|Summary: Searching for tax-effective income in today’s market, investors should not ignore commercial property, especially unlisted property trusts.|
|Key take-out: Keep in mind that for unlisted property trusts the benefit of higher tax-effective income comes at the cost of higher capital gains when the investment is realised. But borrowing costs can be negatively geared.|
|Key beneficiaries: General investors. Category: Investment strategy.|
Successful investing cannot be achieved without due regard to tax. Today I want to show how tax plays a key role in every stage of investing … and to throw some light on one of the less well known areas of tax-effective investment.
Obviously all investors must seek to have a diversified portfolio. One of the most favoured asset classes for Australians with a diversified portfolio is direct residential property investment. This asset class firmly fits into the accumulation and consolidation phases, but can be found wanting once a person enters the drawdown phase. This is because net residential rental returns are often less than 3%.
The tax effectiveness of a property investment, which is increased for buildings constructed after 1985, is maximised through the combination of non-cash deductions for depreciation of fixtures and fittings, and the 2.5% deduction for the capital cost of the building.
The higher the marginal rate of tax paid by an investor, and the greater the non-cash depreciation and capital write off, the more tax effective and cash flow positive a residential investment can be. Unfortunately when an investor reaches the drawdown stage, although being cash flow positive, the actual level of income produced compared to the asset’s value is low.
Investors with large portfolios of residential investments need to seriously consider an organised sell-down as part of preparing for retirement. If this is left until retirement, the ability to reduce tax payable on capital gains, by making tax-deductible super contributions, will not be available. In addition, funds produced cannot be contributed to superannuation.
In the direct property asset class, commercial property can be a valuable addition to an investment portfolio. The problem is that commercial property requires access to large amounts of capital and/or the ability to borrow large sums. Although producing superior income returns, the capital growth is often not as great as residential property.
Direct commercial property income returns over the last 25 years have been remarkably stable. Analysis by real estate research group IPD of direct property returns from March 1987 to March 2012 shows a rolling annual income return of approximately 8%. Capital returns have been more volatile, with gains of more than 30% and losses of around 15%.
The barriers to entry into direct commercial property were meant to be overcome through listed property trusts. Unfortunately, Australian investment history shows that listed property trusts are more an investment in a subset of the All Ordinaries Index rather than being a true property investment. Income has been a combination of rents and development income, and the value has had more to do with market sentiment than the underlying value of property.
Unlisted property trusts
There is another investment that has all of the benefits of a direct commercial property without needing to have access to large sums of capital. That is an investment in unlisted property trusts. In addition to having higher income returns than most other asset classes, unlisted direct property trusts offer major tax advantages with the potential for capital growth as well.
There are three main types of unlisted property trusts:
- The first are reasonably open-ended continuous property trusts that allow investors to access their investment at regular periods so that they can draw down cash more easily.
- The second and least attractive are open-ended trusts that sporadically offer redemption opportunities. These unlisted property trusts are less attractive as the fund manager has too much control over the investor’s money and their access to it.
- The third type are fixed term unlisted property trusts. In many cases, these are for single properties for fixed periods of five to eight years. One of the few criticisms made by ratings agencies of these investments is that they do not meet the diversification requirement. The need to diversify in this asset class is done by holding multiple unlisted property trusts, with varying termination dates, which provides capital proceeds for either re-investing or to meet income requirements.
Unlisted property trusts have a high percentage of non-taxable income due to the depreciation deduction and the write-off of the capital cost of the building. Income yields can be as low as 5%, and as high as 10%, but in most cases average between 7.5% and 8.5%.
The higher percentage of non-taxable income comes from a combination of depreciation of fixtures and fittings, write-off of the building cost, and the amount of borrowing within the trust. The non-taxable income tends to be higher in the earlier years of the investment and reduces over time.
For every benefit there is usually a cost. For unlisted property trusts the benefit of higher tax-effective income comes at the cost of higher capital gains when the investment is realised. Where borrowed funds are used to invest in unlisted property trusts the impact of this cost is reduced, because 100% of the negative gearing loss can be offset against other income while only 50% of the capital gain is assessable.
In the final analysis, when it comes to investors wanting to produce superior income returns that are tax effective, using a balanced approach with investments across all of the asset classes is the best approach.
I will return to my regular Ask Max column next week.
* Max Newnham will be appearing at Eureka Report’s ‘Maximising Income for the Future’ conference to be held at Sydney Town Hall on Tuesday May 27: To find out more about the event or book a ticket please click here.