Tax Issues When Investing in Commercial Properties

By Eddie Chung | 13 Jan 2014
Eddie Chung

Commercial properties have many advantages, foremost of which is their ability to generate good cash flow without having to worry about the outgoings. If you’re thinking of investing in commercial properties, you need to be aware of these potential issues. Eddie Chung explains

In many ways, investing in commercial properties is quite similar to investing in residential properties. However, there are some differences between the two. If you are like most investors who started off investing in residential properties, it may be a good idea for you to understand these differences before dabbling in commercial properties. On the other hand, you may already own a commercial property and use it for your own business, which may entitle you to a number of additional concessions.

Risk and return

Generally speaking, commercial properties often return a higher yield than residential properties, but the ‘risk and reward principle’ applies – while commercial properties have the potential of giving you a higher return on investment and eventual capital gain when you sell, they are also riskier than residential properties.

The reason for this is that the demand for residential properties, unless oversupplied, is generally not as sensitive to economic conditions as demand for commercial properties, while a sluggish or declining economy could quickly put people out of business and therefore reduce the need for commercial premises.

This heightened sensitivity can in turn affect the value of commercial properties in a more acute and drastic manner.

As a general proposition, the value of a commercial property closely correlates with the lease on the property. If a commercial property is no longer under a lease or the lease will expire in a relatively short period, the value of the property will generally be expected to fall. In contrast, any price fall associated with residential properties is generally less dramatic and usually happens progressively over a longer period of time but for the happening of any drastic event.

While you may need to brace yourself for higher risks if you wish to venture into commercial property investment, your return may be significantly higher as well.

Lease incentives

It is a lot more common for landlords of commercial properties to provide lease incentives to tenants, in particular in a ‘tenants’ market’ where the vacancy rate is on the rise.

The tax treatment of lease incentives can be quite complex, and landlords are well advised to fully understand their tax implications before offering such incentives to tenants.

If a landlord provides a tax-free period to a tenant, the foregone rent is neither assessable nor tax deductible to the landlord. On the other hand, the landlord may still claim other expenses incurred on the property (eg council rates) during the rent-free period. However, if the landlord provides a cash incentive to the tenant, the cash outlay will be tax deductible up front. The same applies if the landlord pays a cash amount to entice the tenant to vary the lease, relocate or stay on the premises.

If the landlord directly undertakes a fit-out of the property for a tenant or makes a fit-out contribution to the tenant, the tax treatment will depend on whether the landlord will retain ownership of the fit-out under the lease agreement.

If the landlord retains ownership of the fit-out, the costs incurred by the landlord will need to be analysed to determine the portion of the costs that are tax deductible up front, depreciable over the relevant depreciating assets’ effective life, and/or eligible for the capital works deduction. On the other hand, if the tenant assumes ownership of the fit-out immediately, the costs incurred by the landlord will be tax deductible up front.

Depreciation and capital works deduction

As a landlord, you may be entitled to claim a tax deduction for depreciation and capital works on any improvements you make to a property.

A depreciation deduction claim is generally related to depreciating assets that are not affixed to the building and are functional units in their own right. The claim is based on the effective life of that specific asset. You are allowed to use the effective life provided by the tax office, or to self-assess. Naturally, you will need to be able to defend the self-assessed effective life of an asset if challenged by the tax office.

A capital works deduction claim is usually related to the building and structural improvements that are permanently affixed to the land and building. The claim is generally limited to 2.5% p.a. on the construction expenditure incurred on a straight-line basis, but for some minor exceptions.

As a landlord, if you incur costs on improvements, you may only claim depreciation or a capital works deduction on the costs to the extent that the improvements are owned by you under the lease agreement.

If you do not have ownership over the improvements, you may be entitled to write off the unclaimed portion of the costs as a tax deduction, depending on the timing of when you no longer have ownership of the improvements.

If the tenant incurs costs on improvements and you subsequently assume ownership of those improvements, you are considered to have acquired those improvements for their market value when the change of ownership occurs. In reality, it is not uncommon that the improvements no longer have material value by the time the tenant moves out of the premises.

It is often not straightforward to determine whether the landlord or the tenant has ownership of an improvement. The determination of this ownership issue must be based on a clear analysis of the lease agreement and the relevant legislation of the jurisdiction involved.

Lease surrender payment

As a landlord, if you wish to terminate a lease prematurely before it expires, you may try to encourage the tenant to agree by offering them a lease surrender payment. Alternatively, your tenant may pay you a lease surrender payment as compensation to you for terminating the lease early. If you own the property as an investor, the lease surrender payment you make to a tenant is generally not tax deductible and is simply added to the cost base of the property for future capital gains tax (CGT) purposes.

However, if you incur the lease surrender payment in the course of carrying on a business (eg you carry on a business of leasing multiple properties) or in connection with ceasing to carry on a business, you may write off the lease surrender payment at 20% per year over five years, rather than include it in the cost base of the property, provided that the payment is for the purpose of terminating a lease and is not made for entering into a new lease with the same tenant under similar terms.

On the other hand, if you receive a lease surrender payment from your tenant, the payment will either be assessed as income or as a capital gain to you.

If you are a passive property investor, the payment will likely be a capital gain, which may potentially qualify for the CGT discount. If you own the property in the course of carrying on a business, the lease surrender payment will be assessable income in your hands.

Small-business CGT concessions If you own a commercial property at which you carry on an active business, you may be entitled to the small-business CGT concessions if you sell the property, even if the business has been carried on by a related entity of yours that does not directly own the property.

The suite of small-business CGT concessions is extremely powerful, and includes the 15-year exemption, the 50% active asset reduction (in addition to any applicable 50% CGT discount), retirement exemption, and small-business replacement asset rollover. Using one or more of these concessions in conjunction may substantially reduce or even eliminate any taxable capital gain on the sale of a property.

To access the concessions, there are a number of qualifying conditions to consider. Given the tax attractiveness of these concessions, professional advice is highly recommended as the tax office regularly reviews and audits arrangements that have applied the concessions, as part of its tax compliance program.

Final words

More often than not, commercial properties involve higher-value transactions, which means that any tax implications associated with them are generally higher in value compared with those associated with residential properties. Given the higher stakes involved, it is important that correct tax advice be obtained to ensure that you, as a commercial property owner, are maximising the return on your investment.

Eddie Chung is partner, tax & advisory, property & construction, at BDO (Qld) Pty Ltd. Contact or call (07) 3237 5927

Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article

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