Many clients have questions concerning issues connected to co-ownership of a commercial property. To answer these questions we take the specific example of four GPs buying and developing a new surgery, but its content is generic and therefore applies just as much to non-medical persons and non-medical properties.
Co-ownership of commercial properties is becoming more and more of an issue with clients. Clients are becoming more aware of this asset class and, aware of the high entry price, are often combining together to co-own property that may be beyond their reach as individuals. This is usually a good move but there are no guarantees and we recommend clients consider all proposals very thoroughly before proceeding with them.
The best structure is a company as a trustee of a unit trust or a hybrid trust, with the level of debt in the trust controlled so that the property will be cash flow positive and the trust will have a net income for income tax purposes rather than a tax loss.
Why is this the best structure?
This is the best structure because:
- it is income tax efficient. There are no problems with losses being locked up, and therefore not available to the owners, and there is no taxing point until the net income has flown through to the ultimate beneficiary, usually a low tax rate relative or possibly a company
- it is capital gains tax efficient: the 50% CGT discount on the sale of assets after 12 months applies, and this CGT exempt amount can be paid out to the unit holders without a further tax charge;
- it is easy and cheap to admit new owners and to exit old owners. This can be done either by a transfer of units from the old owner to the new owner or can be done by an issue of new units or a cancellation/redemption of old units. There is no stamp duty on these admissions and exits (subject to one exception) whereas if the owners held the property in their own names there would be a stamp duty charge, and a more cumbersome and costly transfer process, each time a new owner was admitted or an old owner exited. The exception arises where the so called land rich company rules (which also apply to trusts) apply, ie where the net value of the land in the trust is more than $1,000,000 and there is more than a 50% cumulative change in ownership: separate legal advice should be sought if a proposed transaction could trigger this rule; and
- it is easy to administer. The trust has its own bank account and runs its own profit and loss statement and balance sheet. There is no mingling of funds, apart from the distribution of net income. The trust will register for GST if its rent income is more than $75,000 a year, and it will have its own ABN and TFN. It will lodge its own income tax return each year, and the trustee company will lodge an ASIC return and pay an ASIC fee of $236 per year.
But it is possible that another structure can be better suited to a particular project.
How much does a trustee company and a unit or a hybrid trust cost to set up and run each year?
It usually costs about $1,800 to set up a company and a trust. If a hybrid trust is used there is also a separate stamp duty charge of around $200. The annual accounting costs depend on the time taken to prepare the accounts and the tax returns. These are largely determined by the number of transactions that occur. It’s safe to assume that the accounting costs will be at least $1,000 a year.
There is a $246 annual ASIC fee.
How is the debt structured?
Most commercial properties are bought and held using debt.
There are a number of different ways to structure the debt, and each has advantages and disadvantages. Our usual preference is to have the unit holders contribute equity of 30% plus transaction costs, including stamp duty, which really comes out of their own resources or borrowings against other assets they hold, such as their home. This makes the total equity contribution about 37% of the purchase price.
This is contributed to the trust as capital, in return for an issue of units. So, if the total cost of the property is $1,000,000, including stamp duty, and there are four unit holders, then each unit holder would contribute $92,500 (ie $1,000,000 times 37% divided by 4). This $92,500 would be paid into the trust before settlement, and the trustee would use this capital receipt of $370,000, plus the $630,000 of borrowings, to settle the purchase of the property.
Technically the unit holders are issued with units at the time their money is paid in. But as a practical matter the paper work to record the issue of units would not be completed until the trust’s first set of accounts and tax return is being prepared. This is because there are usually a few other transactions which impact unit holdings and it is simpler and cheaper to wait and see how the dust settles, and then document them all in one go, rather than have a series of paper chases during the year.
We have chosen equity of 30% (plus stamp duty) because the larger banks will normally lend 70% of the market value of a commercial property without any collateral security other than directors’ guarantees. This means the four owners/unit holders can buy and hold the property together without having to give cross securities over each other’s home and other assets. Each of the four owners may borrow this equity of 30% (plus stamp duty) if they wish to. They just cannot borrow against the security of the new property. It is not unusual for an owner to borrow their share of the owners’ equity, in this example, $92,500.
Who should be the unit holder?
If clients have family trusts, then the family trusts should be the unit holders. This is because they enable the trust’s net income and net capital gains to be distributed on to clients’ family members or other related persons. Family trusts are discussed in detail a number of our memoranda, and you should contact us if you need copies of these documents.
If a client does not have a family trust then a spouse can be considered, presuming the spouse faces a lower tax rate and is not in a risky profession or occupation. Or they could consider using a hybrid trust deed and distributing net income and net capital gains to family members or other related persons direct from the hybrid trust. Hybrid trusts are discussed in detail in a number of our memoranda and you should contact us if you need copies of these documents
Self-managed super funds should not be unit holders.
What will the profit and loss look like?
By limiting the amount of debt in the trust one can maximise the prospects of having net income in the trust, and not a tax loss, for taxation purposes. This is important because a trust cannot distribute a loss, and losses in trusts can create problems elsewhere. It is simplest and safest to structure the debt so that the prospects of a loss are, if not eliminated, at least minimised.
This means the trust’s profit and loss statement might look like this:
|Interest ($630,000 times 7%)||$44,000|
This will be distributed equally to each of the four unit holders, that is, they will be required to include $5,000 as assessable in each of their tax returns. How this is taxed will depend on each unit holders’ own tax profile.
How does the tax distribution differ from the cash distribution?
The potential cash distribution to each unit holder is $7,500. This is because depreciation, which is a negative in the net income calculation, is a non-cash item and therefore does not reduce the amount of cash available for distribution. $10,000 divided by four is $2,500, which means potentially extra $2,500 cash is available to each unit holder. This extra $2,500 is tax-free. Whether the actual cash distribution is $7,500 per unit holder is another thing. The trust will presumably have to repay the $630,000 borrowed. The actual cash distribution will be reduced by the amount of borrowings that are repaid each year.
The unit holders will have to show $5,000 as income in their tax returns irrespective of whether they receive it. This is because this is what the tax law says. Sometimes unit holders get upset because they are paying tax on income that they have not received in cash. This can create cash flow problems but they have to remember that the value of their units will go up by an amount equal to the shortfall. So they are still in the same position overall.
It’s not a bad idea to choose a bank which none of the investors has any other borrowings with. This way there is no risk of client’s private affairs being tangled up with the business premises. This may seem excessively cautious, but we can remember the late 80’s and early 90’s and there were definitely problems like this: Dr Smith’s own bank lent him money for his own investments and also lent money to the property trust, of which he owned one quarter. When property prices fell, and the 70% security was no longer there, the bank was able to pump up the interest rate on both the property and Dr Smith’s other investments and businesses, and there was nothing he could do about it. His partners were all in the same boat.
If possible, use a different bank for your co-ownership exercises.
We are often asked “which bank is best?”, and the answer is they are really all the same. You should choose the bank which offers the lowest interest rate. With commercial property lending the concept of service does not really apply. Once the loan is in place and the property is settled its just automatic pilot, and automatic repayments, for the term of the loan. So the answer to this question is “the one with the lowest interest rate”.
What if someone wants to leave?
A client wanting to leave the investment is not an unusual event. If there are four investors in a group, and one leaves every five years, that means there is an average stay of 20 years. That’s a pretty stable investment. This means that everyone needs to be up-front at the beginning about this issue and make sure everyone knows what will happen. The procedure for someone leaving should be set out in an agreement (see below) and should be something like:
- transfers to related parties can be done any time without the consent of the other unit holders; but
- transfers to non-related parties can only be done if a procedure is followed, and this procedure will involve:
- offers to the other unit holders to sell to them at market value, in their proportions; and
- if any unit holders fail to take up the offer to buy, those units are then offered to the other unit holders in their proportions; and
- if after three months the offer is not accepted the units can be sold to other persons.
In practice this type of procedure tends to be superseded by negotiation and discussion between the parties. The fact that the unit holders’ agreement prescribes a set procedure does not mean that it has to be followed to the finest detail, if all the unit holders agree to this.
How are renovations dealt with?
It is not unusual for a commercial property to be renovated. This may be at the time the premises are bought or it may be much later.
The renovation issues are much the same as the ownership issues. However, if equity has been built up (ie borrowings re-paid and/or values have increased) the bank may be prepared to lend 100% of the renovation cost. But if this is not the case the unit holders may have to contribute a further amount to create additional equity to allow borrowings for the renovation to proceed. The unit holders may be able to persuade the bank that the renovation will add net value, ie increase value by more than the renovation cost. But we have found banks normally take a more conservative view and if anything discounts the value back.
The rent should be increased post-renovation to reflect the increased value. This will create cash flow for the trust that can be used to service the renovation debt.