Direct property funds pay income to investors in the form of distributions. These distributions include the rental income received from the properties and other income such as interest. Part of this income distribution may include a “tax deferred” component.
Key benefits of tax deferred income for investors
- Tax is not applicable in the year in which income is received (thus the term “deferred”). The compound impact of reinvesting cash that has not attracted tax over many years is significant.
- Tax deferred income is brought to account when the investor sells the asset and is discounted by 50% (PAYE) or 33% (Super).
- Tax deferred income in a superannuation fund can be transitioned to an allocated pension, without triggering an income or capital gains tax event. Allocated pensions pay no tax.
Tax deferred component of a distribution affects an investor’s tax
Commonly, an investor would pay tax on the income received from an investment at their marginal tax rate (MTR) in the financial year in which the income is received.
The tax deferred portion of the income received from a property trust is treated differently. The tax deferred portion of the income received is deferred until the property trust investment is sold. At this time, the investor includes the tax deferred income as part of the capital gains tax (CGT) calculation.Tax is then paid at the investor’s MTR that applies when the investment is sold.
An investor (individual) may benefit from the CGT rule that only 50% of the gain is taxable if the investment is held for longer than 12 months. This benefit also applies to the tax deferred income.
Tax deferral can be of particular benefit to investors who redeem an investment when they retire and move into a lower income tax bracket. Commonly retirees have a low marginal tax rate compared to their marginal tax rate prior to retirement.
Case Study – Invest $20,000 in cash
Hayley has invested $20,000 in a one-year term deposit that pays her an interest return of 6% p.a. Her MTR is 39.5%.
Hayley receives interest of $1,200 ($20,000 x 6%) on her term deposit. She needs to include this income in her tax return for that financial year. Based on her marginal tax rate, Hayley is likely to pay tax of $474 on the interest from her term deposit ($1,200 x 39.5%).
Case Study – Invest $20,000 in unlisted property
John is two years from retirement and invested $20,000 in a direct property investment that pays an income distribution of 8% of which 70% of this distribution is tax deferred. His MTR is currently 39.5% and expects it to fall to 16.5% in retirement.
John will receive an income return of $1,600 p.a. of which $1,120 is tax deferred and only $480 is taxable in each financial year at his MTR. This equates to tax payable of $189.60 each financial year. The tax on the remaining income amount is deferred until the investment is sold.
John decides to redeem the direct property investment when he retires. To illustrate the potential benefits of the tax deferred component compared to an investment with no tax deferred component, it is assumed that the capital value of the direct property investment has not changed. When sold, the tax payable on the deferred component is:
Capital gain = Redemption price – (Acquisition price – Tax deferred income received during the time held) x MTR
As such, the capital gain in this example is: $2,240 = $10,000 –($10,000 – $1,120 x 2 years)
The CGT payable on this amount is: $184.80 = 50% x $2,240 x 16.5%
The total tax paid (income + CGT) on the distributions over the two years has been: $564.00 = ($189.60 x 2 years) + $184.80
If the income distribution did not contain any tax deferred components, then the total tax payable each year would amount to $632 ($1,600 x 39.5%) or $1,264 in two years. Over the two years the tax deferred component of the income distributions and the movement into the lower tax bracket saved John $700 ($1,264 – $564).
Case Study – Invest $20,000 in direct property via SMSF
Adrian is two years away from retirement and invested $20,000 in a direct property trust via his self managed super fund (SMSF). The trust pays an income distribution of 8%, of which 70% is tax deferred.
The MTR of his superannuation fund is 15%. Adrian’s superannuation fund will receive an income return from the property trust of $1,600 p.a. of which $1,120 is tax deferred and only $480 is taxable in each financial year at 15% MTR. This equates to tax payable of $72 each financial year. The tax on the remaining income amount is deferred until the investment is sold.
Adrian transfers the investment from his superannuation fund to allocated pension funds at retirement. This does not trigger an income or CGT event. Adrian decides to redeem the direct property investment after he retires. The deferred income amounts are included in the CGT calculation. Any CGT is taxed at the pension funds marginal tax rate, which is zero.
Effectively Adrian pays no tax on any capital gain made on the trust and the deferred tax income amounts of $2,240 ($1,120 each year) are tax free. If the income distribution did not contain any deferred components, then the total tax payable each year would amount to $480 ($1,600 x 15% x 2 years). Over the two years the tax deferred component of the distributions saved Adrian’s SMSF $336 ($480 – $72 x 2 years).
Buying direct property in a superannuation fund and selling it after retirement
Some investors may invest in a direct property fund through their superannuation fund. When the investor retires after age 60 and commences the pension phase, the marginal tax rate of the pension fund is zero.
This may mean that if the direct property trust is sold in the pension phase, the tax deferred portion of the income is received effectively tax free.
Speak with your financial planner about how the benefits of tax deferred income may apply to you.
Source: Charter Hall Direct Property, October 2011
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