COMMERCIAL PROPERTY with Bayleys Commercial North Shore
As always; seek professional advice.
A number of significant tax changes affecting commercial and industrial property investors will come into effect next month, including limitations on the ability to claim deprecation allowances and offset losses from a property against other taxable income.
While tax depreciation allowances on most building structures will end on April 1, depreciation can still be claimed on a wide range of commercial and industrial building fitout assets, however.
When announcing the removal of tax depreciation allowances on buildings in last year’s Budget, the government indicated that a review of commercial property fit out assets would be undertaken to clarify whether these would also lose depreciation allowances from the 2011/12 income year. A similar review on residential building fit out had already signaled the withdrawal of depreciation allowances for many asset categories that are also within commercial buildings.
However, after strong representations by the property sector through the Property Council of New Zealand, KPMG, Bayleys Valuations and other parties, legislation was passed late last year maintaining depreciation allowances on building services assets such as lifts, air conditioning systems, plumbing and electrical reticulation in commercial buildings.
Fit-out deprecation will be able to continue to be claimed on a wide range of commercial property which in addition to office, retail and industrial buildings will include hospitals and other convalescent complexes, hotels, motels and other types of guest accommodation including serviced apartments and camping grounds.
“The legislation recognises the practical reality that items of fitout in commercial, retail and industrial buildings suffer enormous wear and tear compared to residential property,” says John Freeman, a depreciation specialist and a director of valuation and advisory services for Bayleys Valuations.
However, he says a disappointing aspect of the legislation relates to the splitting of tax book value for commercial property owners who have never commissioned a detailed valuation spilt between structure and fitout before. Such owners can now take 15% of the adjusted or current tax book value of their properties, call it fitout and depreciate it at a rate of 2% per annum.
“The 15% fitout allocation seems extremely miserly,” says Freeman. “Bayleys Valuations Ltd has just finished analysing one of the biggest commercial property sales of 2010. It is evident that the purchaser’s loss of structure depreciation has been offset significantly by correctly segregating the fitout component now and not accepting the 15% Government allowance. The level of fitout in this particular case was around 29% of the building’s purchase cost and that sum will be depreciating at about 9.4% per annum from now onwards.”
An analysis of seven other fitout depreciation segregation valuations undertaken by Bayleys Valuations shows that that from 24% (for a warehouse), to 55% (for a hotel) of the total depreciation allowances claimed from a combination of building and fitout allowances were for fitout. In general terms, the fitout depreciation achieved annually from purchase date onwards for these buildings is between 9% and 12%, so again the Government’s 2% annual allowance seems stingy, says Freeman
“These valuations show that even though structure depreciation goes in April, overall loss of depreciation allowances will not be as big as many investors first feared if a comprehensive fitout allocation is undertaken.”
Freeman says property owners should consider getting an allocation of cost between buildings and the fitout components that they own undertaken before April 1, where one is not already in place. For all new property purchases, assets should be correctly segregated at the date of acquisition.
“As we head into a new tax environment, the depreciation rules more than ever now demand commercial property owners correctly segregate assets by tax category to maximise their after-tax returns. Building fitout assets wear out and are regularly replaced for several reasons so claiming your full tax depreciation entitlement on such assets is also sound business practice.”
In another significant tax change affecting property investors from April 1, the government has moved to limit the ability to offset tax losses from a property against other income.
Writing in Bayleys’ latest Total Property magazine, PwC partner Mark Russell says it has become common to invest in property through qualifying companies and in particular Loss Attributing Qualifying Companies (LAQCs) because of the limited liability they provide as well as the ability to offset tax losses.
“When the top personal marginal tax rate became much higher than the company tax rate in 2000, another benefit emerged - when losses arose they were used by shareholders against other income at their marginal tax rate. However, any profits that arose were taxed at the lower company tax rate.”
However, this tax rate inequality has been addressed and LAQCs will no longer be able to pass losses to their shareholders from April 2011, rendering them largely ineffective where they own property that is producing negative returns, says Russell.
At the same time as removing loss attribution for LAQCs, a new tax entity is being introduced called a “Look Through Company” (LTC). An LTC is taxed as if it were a partnership. That means both tax losses and profits flow through to the owners/shareholders and are taxed at their marginal tax rates.
Like QCs, there are criteria to become a LTC. These include having five or fewer “counted owners”. The owners can be either individuals or trusts and there are aggregation rules for relatives and specific rules for trustees and beneficiaries of trusts. All shareholders must also elect to apply the LTC rules.
The losses a shareholder in an LTC can use are limited to the shareholder’s investment in the company (including equity contributed, loans made to the LTC and debt guaranteed by the shareholder). A shareholder can carry forward losses they are unable to utilise to future years to offset against income, but from the LTC only, says Russell. “With careful planning, this limitation should not prevent investors from claiming ongoing tax losses arising from operating a property investment.”
Russell says property investors can elect to transform a QC into a LTC, partnership, limited partnership or sole trader for the 2011/12 or 2012/13 tax years (which must be done in the first six months of each of those years) and no tax issues will arise. After this date, the transition is treated as a deemed disposal of the assets of the QC, and there may be a tax liability on the recovery of depreciation claimed.
“If a property owning LAQC isn’t negatively geared and shareholders are on the top marginal tax rate of 33 cents it may, on the face of it, make sense to maintain the status quo,” says Russell. “However, that needs to be balanced against the potential risk of losses from, for example, the departure of a tenant.
“An investor with a property that is producing tax losses will most likely benefit from electing for their LAQC to become a LTC within the transition period. Given this is limited, investors with qualifying companies should review their positions to determine the most appropriate structure going forward.”
A Bayelys Licensee will always recommend you seek professional advice in the area’s as discussed above.
Daryl Devereux is Director, Sales & Leasing
of Bayley’s Commercial North Shore
(Devereux Howe-Smith Realty Limited).