held, e.g. as a direct investment, or through a pooled investment, such as an unlisted property trust or even a listed property trust.
 
Why does depreciation make income tax-advantaged?

Property funds make distributions to investors which come primarily from the rental income received from tenants. Tax-deferred distributions arise because the tax deductions that property owners can claim mean there is a difference between the trust’s cash or distributable income and its taxable income.
 
These benefits flow through to investors, because investors can effectively claim the deductions (in proportion to the size of their ownership in the property) against their personal income. This means that their taxable income (not their actual income) is reduced, thereby reducing their tax liability. This difference between distributed income and taxable income, referred to as a tax deferred distribution from a property trust, is only recouped when the investment is sold. This is because the cost base of the investment is reduced by these deferred tax amounts and CGT will be paid on the difference between the cost base and the sale price.
 
The good news is that if the property is held in a trust structure, such as an unlisted trust, then you will be eligible for 50% CGT discount if the investment has been held for over 12 months. This is almost always the case in an unlisted property trust, which typically has a fixed term of five or seven years during which time investors cannot exit and the property will not be sold. This means you are paying only about 50% of your marginal tax rate for this portion of the income.
 
What is a Depreciation Schedule and how does it work?

Commercial properties are subject to a ‘depreciation schedule’ – which sets out capital allowances and tax depreciation. There are two main elements: deductions for capital works, and deductions for plant and equipment.
 
High quality commercial properties tend to have higher depreciation allowances, and larger, higher buildings, which have more services (lifts, fire services, air-conditioning etc.) typically have higher depreciation allowances as well.
 
Capital works deductions

Sometimes referred to a ‘building write-off’, capital works deductions are allowed for various structural elements of a building, including fixed parts of the property such as the foundations, walls, roof, doors and windows. How much you can ‘depreciate’ depends on when the property was built, and ranges from 2.5% to a maximum of 4% per annum.  
 
These kinds of structural elements of a property are typically depreciated over a long time period, potentially up to 40 years.
 
Plant and equipment deductions

Plant and equipment refers to assets which can be easily removed or are mechanical in nature – in essence, assets which are deemed to have a limited effective life so could reasonably be expected to depreciate over time. The effective life of an asset is set by the tax commissioner and changes over time.
 
Plant and equipment such as air conditioners and even lifts usually don’t last more than 10 years or so, so are depreciated more quickly and at a higher rate.
 
Deciding how to claim depreciation entitlement is also important.

Once depreciation has been calculated, the property owner (in an unlisted trust this will be the manager of the trust), can choose one of two methods to claim: the ‘prime cost’ method and the ‘diminishing value’ method. Prime cost means the deduction for each year is calculated as a percentage of the cost. The diminishing value method calculates the deduction as a percentage of the balance you have left to deduct.
 
Neither method is intrinsically better than the other – the one which will work best depends on the time horizon of the property investment. Under the diminishing value method, more of the depreciation allowances will be claimed in the earlier years, whereas with the prime cost method, deductions are spread evenly over time, which will tend to suit long-term investors better.
 
Transparency. At the beginning and over the life of the trust.

One of the nice things about tax benefits from property investment in an unlisted trust structure is that they are transparent – from the beginning of the trust to the end. The Product Disclosure Statement (PDS) will outline the first two years of returns and forecast tax benefits clearly.
 
Unlisted trusts do not pay tax within the trust structure; rather, all benefits and deductions flow through to the investor. At the end of the financial year, Centuria will issue you with a tax certificate which shows all tax deferrals and depreciation which can be included in your personal tax returns. And chances are, you may end up paying less tax than you think.

This is a sponsored article from Centuria.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Published: Monday, November 13, 2017


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