Investing in commercial property can be a lucrative decision provided the asset is well located and the right steps are taken in the lead-up to the purchase. From doing due diligence on the property’s viability as a commercial premises to reviewing the lease with the tenant and understanding the tax implications of the purchase given your business structure, there is a lot to get right to realise your return on investment.
In this post, we’ll try and address some of these key considerations to help make the process clearer, while reminding that the advice and guidance of a legal firm with real-world experience in the buying and leasing of commercial property can be essential to getting it right before committing time and money.
Business structures and tax implications
Before embarking on a commercial property investment it’s important to understand how your business structure will affect the tax payable on the asset – which may determine whether it is worth going forward with the investment or not.
Individuals: Owning the property in your own name can be the simplest way to secure a commercial asset, when compared with business other structures. Rental income is incorporated as part of your assessable income and taxed at your marginal tax rate. This means negative gearing losses on the property may be offset against your income.
Like owning residential property, tax must be paid on any capital gain made from the sale of a commercial property, which will be added to the individual’s assessable income. Goods and services tax (GST) may also be charged on the sale price if the ‘going concern’ assumption isn’t satisfied – this means that both the buyer and the seller are registered for GST, that there is a current lease in place on the property, and that everything necessary is being done to support the ongoing operation of the business. The buyer then pays GST on one-eleventh of the sale price and claims credits on purchases that relate to selling the property.
If you’ve owned the property as an individual (or as part of a partnership or a trust – see below) for at least 12 months, you may be eligible to discount your capital gain by 50 per cent.
Partnership: Two or more partners who carry on a business in common with a view to profit are also considered a partnership for tax purposes if they own a commercial property together. Each partner, therefore, claims a share of any net profit or loss incurred by the partnership so that if its commercial property is negatively geared, each partner may offset their share of the net loss against their own income. If each partner is an individual or owns their share through a trust, the 50 per cent CGT discount will apply if the property is sold and a capital gain is made, provided that the property has been held for at least 12 months before its sale.
Company: At the outset it should be noted that commercial property owned by a company becomes one of its assets and therefore can become the subject of civil litigation or bankruptcy proceedings. But signficantly, tax paid on the property’s net rental income is charged at the corporate tax rate, which is lower than a high-earning individual’s marginal tax rate (inclusive of the Medicare levy). Capital gains are also taxed at 30 per cent and some companies may be eligible for small business CGT concessions.
Negative gearing losses on the property, however, must be absorbed by the company and can’t be employed to offset another entity’s income. The loss, however, can be carried forward indefinitely or used to offset the company’s future income and capital gain if the property is sold.
Property held within a company structure must also pay GST on one-eleventh of a commercial property’s sale price, but can claim GST credits on purchases that relate to selling the property.
Trust: Commercial property can be held by a unit trust, family discretionary trust or hybrid trust. Property held within a discretionary trust is generally protected in the event of litigation against a beneficiary of the trust.
Another key benefit of commercial property held within a trust structure is taxation because the trustee can distribute different amounts of net rental income to different beneficiaries based on their tax position each year, minimising each beneficiary’s tax liability. Like individuals and partnerships, if the trust makes a capital gain after owning the property for at least 12 months before it is sold, the 50 per cent CGT discount will be available if the capital gain is distributed to an individual or another trust.
Self-managed super fund (SMSF): Using this entity for purchasing commercial property is considered complex but the pay-off is the substantial tax benefit available. Rental income from the property is taxed at 15 per cent when held by an SMSF, and drops to zero at the time the fund moves into its pension-paying phase.
SMSFs can claim a capital gains tax discount of 33 per cent while the fund is in the accumulation period after the asset has been held by the fund for more than 12 months. The fund pays 15 per cent tax on two-thirds of the capital gain, equal to 10 per cent of the total capital gain. Negative gearing the property under the SMSF structure is not as effective as for an individual, because the losses are only offset against income taxed at 15 per cent during the accumulating phase.
SMSF entities must be registered for GST if they own a commercial property and annual turnover exceeds $75,000. GST must be paid on one-eleventh of the sale price, but GST credits can be claimed on any purchases that relate to selling the property.
It’s important to note tax deductions can generally be claimed by commercial property owners under the structures discussed above. These include interest paid on the loan used to purchase the property, travel costs related to attending the property, repair, maintenance and property management expenses, and depreciation of the asset.
Seek expert tax advice
What we cover here is general only in nature, subject to a number of exceptions and qualifications, and also invariable changes in the law. Suffice to say it is vital that you take advice from your accountant before settling on the structure you intend to use.
The importance of due diligence
The due diligence process is crucial before an investment in commercial property for a buyer to be fully aware of the technical, legal, financial, planning, environmental and risk management issues associated with the asset. Areas requiring close attention before signing a contract of sale include:
Condition of the building: An established service industry to commercial property investors is building consultants, who can be contracted to complete a comprehensive technical report assessing the asset’s structure, from façade and walls (external and internal), roof and guttering, ramps and stairs, entry lobbies, floors & floor finishes (carpets, tiling, etc.), ceilings, stairways and amenities such as kitchenettes.
The report can also assess any mechanical and electrical systems such as lifts, escalators, switchboards and airconditioning, and also address fire protection systems, water supply, sewerage and stormwater systems.
Location: This is perhaps the most important of all considerations for a commercial property and requires a prospective buyer asking questions including:
- Is the building located in a good area with foot traffic, parking and access to public transport?
- Are there zoning regulations which will restrict what commercial use the property can be put to?
- Is the property close to amenities such as schools, transport and other shops?
- Are there direct competitors close by?
Planning and environment: This step involves discovery of current zoning and height restrictions to confirm the property can be used for the commercial purpose you intend; reviewing changes made to the original development application; obtaining copies of original occupation and development certificates; fire safety statements; recent environmental or heritage assessments, and any existing contamination issues (e.g. asbestos, etc.).
If buying vacant commercial land, a buyer should obtain a signed written notice from the seller or agent stating that the land is of a commercial nature and is not capable of being used for residential purposes, now or into the future.
Financial: A financial assessment includes examining an existing lease of the building and, if not leased, the current market conditions that determine the likely value and potential of renting the property.
Assessing lease arrangements involves sourcing lease documents from either the current owner or the tenant to discover:
- expiry dates and options to renew, including the rent review process and its frequency;
- whether there are planning approvals granted prior to entry into the lease;
- that there are no ‘first rights of refusal’ to purchase;
- that there are no other restrictions within leases that might affect the sale or your capacity to operate or expand the building;
- details of any bonds/deposits/bank or personal security guarantees held;
- details of tenant’s agreements regarding maintenance and repair;
- details of any caveats lodged;
- whether the tenant/s are in arrears;
- whether GST is being charged (longer-term leases may not include this provision, which may affect the buyer’s decision to purchase).
Title: The land title of the property should be checked to see there are no liens or encumbrances on the property, no easements or rights of way, and that it is registered in the correct name.
Leases: A would-be buyer should first check the lease of any existing tenant/s to determine both its length and its terms. A lengthy lease on favourable terms to the tenant may be influential on the decision to purchase. Likewise, the need to find new tenants could be off-putting. The length of the lease may also affect the buyer’s ability to renovate and alter the property.
Insurance: Any commercial property should be covered for public liability, contents and the risks of fire, flood, theft and vandalism. If finance is needed to purchase the property, the lender will likely require a policy that provides coverage equal or greater than the value of the loan.
Seek expert legal advice
Legal professionals with specialist knowledge of purchasing commercial property can make the due diligence process described above far more streamlined and stress-free. At PD Law, we can check existing leases, caveats and covenants over the property, title details, existing maintenance contracts, insurance policies and all of the many other details required to make a fully informed investment decision on commercial property.
For more information on any of the material covered in this article, contact PD Law today for a comprehensive initial discussion.
