This article was originally published 09 October 2015, and updated 22 December 2021.
Unit trusts have long been popular property investment vehicles, especially where multiple owners are involved. Similar to shareholders owning shares in a company, unit holders can indirectly own their proportionate interests in an underlying property held by a unit trust. This is a reasonably simple structure for people to understand, notwithstanding that unit trusts and companies are fundamentally very different things at law.
Tax benefits of unit trusts as property investment vehicles
Unit trusts are generally preferred when it comes to investment property ownership over companies because they have the ability to pass on any net cash profit from the property that represents non-cash depreciation and capital works deductions to the unit holders. Such cash distributions, also known as ‘non-assessable amounts’, made by a unit trust will generally reduce the cost base of the units and do not give rise to any immediate tax consequences.
However, when the cumulative non-assessable amounts exceed the entire cost base of the units, any excess will give rise to a taxable capital gain. Provided that the underlying units on which the distributions are made have been held by the relevant unit holder for at least 12 months and the unit holder is either an individual or a trust, the capital gain will be halved under the 50 per cent capital gains tax (CGT) discount (if the unit holder is a complying superannuation fund, the CGT discount is 33.33 per cent).
In contrast, if this kind of distribution is made by a company to a shareholder, it will generally be treated as an assessable dividend upfront, which may give rise to an immediate tax liability.
Unit trusts also shine in comparison with companies when an investment property is eventually sold and a capital gain is made. Provided that the property has been held for at least 12 months, any capital gain derived on the property by a unit trust would generally qualify for the 50 per cent CGT discount, as long as the gain is not distributed to a company. Assuming that the relevant unit holder to whom the capital gain is distributed is paying tax at a marginal tax rate of 47 per cent inclusive of the Medicare Levy, the effective tax rate on the discount capital gain will be 47% x 50% = 23.5%.
On the other hand, if the capital gain is derived by a company instead, no CGT discount will be available and the capital gain will be taxed at 30 per cent. If the company is a ‘base rate entity’ (BRE) the tax rate is 25 per cent for the 2021-22 and future income years, 26 per cent for 2020-21 or 27.5 per cent for 2017-18 to 2019-20. A company is classed as a BRE when no more than 80 per cent of the company’s assessable income is BRE passive income, and its aggregated turnover is less than AUD $50m for 2018-19 to 2021-22, or less than AUD $25m for 2017-18.
If a dividend attributable to the capital gain is eventually distributed to an individual shareholder who is paying tax at the highest marginal tax rate of 47 per cent as a franked dividend, the capital gain would ultimately be subject to an overall effective tax rate of 47 per cent after the franking credits are utilised by the individual shareholder.
Given these differences in tax treatment, it is not difficult to understand why unit trusts are generally preferred as property investment vehicles over companies. Having said that, taxation should only be one of the many factors to consider in any structuring decision. Other factors will also need to be considered to evaluate the merit and appropriateness of using unit trusts in different circumstances. For example, the stamp duty treatment for the transfer of units and shares may be significantly different, depending on the relevant jurisdiction in which the dutiable transaction takes effect.
Potential double taxation problem
Notwithstanding the above, many property investors are not aware that the current tax rules contain cost base reduction mechanisms that may apply to the units in the trust, as well as the actual property held by the trust, which may inadvertently give rise to double taxation.
Consider an innocuous situation where a sole unit holder of a unit trust contributes AUD $1m to acquire units in the trust. The trust subsequently spends the AUD $1m to acquire an investment property.
Disregarding other rental income and expenses, assume that the unit trust claims a capital works deduction of AUD $5,000 in the first year and distributes the cash representing the deduction to the unit holder. This AUD $5,000 distribution is treated as a non-assessable amount because the deduction is inherited from the previous owner and is therefore not a cash expense for the unit trust, and the income of the trust sheltered by this deduction is excluded from the assessable income of the trust but is distributed to the unit holder. The distribution of this non-assessable amount will trigger CGT event E4, which requires the tax cost base of the units held by the unit holder to be reduced to AUD $1m – AUD $5,000 = AUD $995,000. As discussed above, the cost base reduction does not in itself trigger a tax liability upfront.
If the trust sells the property immediately at the end of the year for AUD $1.2m, the taxable capital gain derived by the trust, ignoring the effect of the 50 per cent CGT discount for simplicity, is calculated as follows (all figures in AUD):
|
Capital proceeds |
|
$1.2m |
|
Original cost of property |
$1m |
|
|
Less: Cumulative capital works deductions claimed |
($5,000) |
($995,000) |
|
Taxable capital gain |
|
$205,000 |
The AUD $205,000 capital gain of the trust is assessable to the unit holder as a taxable capital gain, even though the cash representing the actual capital gain distributed to the unit holder is only AUD $200,000, as the AUD $5,000 clawback related to the cumulative capital works deductions claimed is only a tax adjustment.
At some stage, when the units held by the unit holder are either redeemed or cancelled, the capital proceeds on the disposal of the units will still be AUD $1m, even though the cost base of the units is AUD $995,000 due to the previous operation of CGT event E4. Therefore, the disposal will give rise to a taxable capital gain in the unit holder’s hands of AUD $1m – AUD $995,000 = AUD $5,000.
Pulling all of the above together, the unit holder has derived an overall economic benefit as follows (all figures in AUD):
|
Non-assessable amount sheltered from tax |
$5,000 |
|
Actual capital gain in cash |
$200,000 |
|
Total overall economic benefit |
$205,000 |
However, the total amount taxed in the hands of the unit holder is:
|
Taxable capital gain distributed by trust |
$205,000 |
|
Taxable capital gain on disposal of units |
$5,000 |
|
Total taxable capital gain |
$210,000 |
In other words, the AUD $5,000 attributable to the capital works deduction would effectively have been taxed twice.
While the above double taxation issue has been a known problem for a long time, it still exists today in a number of circumstances. Please get in touch with one of our team if you require assistance with unit trusts, taxation or have any other related queries.