The Power of Timing: How Tax Deferral Can Enhance Your Property Investment Returns

Investing in unlisted property funds offers many advantages, with tax-deferred income being one of the most valuable yet frequently misunderstood features.

For investors seeking both regular income and tax efficiency, understanding this concept is crucial to making informed investment decisions.

What is Tax-Deferred Income?

Tax-deferred income is a portion of your investment distribution that is not immediately taxable in the current financial year. Instead, the tax obligation is postponed until a future date, typically when you sell your investment.

In unlisted property funds, tax-deferred income arises because of the difference between:

• The cash amount the fund distributes to investors, and
• The lower taxable income amount the fund reports after claiming non-cash deductions

This difference occurs because property funds can claim non-cash deductions such as:

• Building depreciation (the gradual reduction in value of physical structures)
• Plant and equipment depreciation (for items like air conditioning, elevators, etc.)
• Capital works allowances (deductions for construction costs)

These deductions reduce the fund's taxable income without affecting the cash available for distribution to investors.

For investors, this means:

1. You receive your full cash distribution
2. Only a portion of that distribution is immediately taxable at your marginal tax rate
3. The tax-deferred portion isn't taxed now but reduces your "cost base" (the original amount considered as your investment for tax purposes)
4. When you eventually sell your investment, you'll pay capital gains tax on a larger amount due to this reduced cost base

For example, if a fund has a 70% tax-deferred component and distributes $1,000 to you, only $300 is immediately taxable, while $700 reduces your cost base and will be factored into your capital gains calculation when you sell.

The Tax Impact Comparison

All scenarios provide the same cash distributions, but with significantly different tax timing. With higher tax deferral, you pay less tax during the investment period but generally will face a larger capital gains tax bill upon sale.

Benefits and Considerations

Tax deferral creates potential advantages through the time value of money, possible tax rate differentials, and CGT discount benefits. However, investors should be aware that if your cost base reduces to zero, further tax-deferred amounts become immediately taxable. Additionally, the tax-deferred percentage isn't optional, it's determined by the fund's structure and property portfolio.

Who Benefits Most?

Tax-deferred income typically benefits high-income earners in top tax brackets, long-term investors who can maximise the time value of deferred tax, self-managed super funds (particularly those in pension phase), and investors who anticipate being in lower tax brackets when they sell.

When evaluating unlisted property funds, consider the tax-deferred component alongside other crucial factors. While it can significantly reduce taxable income during the holding period, you must account for the impact on your capital gains liability upon exit. The optimal tax profile depends on your marginal tax rate, investment horizon, and return expectations.

Key Terms

Net Operating Income (NOI): The total income generated by a property after deducting operating expenses, but before deducting taxes and financing costs.

Depreciation: The accounting method that allocates the cost of a tangible asset over its useful life, reflecting its gradual wear and tear.

Cost Base: The original value of an asset used to calculate capital gains or losses for tax purposes, adjusted for certain events like tax-deferred distributions.

Capital Gains Tax (CGT): Tax applied to the profit from selling an asset that has increased in value.

Unlisted Property Fund: A type of investment vehicle that pools money from multiple investors to purchase and manage a portfolio of properties, without being listed on a public exchange.

Tax-Deferred Income: Income on which tax payment is postponed to a future date rather than being due in the current tax year.

Capital Works Allowance: A tax deduction for the construction costs of buildings and structural improvements, typically claimed at 2.5% per year over 40 years.

Marginal Tax Rate: The tax rate applied to your last dollar of income in a given tax year.

Disclaimer and Assumptions

This information is general information only and does not take into account the objectives, financial situation, or particular needs of any person. It is strongly recommended that you seek your own independent professional tax advice applicable to your particular circumstances. You should consider whether this information is appropriate for you and consult your financial or other professional advisor before making any investment decision.

This article has been prepared from information believed to be accurate; however, no representation or warranty is made as to the accuracy or adequacy of any information contained in this article. Except insofar as liability under any statute cannot be excluded, the authors, publishers, and their associates, related entities, directors, employees, and consultants do not accept any liability for any loss or damage (whether direct, indirect, consequential, or otherwise) arising from the use of this information.

Assumptions used in the example:

• An investment of $500,000 into an unlisted property fund at a unit price of $1.00 per unit.
• The investment is held for 5 years and sold at the end of this period.
• The fund distributes 6% per annum ($30,000 on a $500,000 investment).
• Three scenarios are compared with tax-deferred portions of 70%, 20%, and 0% respectively.
• The investment is sold for $575,000 after 5 years.
• No allowance has been made for any potential changes in distribution rates over the investment period.
• The investor is eligible for the 50% CGT discount (investment held for more than 12 months).
• The investor does not have any capital losses available to offset gains.
• All calculations are simplified for illustrative purposes and actual outcomes may vary.