REAL ESTATE RELATED INCOME TAX ISSUES

DISCLAIMER: This statement is a summary of a number of the major issues relating to the taxation of real property; it is not intended to be an exhaustive interpretation and the reader should seek formal advice before taking any action based on the information in this paper.

The material is current at the 1998 Budget.

References:

Inglis & Miller "Real Estate Investment Decisions - The Impact of 1985 Tax Changes", CCH

Cooper & Inglis "Australian Capital Gains Tax", Butterworths

Deutsch et al "97 Australian Tax Handbook", Australian Tax Practice (ATP)

"The Valuer" October 1986 pps 276 - 283; April 1986 pps 94 - 102; January 1986 pps 17 - 24 & 41 -45; October 1987 pps 615 - 617; October 1988 pps 188 - 190; April 1989 pps 304 - 311; July 1989 pps 373 - 375; February 1991 pp 320 - 322; May 1991 pp 393 - pp 403 -; August 1991 pp 459 - ; November 1991 pp 547 -; August 1992 pp 182 - 186

"Australian Accountant" April 1992 pps 58 - 62, June 1997 pps 69 - 70

"Weekly Tax Bulletin" No 23 13/5/97 (ATP)

Investment in real estate has generally carried with it two separate rewards: the rental income and the capital appreciation. Another benefit that accrues to the owner of investment real estate is the possibility, in certain circumstances, of offsetting losses on property investments against other income. A further incentive for property investment was that the capital appreciation referred to above was generally not subject to any taxes.

The major tax changes introduced in 1985 and 1987 significantly altered the environment in which property investment decisions are made; and makes it possible that two comparable competing real estate investments can, because of their taxation situations, have differing after tax returns.

The following discussions will give some indication as to these situations.

Income & Expenses:

Rental income from property forms part of the assessable income of the owner of property.

From this income can be deducted the normal cash expenses incurred with property ownership; i.e. rates, insurances, maintenance, management, etc. In addition an allowance for depreciation of plant and equipment is also an allowable deduction. This is further discussed later in the paper.

The major outgoings in relation to property investments is interest. A deduction for interest is normally claimed under Section 51 of the Act which provides:

All losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income."

One of the important points to note is that deductibility for interest is dependent upon how the borrowed monies were applied and are not dependent upon what the borrowings were secured against. For instance a deduction will be allowed for interest paid on a loan used to acquire an investment property even though the borrowings are secured against the investor's principal residence. On the other hand interest on a loan secured against an investment property to buy a boat would not be allowable.

This has a further complication for our discounted cash flow analysis in that the principal component of any mortgage payment must be paid from after tax monies. This will necessitate the splitting of any mortgage payments into the principal and interest components. The fact that the principal must be paid from after tax money is one of the major reasons behind the popularity of interest only loans for investment property.

As a historical note for property investments entered into after 17/7/1985 or where an investment property owned prior was re-financed the interest deduction was limited to an amount equal to the difference between the "net rental income" and zero. Any loss incurred due to interest payments could be carried forward to be offset in later years. This carry forward was called "quarantined interest". The "net rental income" was defined as the gross rents (assessable income) reduced by tax deductible outgoings (other than interest). The 1987 Federal budget re-instated the full deduction basis for interest with effect from 1/7/1987. Further, the amounts carried forward (quarantined) were allowed to be written off in the tax year 1987/88.

Borrowing on Property Acquired for Development

Interest paid on borrowings on property acquired for development/re-development is generally not an allowable deduction but is treated as a cost of development. A 1997 Privy Council case (Wharf Properties v. Commission of Inland Revenue) was specifically considered by the Full Federal Court in Steele v. Federal Commissioner of Taxation 35 ATR 18 March 1997 and provides a comprehensive analysis of the various rules to be applied in determining whether interest is deductible or not.

Section 67 of the Act provides that the costs of arranging finance for a property investment can be deducted (amortised) over a period of 5 years or the term of the loan whichever is the lesser. These could include valuation fees, finance brokers fees, stamp duty on the mortgage, titles office fees on the mortgage, etc Such costs are paid at the start of the project and are a cash flow at that time, but are an allowable deduction, for taxation purposes, over the time period allowed.

Section 53 is a specific provision which allows a deduction for repairs. Sub-section 53(1) provides:

"Expenditure incurred by the taxpayer in the year of income for repairs, not being expenditure of a capital nature, to any premises, or part of premises, plant, machinery, implements, utensils, rolling stock or articles held, occupied or used by him for the purpose of producing assessable income, or in carrying on a business for that purpose, shall be an allowable deduction."

A repair generally involves the replacement or renewal of a part but not of an entirety. Where different materials are used and it results in an improvement of the asset then the work will not constitute a repair. A deduction will not be allowed for repairs of items which were defective at the time of purchase. It is immaterial that the defects which were subject of the subsequent repairs were not known by the purchaser at the time of purchase.

In some of the material you will see this referred to as building depreciation or building write off. This allowance provides that a deduction of the relevant percentage of the original construction cost of the asset can be claimed as a deduction against income. Site preparation costs, landscaping, cost of constucting driveways and detached car parks, and the cost of depreciable plant do not qualify for this deduction.

There are a number of features that distinguish this allowance from depreciation of plant and equipment.

• for property acquired prior to 7.30 p.m. (Eastern Standard Time) 13 May 1997 there is no balancing charge at the disposal of the building (See later for further explanation)

• the new owner is entitled to continue with the deduction at the same rate for the balance of the relevant period.

Relevant dates:

1. where construction commenced after 21/ 8/1979     40 years (2.5% p.a.)
     -short-term traveller accommodation

2. where construction commenced after 19/ 7/1982     40 years (2.5% p.a.)
     - non-residential income producing property

3. where construction commenced after 22/ 8/1984     25 years (4.0% p.a.)
     - both of the above

4. where construction commenced after 17/ 7/1985     25 years (4.0% p.a.)
     - residential income producing property.

5. where construction commenced after 15/9/1987     40 years (2.5% p.a.)
     - all property types

6. where construction commenced after 26/2/1992     25 years (4.0% p.a.)

     - short term traveller accommodation and "eligible industrial activities".
     Warehouse, office, retail and residential remain at 40 years (2.5% p.a.).

Eligible industrial activities are defined as manufacturing operations, operations involving the processing of primary products, printing activities and the production of energy either for sale or use in manufacturing and related activities. Ancilliary storage for raw materials or processed goods, packaging, etc are also included in the definition.

The tax laws provide that anyone selling a building or a lease of a building to provide sufficient information to the purchaser to enable the purchaser to ascertain the manner in which capital allowance deductions will apply to the purchaser.

For properties acquired after 13 May 1997 there is to be an offsetting add back of capital allowance claimed during the periof of ownership in the calculation of capital gains tax.

The capital gains tax applies to assets acquired after 20 September, 1985. The tax will be levied on "real gains" made and will apply upon realisation of assets. There is provision for any expenditures associated with the purchase, capital improvement, or disposal of the asset, that is subject to capital gains tax, to be included in the cost base of that asset.

The taxpayers principal place of residence is specifically exempt from the provisions relating to capital gains tax.

To determine the "real gain", referred to above, the cost base of the asset is to be adjusted by the movement in the Consumer Price Index, on a quarterly basis for the period of ownership. Only the gain in excess of this indexed cost base is taxable. If an asset is held for less than 12 months there is no indexation benefit.

 

CPI at	March	June	September	December
1985			71.3	72.7
1986	74.4	75.6	77.6	79.8
1987	81.4	82.6	84.0	85.5
1988	87.0	88.5	90.2	92.0
1989	92.9	95.2	97.4	99.2
1990	100.9	102.5	103.3	106.0
1991	105.8	106.0	106.6	107.6
1992	107.6	107.3	107.4	107.9
1993	108.9	109.3	109.8	110.0
1994	110.4	111.2	111.9	112.8
1995	114.7	116.2	117.6	118.5
1996	119.0	119.8	120.1	120.3
1997	120.5	120.2	119.7	120.0
1998	120.3

 

Note that the Australian Bureau of Statistics has changed the way the CPI is calculated. Rather than having a base of 100 in 1980/81 the new CPI has a base of 100 in 1989/90. This change was part of the five yearly review of the CPI.

When calculating the indexation factor it is rounded to the third decimal place.

Example

A taxpayer acquired an asset for $100,000 on 1/8/1987 with associated costs of $6,000 and then sold that asset on 1/8/1992 for $150,000 with selling costs of $4,200. The consumer price index at the date of purchase was 90.2 and at the date of sale, 107.4. The indexed cost base can be calculated as follows: (100,000 + 6000) x 107.4/90.2 = $126,246

The capital gain is thus the net selling price ($145,800) less the indexed cost base ($126,246) = $19,554. The capital gain is taxed, generally, at the taxpayers marginal rate of tax. (There are some averaging provisions for low income earners.)

A capital loss will only occur when the disposal value of the asset is less than the initial purchase price.

Rollover relief for the sale of small businesses where the proceeds are re-invested in a like kind business. The test is "would a reasonable person be satisfied that the newly acquired asset is to be used in a business which is substantially of the same kind as the taxpayer's current business?". A like kind test will not generally apply asset by asset. Will apply from 1 July 1997.

Sale of small business for retirement individuals will be able to claim an exemption from capital gains tax on the sale of small business (under $5 million) where the proceeds are used for retirement purposes. Will apply from 1 July 1997.

Extending Principal place exemption for inherited property.

Change of ownership provisions. Existing provision is that where the underlying ownership of an asset changes by more than 50% a pre-capital gains asset is deemed to become liable for capital gains.

The 1997 Budget announces a change in the treatment of capital allowance deductions in that for properties acquired after budget day the cost base will be reduced by the amount of capital allowance claimed during the ownership of the asset. This measure is designed to stop the "double" deduction of the capital expenditure previously allowed; first from the capital allowance deduction and secondly from the inclusion of the amount in the cost base of the underlying asset resulting in a reduction in taxable capital gain or in an increase in capital losses when the asset is sold.

In recent time (7/98) there has been press and property industry speculation regarding the ORICA decision (Commissioner of Taxation v ORICA Ltd 72 ALR 969). The concern is that if there is a change in value between the date of entering into a contract for the purchase of a property and the date of settlement, the purchaser will be liable to capital gains tax on the change in value between the two dates. There is a fine legal line between the actual ownership of the property after settlement and the rights under the contract of sale that subsequently give the right to ownership. In delayed completion cases, vendor terms contracts or purchases off the plan, for example the risk of a taxable gain increases.

Prior to 25th May 1988 plant and equipment could be depreciated over either 3 or 5 years. However after that date plant and equipment is to be depreciated on an economic life basis. This has had the effect for example of making a lift depreciable at the rate of 9% against 20%.

In a related twist any plant and equipment ordered before the 25th May 1988, completed, installed and ready for use no later than 30th June 1991 was still eligible for the old depreciation rates. This was one of the driving forces behind the need to complete (in Melbourne) the number of landmark buildings that contributed to the large vacancy rate in the city.

In February 1992 the government again changed the depreciation rates. This 6 rate band (shown below) applies to assets whether new or secondhand acquired after 26 February 1992. The new bands are based on the effective life of the asset.

Effective Life (years)	Prime Cost (%)	Diminishing Value (%)
3 to less than 5	40	60
5 to less than 62/3	27	40
62/3 to less than 10	20	30
10 to less than 13	17	25
13 to less than 30	13	20
30 or more	7	10

Unless a specific declaration is made depreciation on assets acquired after May 1988 is assessed on a reducing balance basis. The appropriate depreciation rates can be found in schedules to the Tax Act.

With effect from 27/2/92 depreciation will be allowed for building improvements constructed on Crown Land. Technically such improvements are probably a fixture and so be owned by the Crown, which means that currently available depreciation deductions are not available. Only allowed for the "owner" of the improvements.

In Coolings case the Commission of Taxation assessed a taxpayer for income tax on cash and the like incentives received by the taxpayer. The incentive was to encourage the taxpayer to move to a new building and was used to fund the removal costs and some of the fitout expenses. In the initial case the court held that the incentive was not assessable as either income or capital gain.

The Commissioner successfully appealed against the lower court decision in the Federal Court and the incentive paid was held to be taxable. The High Court in November 1990 confirmed the Federal Court decision in the Commissioner's favour by refusing leave to appeal to the High Court.

This case has recently been confirmed; in Montogmery v. FC of T 35 ATR 8 April 1997 the court held that any profit made to induce a firm to move premises is just an ordinary incident of its business and is thus assessable.

Infrastructure borrowings are intended to facilitate private investment in the constructgion of certain public infrastructure projects by enabling investors in such projects to obtain tax exempt financing. It applies to monies borrowed after 1 July 1992 and used for one of the following forms of infrastructure investment:

• a land transport facility that is to be used for the transport of the public or their goods at a charge;
  
• a seaport facility where there is a charge for the transport of the public or their cargo on the vessels; and
  
• an electricity generating facility where the electricity generated is primarily or principally for sale to the public through the public electricity grid.

The Federal Treasurer announced a halt to this scheme in February 1997 and a new scheme was announced in the May 1997 Budget. The infrastructure scheme is now limited to private land transport infrastructure (rail and road) projects and the cost to revenue of future infrastructure projects is to be limited to $75 million per annum. The ATO will call for applications for the infrastructure rebate on a twice yearly basis.

This measure will permit resident infrastructure financiers to apply for a tax rebate on interest received from infrastructure providers in return for the infrastructure providers forgoing the tax deductability on that interest. This will benefit infrastructure providers because financiers will be able to offer lower rates on interest or other benefits.

Since July 1993 employers may be liable for fringe benefits tax where car parking facilities are provided for employees within a one kilometre radius of a commercial parking station and the following conditions are present:

• the car is used by the employee to travel to and from work;
  
• the car is parked for periods totalling more than 4 hours between 7.00 a.m. and 7.00 p.m.; and
  
• at least one commercial parking station operator within the 1 kilometre radius ordinarily charges more than the "car parking threshold" amount ($5.20 for the 96/7 tax year) for all day parking.

The value of the benefit may be determined by a suitably qualified valuer who must have expertise in the valuation of car parking facilities and be at arms length in relation to the valuation.

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