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Giving with one hand and taking with the other
Affordable housing, managed investment trusts and residential property
As we reported back in May 2017, the Treasurer announced measures to assist with housing affordability in the 2017/2018 Federal Budget. Draft legislation (ED) has recently been released for consultation, but with a couple of kickers, including the denial of certain tax benefits to investors in trusts that would otherwise qualify as managed investment trusts (MITs). Yet again, the Government is in damage control, defending another policy announcement that could have been better handled.
The short of it
If the ED is enacted as currently drafted, it will have the following impact:
Extra Capital Gains Tax Discount
Up to an extra 10% capital gains tax (CGT) discount on disposal of affordable housing (resulting in a total CGT discount of up to 60%).
Trusts do not qualify for MIT status if they acquire residential premises other than affordable housing and commercial residential premises after the effective date.
Non-residents only qualify for the 15% MIT withholding tax rate in respect of affordable housing if the dwelling is held and used as affordable housing for more than 10 years.
Disposals occurring after 1 January 2021.
Residential premises acquired after 4:30pm AEST 14 September 2017. All residential premises from 1 October 2027.
Who is affected
Individuals holding interests in affordable housing directly, in partnership or through a trust.
Trusts investing in residential premises other than affordable housing and commercial residential premises.
Must hold the dwelling as affordable housing for 3 years from 1 January 2018. Earlier holdings and non-affordable housing use will reduce the discount available.
Loss of MIT tax benefits but question real impact on a case by case basis.
The gift in the ED is the extra 10% discount applied to capital gains from affordable housing for individuals.
This incentive is misleadingly intended to apply to CGTevents happening on or after 1 January 2018 – in reality, it can only apply to CGT events occurring on or after 1 January 2021 (see the 3 year requirement below).
Who can receive the extra discount?
Individuals who make a capital gain (either directly, through a trust or partnership) from an ownership interest in a dwelling that was used to provide affordable housing for at least 3 years (not necessarily on consecutive days) after 1 January 2018 will be entitled to a CGT discount of up to 60%, instead of the usual 50%.
What is affordable housing?
A residential premise (land and buildings occupied as, or intended and capable of being occupied as, a residence or for residential accommodation) is used to provide affordable housing if:
- it is tenanted or available to be tenanted;
- it is not commercial residential premises (such as hotels and motels);
- its letting is exclusively managed by an eligible community housing provider (ECHP) (ECHPs are entities registered as providers of community housing services, such as the Uniting Church and Mission Australia);
- the ECHP provides the owner with a certificate confirming paragraphs 1, 2 and 3 above within 31 days of the income year end; and
- no entity is entitled to receive an incentive under the National Rental Affordability Scheme (that is, no double dipping in the Government coffers).
If a tenant or occupant of the dwelling (together with any associates) holds an interest of at least 10% in that dwelling through a MIT, the dwelling is deemed not to be used to provide affordable housing. One might wonder which tenant or occupant of community housing would own more 10% of a MIT (which must inherently be a widely-held vehicle), and what Treasury’s concerns were in including such an integrity measure (especially as a direct holding or using other structures easily gets around this restriction).
One also wonders why the EHCP certificate is necessary as items 1, 2 and 3 above can be assessed and confirmed by the relevant taxpayer itself. All it does is add another level of compliance to a sector that is already constrained for funds and time, and potentially discourages some EHCPs facilitating such investments.
There are some kickers in the ED.
3 year use for affordable housing
To be entitled to the extra CGT discount, the dwelling must have been used to provide affordable housing. This means that the benefit of the incentive will not arise until 1 January 2021, at the earliest.
Beware pre-1 January 2018 ownership
Quite sensibly, the ED provides that, if a dwelling has been used to provide affordable housing for only some part of the time that it has been owned by the taxpayer, the extra discount is pro-rated. So, if the dwelling has been used for affordable housing for 3 years but has been owned for 4 years, then the extra discount is only 7.5% (a total CGT discount of 57.5%).
However, if the taxpayer happens to have owned the dwelling before 1 January 2018, the period prior to 1 January 2018 is excluded from the days counted towards its use for affordable housing even if it was actually used to provide affordable housing. This means that taxpayers who already own such dwellings will never qualify for the full 10% extra discount regardless of how long the dwelling continues to be used for affordable housing after 1 January 2018. Astounding!
Non-resident MIT unitholders
For non-residents who hold interests in MITs, stricter rules apply. Residential premises must be held and used to provide affordable housing for at least 10 years in order for non-resident unitholders to be eligible for the 15% MIT withholding tax on capital gains on those premises. Otherwise, a new uplifted 30% MIT withholding tax will apply.
Trusts holding residential property cannot be MITs
The biggest surprise kicker in the ED has nothing to do with affordable housing at all. In what the media has wrongly labelled a prohibition on MITs holding resident premises(other than affordable housing and commercial residential premises), the ED treats a direct investment in residential premises, or a controlling interest in another entity which holds residential premises, as being ineligible activities that disqualify a trust from being a MIT.
The good news
The ED encourages MITs to invest in affordable housing and commercial residential property. In the case of affordable housing, the ED makes it clear that constructing, altering, improving and repairing affordable housing, as well as preparing it for sale, are eligible activities that do not adversely affect MIT status. Retaining MIT status will allow individual beneficiaries in the MIT to qualify for the extra CGT discount discussed above.
What is so great about a MIT?
A MIT has two clear tax-related advantages:
- Upon making an election, all gains made by a MIT from the disposal of assets are deemed to be capital gains (and therefore, in the hands of the right investor, eligible for the CGT discount); and
- Gains distributed to non-residents from information exchange countries are subject to a maximum 15% tax rate.
By denying eligibility as a MIT, these two advantages disappear and ordinary taxing rules apply. Gains may be treated as being on revenue account, and therefore the CGT discount (including the extra CGT discount) may not apply. Further, distributions to non-residents may be subject to tax at up to 47% (for individuals) or 30% (for companies), albeit a tax credit may be available in the non-resident’s tax jurisdiction.
Trustees investing in residential property will have to consider the risks associated with these issues. However, the length of holding and the regularity of rental income should help ameliorate the risk relating to the revenue character of gains on disposal.
A consequential change is to “disregard” the investing in affordable housing in determining whether a unit trust is a public trading trust (public trading trusts are taxed as companies). If this was a point of clarification, it has the potential to create more confusion!
A unit trust is a public trading trust if, among other conditions, it carries on or controls a trading business. A trading business is one that is not an eligible investment business.
The investing in land for the purpose or primarily for the purpose of deriving rent is an eligible investment business, not a trading business. Some commentators have suggested that the proposed changes mean that investing in residential premises is a trading business. Even the Treasurer told the Australian Financial Review: “You cannot currently put residential properties in a MIT. The sector is asking for a tax concession not available for Australian investors.”
With respect to the Treasurer, the legislation his portfolio is responsible for is clear – there is currently no prohibition on MITs or any other investor holding residential premises. Even the Tax Office has ruled favourably in this area. The ED does not clarify existing law – it limits it.
Is there any way for a MIT to still invest in regular residential property?
For MITs that do wish to invest in residential property, all is not lost. It is still possible under the ED for a MIT to hold interests in another entity (that is, a trust or company) that holds a residential premise, so long as the MIT does not “control” that other entity.
Recognising that MITs may already hold residential premises, transitional provisions are proposed to allow MITs to divest their existing holdings within 10 years without affecting their MIT qualifications.
Consultation closes on 28 September 2017. Please contact us for more information or if you would like to contribute to the consultation process.