Tax-deferred income in unlisted property funds

When investors receive distributions from property funds, a portion of this income may be classified as “tax deferred” or “tax advantaged”. Generally speaking, these components result from differences between the fund’s distributable income and its taxable income, which can arise from the fund’s ability to claim tax deductions for items such as depreciation, capital works on building structures and the costs of raising equity (amongst others).

How are “tax-deferred” components treated from a tax perspective?

Investors generally will not have to pay tax immediately on the tax-deferred component of the distributed income. Instead, these amounts are generally applied first to reduce the cost base of their investment, with the investor’s tax liability on this income being deferred until a Capital Gains Tax (CGT) event occurs in respect to the units in the fund (i.e. when the assets in the trust are sold or when the cost base of the investment is reduced to nil by the tax-deferred distributions).

Tax-deferred Distributions in Practice

John invests $100,000 in an unlisted property fund and receives a distribution of $8,000 per annum for the first year. Distributions from the Fund are declared as 40% tax deferred.

If there were no tax deferral benefits, the tax payable would have been $2,160 ($8,000 x 27% assumed effective tax rate), resulting in an after tax income of $5,840.

However, because the distributions are 40% tax-deferred, the tax payable in this case would be $1296 ($8,000 x 27% x 60%). As a result, John actually receives an after-tax income of $6,704, resulting in an extra $864 cash in his pocket each year.

Potential benefits of tax-deferred income

Whilst tax-deferred income can significantly increase an investor’s after tax cash flow each year during the investment term, it can also hold a number of long-term benefits for investors depending on what taxable entity they are making the investment through and the period for which they hold units in the fund.

  • If an individual taxpayer has held units in a property fund for more than 12 months, they may be entitled to a 50 per cent discount on the CGT payable.
  • Eligible superannuation funds that have held units for more than 12 months may be entitled to a one third discount on the CGT payable.
  • If units in the fund are held by a superannuation fund that realises the investment during an allocated pension phase, the tax-deferred income distributions may be completely tax-free. Providing the units were disposed of after transitioning into this phase, this can still be the case regardless of whether the tax-deferred distributions were received before the allocated pension phase began.

Example continued

Using the same example as above, the tax deferred amount of $3,200 ($8,000 x 40%) reduces the cost base of John’s investment in the unit fund to $96,800 ($100,000 – $3,200).

In this scenario, John would be liable to pay CGT on the deferred element of his distributions (that is, $3200 per annum), but only upon the disposal of the units in the unlisted property fund or when the cost base of the investment in the unlisted property fund is reduced to nil (CGT is payable on the excess).

Assuming he has held the units in the fund for over 12 months, he is entitled to a 50% CGT discount on disposal of the units or on the excess, and will therefore effectively only be paying CGT on $1,600 ($3200 X 50%) of this component for each year he has held the units.

Further, if units in the fund are held by a superannuation fund that realises the investment during an allocated pension phase, the tax-deferred income distributions may be completely tax-free.

Please note: The above are general comments only and must not be treated as professional advice. Readers and investors should rely on their own enquiries in making any decisions concerning their own interests.