The secret tax lives of unit trusts
It’s not uncommon for property investors to use unit trusts to invest in property, especially when multiple investors are involved. In the old days, unit trusts were used prolifically because superannuation funds couldn’t directly borrow so investors would subscribe for units in unit trusts that would borrow as a way to step around the issue.
While the arrival of the in-house asset rules rendered this arrangement no longer effective, unit trusts are still quite popular as a vehicle to undertake property investments.
Unit trusts offer a reasonable degree of asset protection if the units are held by a safe entity and are easily transferable, providing flexibility in admitting or retiring investors.
However, one should be aware there would be stamp duty on unit transfers and the transfer duty on the units is generally calculated with reference to the gross value of the assets of the trust without accounting for the liabilities associated with the assets.
In respect of the annual profits of the trust, a unit trust would normally distribute profits to unit holders every year because retaining them would expose profits to the highest marginal tax rate in the hands of the trustee by default.
Despite the lack of ability to retain profits, a unit trust has the ability to pass on ‘tax sheltered income’ to the investors.
For instance, while a unit trust may claim depreciation and capital works deductions associated with a property investment, these deductions are not ‘real’ cash expenditure.
Therefore, the unit trust would generally have a lower taxable income to distribute than its cash profits, rendering the difference a ‘non-assessable amount’ in the hands of the investors.
While investors are required to reduce the cost base of their units by these non-assessable amounts, to the extent that the cost base hasn’t been exhausted, the excess cash profit isn’t immediately taxable.
From a capital gains tax perspective, unit trusts are eligible to apply the 50% CGT discount if the relevant asset has been held by the trust for at least 12 months before it’s sold.
Companies are not entitled to this discount at all. The same applies to the disposal of the units in the unit trust – provided the units are not held by a company, the CGT discount would generally apply to any capital gain derived on the units if they’ve been held for at least 12 months.
So, are unit trusts the tax magic bullet for property investors? Before you start setting up unit trusts left, right, and centre to invest in property, consider a unit trust that’s set up to hold a commercial property for rent for a single unit holder with the following parameters:
Cost base of the property (including building expenditure) = $5,000,000
Cost base of the units in the unit trust = $5,000,000
Annual rent = $500,000
Annual capital works deduction claim = $25,000
Annual rental costs (including interest) = $100,000
After the first year, the trust would have a net cash balance of $400,000 ($500,000 – $100,000) to distribute to the unit holder.
While the unit holder would receive a cash profit of $400,000, taxable profit would only be $375,000 due to the capital works deduction claim.
Under the capital gains tax rules, the amount by which the cash distributed exceeds the taxable profit, being $25,000 in this case, would reduce the cost base of both the property and units in the unit trust for tax purposes.
Using the figures above, the cost base of the property in the trust would now be reduced to $4,975,000 ($5,000,000 – $25,000), which is the same as the cost base of the units in the unit holder’s hands.
Let’s say a good deal comes along and the units trust sells the property at the end of the year for $6,000,000. The capital gain made by the trust would be $1,025,000 ($6,000,000 – $4,975,000) – reduced cost base.
Putting aside net rental profit, one would have thought that this would be the only taxing point associated with the sale of the property, which isn’t true.
What the unit holder probably doesn’t realise is that the recoupment of the accumulated capital works deduction by way of the cost base reduction of the property in the trust has been repeated in the hands of the unit holder.
This is because the cost base of the units was also reduced previously when the unit holder received the tax-deferred amount representing the capital works deduction of $25,000.
Therefore, while the unit holder would get back $5,000,000 on the redemption of the units, the cost base of the units has actually been reduced to $4,975,000, meaning the redemption of the units would give rise to a second lot of capital gain of $25,000.
Under the current law, there’s nothing to prevent this double taxation issue from arising but at least you’re now aware of this dirty little secret of unit trusts.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO Services Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO Services Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO Services Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.