A must read for current and prospective commercial property investors!
Beyond its immediate impact, the COVID-19 pandemic also shook up the commercial real estate market. The long-term ramifications of this will be felt for a while. For example, with many employers incorporating flexible work from home policies, there has been a substantial shift in how businesses factor in the importance of and need for spacious offices. In addition to the impact the pandemic has had on the commercial office sector, a substantial impact can also be seen on the retail sector with the increasing number of vacancies in retail spaces over the last 12 months. With all these long-term issues engulfing the property market, owners of commercial properties will be considering offering generous lease incentives to attract prospective tenants.
As a commercial property investor, it is important to be aware of the tax issues surrounding lease incentives. Depending on the type of incentive being offered, the tax and cash flow impact will differ. To ensure you do not miss out on valuable tax deductions, we have put to together some of the most commonly missed deductions you should consider.
LEASE INCENTIVES
Lease incentives are often provided by commercial property owners to attract new tenants – a common trait in a ‘tenant’s market’ where the vacancy rate is on the rise.
The tax treatment of these incentives will depend on the nature of the incentive provided. For example:
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Rent-free period or a reduced rent period: The landlord is not allowed any deduction in respect of the rent forgone because it is not a loss or outgoing incurred. However, the landlord will pay tax on the reduced rent amount.
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Holiday package or other entertainment: These incentives are not an allowable deduction as expenditure relating to providing entertainment is specifically denied.
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Fit out contributions: With free fit-outs, the treatment will depend on whether the ownership of the fit out has passed to the tenant or remains with the landlord. If the landlord owns the fit outs, the landlord will be eligible to claim either a capital allowance or capital works deduction, depending on the nature of the cost. On the other hand, if the ownership of the fit out is transferred to the tenant, then an immediate deduction is available to the landlord.
Depending on the lease incentive provided, the difference in tax deduction claimable can be quite significant. For example, if a landlord provides a rent reduction of $100,000 on a 10-year lease, the rent forgone by the landlord is $10,000 per year. Effectively not paying tax on $10,000 per year.
On the other hand, if the landlord charges full rent and contributes for office fit-outs of $100,000 and the ownership of the fit-out remains with the landlord, then the landlord may be able to claim these at 2.5% - assuming the capital works provision is applicable (i.e. the deduction claimable every year will be $2,500).
Comparing this with a scenario where the landlord contributes for office fit-outs of $100,000, and the ownership of the fit-out passes to the tenant, then the landlord will be able to claim an immediate deduction of $100,000 in the year the incentives were provided.
In all three cases, the cash forgone or spent by the landlord is the same ($100,000), but the outcome for tax vary significantly. Therefore, careful consideration should be given when structuring lease incentives.
It is also important to note that the ATO may apply the anti-avoidance provisions if the purpose of providing the incentives was not to induce tenants to enter into the lease. For example, when it is done for the purposes of benefiting an associate or shifting income to an associate with carry forward losses.
CAPITAL WORKS
Capital works are income tax deductions that may be claimed for buildings and structural improvements. This can be claimed at either 2.5% (over forty years) or 4% (over twenty-five years), depending on the type of property and the construction commencement date.
A quantity surveyor’s report will generally provide a schedule of the capital works deductions claimable each year. We recommend commercial property owners obtain this report, as this deduction may result in substantial tax savings. The cost of preparing a quantity surveyor’s report is also tax deductible. If the actual construction cost is unavailable, quantity surveyors can provide an estimated construction cost, and capital works can be claimed based on this estimate. Along with the capital works claim, the report also outlines any deductions that are claimable on depreciation of plant and equipment. Plant and equipment will generally have a higher depreciation rate than buildings and structural improvements.
It is important to note that there are some costs that cannot be claimed, such as landscaping and land acquisition (together with on-site preparation costs, such as clearing and demolishing buildings).
The tax deduction for capital works will have an impact on the calculation of the cost base for the commercial property. Any deductions that arise under capital works will be excluded from the CGT cost base or reduced cost base to avoid any double dipping. For example, if the cost base of a building is $1 million and capital works deductions of $50,000 are claimed, the cost base of the building would be reduced to $950,000. This adjustment is applicable for assets acquired after 13 May 1997, or where the asset was acquired before that date, but the expenditure that gave rise to the capital works deduction was incurred after 30 June 1999. If the entity selling the property is eligible for the 50% capital gain discount, obtaining revenue deductions for capital works generally provides a better outcome as tax will only be paid on 50% of the capital gains.
LEASING EXPENSES
Any leasing expenses paid to secure a new lease is immediately deductible.
Taxpayers can also claim an immediate deduction for lease documentation expenses. These expenses may include costs relating to preparing, registering or stamping a lease of property to the extent the property is used for the purpose of producing assessable income.
MAKE GOOD COSTS
Most leases will contain a make good provision which requires the tenant to leave the leased premises in the same condition as at the commencement of the lease.
Any cash receipt by the landlord to restore the premises would generally be treated as assessable income in the hands of the landlord. The make-good works required by the landlord after the tenant has left will be treated as immediately deductible, or capital depending on the nature of the work undertaken by the landlord.
Make good expenses can be treated as deductible repairs:
- Where it restores the function of an asset without improving it
- Where it replaces the parts of an asset rather than the entire asset
- When it does not add to or change the character of the asset.
For example, if a property had general wear and tear, the landlord may have to undertake various repairs and maintenance such as repainting damaged walls and replacing tiles in heavy foot traffic areas. If only repairs and maintenance are required to bring the property back to its original condition, then an immediate deduction will be available to the landlord. However, if the landlord undertakes work that involves improving the function of the assets or upgrading an asset, then these expenses may be capital in nature and will be claimed under the capital allowance or capital works measures.
Quite often, better tax outcomes can be achieved by discussing with tax advisors at the outset. For example, fully understanding tax implications before offering a lease incentive to a tenant will ensure you are not hit with any surprises during tax time.
Read the next instalment for Property and Taxes, where we discuss other tax considerations for commercial properties.
MORE INFORMATION
If you have any queries, or would like to make sure you are not missing any tax deductions for your commercial property, please contact your local Moore Australia advisor.
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