WHEN IT comes to property investment, unless you have ample capital at your disposal, most people start off by investing in lower-value properties such as residential houses and units.
However, it may not always be appropriate to invest in residential properties. For instance, the residential property market may have entered a sellers’ market cycle, or an oversupply of rental stock may be driving down residential rents. In comparison, commercial properties may present a much better investment opportunity under the prevailing market conditions.
Despite all the signs suggesting that investing in commercial properties
is superior to investing in residential properties, the most common challenge is the lack of accessible capital.
That’s because of the generally higher investment entry point of commercial properties and the fact that lenders are not usually prepared to lend as much of the full value of the property as they do for residential properties.
In circumstances like this, an option that may enable you to make the investment is to partner with other investors who can contribute some of their capital.
Another common scenario might involve a property developer who has the expertise to identify good sites for development. While the developer may have the expertise in sourcing and developing the right property, they may not have sufficient capital to invest in the property after it has been developed.
It is therefore not uncommon for a property developer to create an opportunity for themselves by identifying a few investors in their network who may wish to own the property after it has been developed and get a minor
‘free carry’ stake in the property as part of the development deal.
Structure: Using a private unit trust
One of the most common structures to use for a private property investment syndicate, as opposed to a managed investment fund where investors are procured from the public at large, is an unlisted private unit trust.
The trust is created by virtue of a trust deed, with a trustee holding the trust property on behalf of the trust beneficiaries. In the case of a unit trust, the trustee will issue units to the beneficiaries as unit holders, which are usually based on the proportionate amounts of investment monies contributed by each unit holder.
The investors may use related entities to hold the units. For instance,
"The trust is created by virtue of a trust deed, with a trustee holding the trust property on behalf of the trust beneficiaries"
it is common for investors to use their own family trusts to own units in a unit trust.
Given that multiple parties will be involved in the investment, it is prudent to set up a new shelf company to act as the corporate trustee for the unit trust. The corporate trustee should refrain from entering into any transaction with third parties in its own right to ensure that its risk exposure is minimised at all times.
As the corporate trustee controls the trust, the directorships of the corporate trustee, being the controlling minds of the trustee company, will need to be carefully considered. In most cases, each investor will have a representative on the board of directors of the corporate trustee.
Further, it is also important for all the unit holders to enter into a unit holders’ agreement. This agreement, among other things, provides for equitable decision-making processes. For instance, even though all of the unit holders may be represented on the board of the corporate trustee, it may be more appropriate for some decisions to be made based on the proportionate ownership of the investors in the investment, rather than equal representation as directors of the corporate trustee.
For instance, the future decision to sell the property should perhaps be determined by an ordinary or special resolution of the unit holders, while each unit holder will have a vote for each unit they own; this will ensure that the minority unit holders cannot collude to frustrate the sale of the property if the investors who have a larger stake in the investment wish to sell.
The unit holders’ agreement may also provide rules that will dictate how potential future scenarios, if they arise, may be resolved. Questions you may want to consider include:
• What if one of the investors wishes to exit their investment in the future before the property is sold? What is the process the investors would need to follow?
• Would the remaining unit holders have the ‘fi rst right of refusal’ to buy the units of the exiting unit holder based on their existing proportionate ownership?
• If so, how will the price of the units be determined?
Whatever the mechanism adopted, a primary purpose of the unit holders’ agreement is to anticipate future situations that may potentially transpire and provide contingencies to minimise any potential uncertainties, problems, and disputes.
For completeness, it is often asked whether multiple unit trusts should be used if the investors are investing in more than one property together. There is no one-size-fits-all answer to this question, but the relevant facts of the circumstances will ultimately determine the outcome. For example, are the properties owned by the same investors in exactly the same proportions? Are the properties exposed to materially different risk profiles? In any event, if multiple unit trusts are required, the establishment and ongoing costs associated with the structure will also be higher, so there needs to be a compelling reason for multiple unit trusts to be used.
Financing your syndicate’s investment
Once the unit trust has been established and ‘capitalised up’ (ie when all the unit holders have contributed their investment monies into the unit trust in return for their units), the trust may need to organise finance to enable it to obtain sufficient funds to acquire the property.
For a commercial property loan, a lender may lend up to 70% of the property’s market value under prevailing market conditions, while the lender may lend up to 80% (or more) for a residential property. The lender would normally take security over the property to satisfy its security requirements.
If the value of the property is not sufficient to satisfy the lender’s requirements, they may ask for more security from the unit holders, but it
is uncommon for this to happen as the reason for setting up the unit trust in the first place is to pool all the unit holders’ monies together to ensure that the trust has sufficient equity to purchase the property.
In addition to security requirements, the lender will want to ensure that there is sufficient income in the future to enable the unit trust to make the loan repayments. To that end, if any expected rent and other income from the property is insufficient to meet these requirements, the lender may need guarantors to top up the income-earning capacity of the unit trust to satisfy its serviceability requirements.
For instance, the lender may require the investors to provide personal guarantees for the loan and/or to enter into an agreement that their related entities (which usually have assets and/or income-earning capacity) will act as guarantors.
Regardless of the lender’s requirements, it is important that you fully understand the fine print of the loan before the loan documents are executed. For example, you need to understand if you and your co-investors are guarantors of the loan on a ‘joint and several’ basis, where you are all
"Recent legal precedents suggest that it is extremely difficult, from a technical perspective, for any unit trust in Australia to qualify as a fixed trust"
jointly guaranteeing the full amount of the loan, or on a separate basis, where you are only guaranteeing that part of the loan that corresponds with your percentage ownership of units in the unit trust.
Similarly, you should ensure that you are not assuming the same level of risk as your co-investors if you are in a better financial position than them. For instance, if one of your co-investors has to borrow in their own right to enable them to subscribe to units in the trust, you or your related entity should not be guaranteeing your co-investor’s loan if you are not being rewarded for the additional risk you will be assuming.
Tax considerations
Provided that the unit trust will only own the property as a passive investment, it is unlikely that it will be characterised as a ‘public trading trust’, which would otherwise be taxed like a company. However, if the trust will also be carrying on an active business, you need to ensure that the special public trading trust provisions will not be applicable. Otherwise, the unit trust will be taxed like a company.
Assuming that the unit trust will only hold the property as a passive investment in return for rental income, it is likely to be taxed as a trust for tax purposes, which generally means that the annual income of the unit trust will be distributed to the unit holders, who will be assessed on the income in their own hands separately, ie the unit trust is merely a ‘conduit’ and does not generally pay tax in its own right.
A unit trust generally has the ability to pass on to the unit holders any net cash profit from the property that represents non-cash depreciation
and capital works deductions. Such cash distributions, also known as
‘non-assessable amounts’, will generally reduce the cost base of the units and will not give rise to any immediate tax consequences.
However, when the cumulative non-assessable amounts exceed the entire cost base of the units, any excess amount will give rise to a taxable capital gain in the hands of the relevant unit holder.
Provided that the underlying units on which the distributions are made have been held by the unit holder for at least 12 months and the unit holder is either an individual or a trust, the capital gain will be halved under the 50% capital gains tax (CGT) discount. If the unit holder is a complying superannuation fund that is liable for CGT, the CGT discount will be 33.33%.
If the unit trust incurs a tax loss, whether it can recoup its carried-forward tax losses against its future income will depend on whether it can pass the relevant tests in the ‘trust loss provisions’. For a ‘fi xed trust’, these provisions will generally allow the trust to recoup its tax losses if the majority of the unit holders of the trust have continued to own the units of the trust since the tax losses were incurred. If the trust is not a fi xed trust, it will need to pass a set of more stringent tests before the tax losses can be recouped.
For quite some time, it was assumed that most unit trusts were fi xed trusts, until a number of relatively recent legal precedents suggested that it is extremely difficult, from a technical perspective, for any unit trust in Australia to qualify as a fixed trust.
As a consequence of these cases, there is now an increasing risk that unit trusts with carried-forward tax losses will not be able to recoup those tax losses easily. While the ATO does not appear to have strictly enforced these precedent legal principles to date, it may still present a risk to unit trusts until such time as the law is changed to resolve this technical issue.
Having said that, the Commissioner of Taxation does have the discretion to treat a trust as a fixed trust if he consider it appropriate. Therefore, if certainty is required, you could consider requesting that the Commissioner exercise this discretion.
When the investment property is eventually sold and a capital gain is made, provided that the property has been held by the unit trust for at least 12 months, any capital gain derived from its sale will qualify for the CGT discount. It is important to ensure that, in calculating the capital gain or loss, the cost base is reduced by the cumulative capital works that have been claimed on the property if the property was acquired by the unit trust on or after 13 May 1997.
Similarly, it is important for each unit holder to ensure that, in calculating the capital gain or loss on the disposal of their units in the unit trust (whether the units are sold to others or redeemed by the unit trust), the correct cost base of the units is used, especially if the cost base has previously been reduced by any non-assessable amount.
Professional advice
The above provides a high-level summary of the ins and outs of using an unlisted private unit trust to invest in property. While the issues associated with such a unit trust may appear reasonably straightforward, professional advice is highly recommended, especially if the arrangement involves less vanilla elements, and could give rise to complicated tax and commercial issues.
For instance, if the units are not issued to the investors up front at the same time, and some unit holders are issued units at a discount, complicated ‘direct value shifting’ rules may be triggered, which could give rise to significant tax challenges.
In that regard, engaging professional advice from the beginning is well worth the cost, especially for the peace of mind that it brings to an investment that is of significant value.
