Tax-deferred income – a hidden perk of unlisted property funds

As millions of Australians knuckle down to complete their 2023-24 tax returns, investors in property funds may be able to take advantage of a valuable tax break.

For many Australians, especially those working in PAYG roles, there can be limited opportunities to claim serious tax deductions.

However, if you’re an investor in a property fund you may be eligible for valuable tax savings thanks to something known as “tax-deferred income” – a common component of fund distributions.

Let’s take a closer look at what it’s all about.

Regular income – a key point of appeal of property funds

One of the great strengths of unlisted property funds is their ability to provide regular income to investors.

Income distributions on unlisted funds can be very attractive as they may be paid monthly (in the case of our funds at Westbridge Funds Management) or quarterly, which gives investors a regular and passive source of income to live on or reinvest.

What is often less well-known is that unlisted property funds can also be a source of tax-friendly income thanks to ‘tax-deferred’ distributions.

Here’s how they work.

Tax-deferred distributions explained

Most investors are aware that if they own an investment property, they may be able to claim non-cash expenses such as depreciation of the building. A similar concept applies to the properties owned by a managed fund.

The fund, which owns the asset(s) in a unit trust for the underlying investors, can claim a tax deduction for various costs such as building depreciation, loan interest, and construction costs to name a few.

When a property fund claims these expenses, the result can be that its cash available for distribution is higher than the fund’s taxable income. The difference between the taxable income and the amount distributed to investors results in ‘tax-deferred’ distributions. That is, distributions that are not immediately taxable in the hands of investors.

Instead of being taxed in the year they are received by an investor, tax-deferred distributions reduce the cost base of a unitholder’s investment in the trust when capital gains tax (CGT) is calculated.

In this sense, tax-deferred distributions live up to their name because the payment of tax (if any) is put off (or ‘deferred’) until such time when units in the fund are sold or redeemed – the normal points at which CGT may be triggered.

Two main benefits of tax-deferred income

It is always important to speak with your tax professional for tax advice tailored to your circumstances – and this is no different for the issue of tax-deferred income.

That said, tax-deferred distributions can offer a number of key upsides for investors in a property fund:

1- Lowering taxable cash distributions

As tax-deferred distributions do not count towards annual taxable income, this can help to reduce your tax bill in a given financial year.

This doesn’t just mean more money to live on. The tax savings can also be used to reinvest in the same fund or other funds until a capital gains tax event occurs – providing compounding benefits over time.

An example in practice:

As an example, let’s say Alex invests $100,000 in an unlisted property fund and receives a distribution of $8,000 per annum for the first year. Distributions from this 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, Alex actually receives an after-tax income of $6,704, resulting in an extra $864 cash in his pocket for the year.

2 – Potential to take advantage of capital gains tax (CGT) discounts

While tax-deferred distributions normally lower the cost base of an investment in a property fund, investors may be able to take advantage of Australia’s generous CGT rules. Depending on your circumstances, this may reduce the total amount of tax you would otherwise have paid.

In particular, an investor who holds onto an asset for longer than 12 months (including units in a property fund) can normally claim a 50% discount on capital gains. In this way, investors can significantly minimise the potential tax bill associated with tax-deferred distributions.

Our example continued:

Going back to our example, the tax-deferred amount of $3,200 per annum from Alex’s distributions (being 40% of $8,000) would lower the cost base of his investment in the fund to $96,800 ($100,000 – $3,200).

Alex would be liable to pay CGT on the difference between the cost base and the eventual proceeds from disposal of his interest in the fund. In this case, if Alex disposed of his units after the first year for $105,000, his gain on sale would be $8,200 (being the proceeds of $105,000 less the reduced cost base of $96,800). However, if he has held the units in the fund for over 12 months, he would be eligible to a 50% discount on this payment, reducing it to only $4,100.

What if I’m investing via a self-managed super fund?

The benefits can be significant even if you’re purchasing units via an eligible superannuation fund.

In this case, eligible funds that have held units in a property trust for more than 12 months may be entitled to a one-third discount on any CGT payable.

Moreover, if the units are held by a super fund that is in the pension (drawdown) phase, tax-deferred income distributions can be completely tax-free. Providing the units were disposed of after transitioning into this phase, this can still be the case if the tax-deferred distributions themselves were received before the allocated pension phase began.

Again, this is something you’ll need to discuss with your tax professional based on your individual circumstances.

What to weigh up

It’s important to stress that each investor has their own unique tax circumstances. This makes it essential to seek tailored advice to know how you could be impacted by tax-deferred distributions.

It’s also worth noting that tax savings should never be the main driver to invest in any asset. At best, tax breaks should be the icing on the cake, and may be useful when comparing after-tax returns of potential investments.

Nonetheless, in a well-managed property fund with one or more compelling properties, tax-deferred income is another sweetener that can make unlisted property funds so attractive to investors looking for regular, tax-friendly income.

 

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This information has been prepared by Westbridge Funds Management as a general guide only. It does not constitute an offer for sale, or solicitation for the purchase of securities, financial products or other investments. It should not be relied upon to determine or to make decisions about the investment objectives, financial situation or individual needs of any person. Westbridge Funds Management recommends investors seek professional advice before making a decision to invest. Westbridge Funds Management and its related entities do not make any representations or give any warranties that the information contained within is or will remain accurate or complete at all times and they disclaim all liability for harm, loss, costs, or damage which arises in connection with the use or reliance on the information. Westbridge Funds Pty Ltd ABN 33 652 852 214 AFSL 533936. Westbridge Asset Management Pty Ltd ABN 48 151 957 676. Westbridge Property Securities Ltd ABN 28 091 623 862. AFS Licence 238386. Momentum Wealth Projects Pty Ltd ABN 29 090 792 439 t/a Westbridge Urban.