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The effect of the GST upon Real Estate

Background Briefing on Taxes on Real Estate

To understand the effect GST will have upon real estate, it is worthwhile reviewing the existing taxes on real estate.

Real estate taxes used to be very simple - stamp duty on purchase, a tax on re-sale at a profit (if it was bought for that purpose), and tax or a tax deduction on rentals, after off-setting property expenses and interest on property loan. Properties transferred by death or by gift were subject to death duties and gift duties prior to 1980.

In 1983, building depreciation was introduced to allow the building costs for new buildings to be written off over a term of up to 40 years.

On 20 September, 1985, Capital Gains Tax (SGT) was introduced and applies to all properties acquired after that date or which had substantial capital expenditure upon them after that date. The tax replaced the "re-sale at a profit" tax and is payable on the sale of all properties purchased after that date except the family home. Death is treated as a sale for these purposes.

What impact will the GST have on real estate? In this article, we will examine the impact of the GST on residential and commercial real estate, and end with some views on its impact upon the real estate market.

Overview: How is GST payable in a Real Estate Transaction?

GST is payable by as a general rule:-
  1. by vendor on sale of real estate; and
  2. by lessors (landlords) on the lease of real estate;

but not

  1. by mortgagees (financiers) on the financing of real estate

GST is payable by vendors and lessors because they provide a "taxable supply" of real estate services.

The GST liability is not passed on to a purchaser unless the contract provides or to a tenant unless the lease provides for it to be passed on.

The situation may well exist where the purchaser receives a windfall where the contract omits to pass on GST. They receive a windfall because they are allowed to claim a credit for the GST payable by the vendor yet pay a lower price. A tenant might also receive a windfall, by receiving a credit for the GST paid by the landlord on the rent yet pay a lower rent (without GST), because there is no provision in the lease to pass on GST.

After 1 July, 2000 prices will normally be quoted inclusive of GST. Sale Contracts will need to make this clear.

Persons liable to pay GST will generally be part of a chain, entitled to receive credits (called input tax credits) against the GST payable by them.

An example of a GST Chain:-

The hardware store supplies building materials to the builder. The price includes GST. The store pays the GST to the Tax Department (ATO).

The builder carries out renovations to shop premises. Their invoice includes GST which is paid by property owner (eg. $100, of which GST is $9 or 1/11th). The builder pays the GST to the ATO less the GST paid on the building materials and other expenses.

The property owner leases a shop as a restaurant. The lease provides for tenant to pay GST on top of rent. The landlord pays GST to Tax Department, but in calculating the GST, offsets the GST component of the invoice from the builder, and GST on council rates, land tax and other expenses.

The restaurateur sells restaurant meals to the public. The price includes GST. The public pays GST to restaurateur. The restaurateur pays GST to the Tax Department, after offsetting GST paid on rental and other services.

The GST chain always ends with the public.

In our example, the GST chain could have ended at any point if the public, rather than a registered business purchased the goods or services. The public wears the tax burden, without having any credits. The public is compensated by lower income tax rates.

In our example, it is assumed that each of the builder, the property owner and the restaurant proprietor must register for GST as their turnover exceeds $50,000 p.a.. If so, they must lodge GST returns quarterly, to account for income received and to pay the GST.

The GST will be a continuous process - there is no necessity to match income from a particular property upon which GST is payable with expenditure on purchases upon which a GST credit is available each quarter - the credit can be claimed for purchases for an entirely separate project or property.

We will now review:-

  1. the Sale and Purchase
  2. the Lease
  3. of Residential and Commercial Property and Premises
Sale and Purchase of Residential Property

The sale and purchase of residential property is not subject to GST, except for new residential property.

Therefore, on the sale of a second-hand home, GST is not payable by the Vendor, nor can the Purchaser made liable to pay GST. It does not matter whether the property is owner occupied or is an investment property - as long as it used for residential purposes and is not new it is exempt. To this extent, exemption is wider than the owner occupied exemption for capital gains tax purposes.

There are a number of limitations on this broad rule, namely:-

new residential premises are subject to GST on their first sale. "New" means premises which have not previously been used a residence. New residential real estate can consist of subdivided land, a newly built house, a newly built apartment, and even a newly built house-boat. It will no longer make any difference whether the builder or developer of the new residential real estate is an owner occupier before sale - GST is payable on the sale including the first sale of new residential real estate.

There will be instances where second-hand real estate is converted into new real estate, such as when a house is completely demolished and re-built as a house or as townhouses or units. However, if a house is merely extended, such as with a second-storey addition or living room/garage style extension, or the house is merely renovated, then GST will not be payable on sale. One "grey" area is whether strata subdivision of an existing block of flats or row of townhouses creates new residential real estate. This will need clarification.

Although it will apply to "new residences which have already been built, the tax will not be significant for the first few years after 1 July, 2000, except for residences built after that time, because of what is known as the "margin scheme". Under the margin scheme, the owner of a new residence is entitled to have it valued as at 1 July, 2000 and pay GST only on the increase in value after that time.

A purchaser from a vendor using the margin scheme can carry it on when they re-sell.

Recommendation: All residential property developers and owner builders should obtain valuations as of 1 July, 2000.
  1. properties which are used for commercial residential purposes are not exempt. For example, hotels, motels, boarding houses, caravans parks and cruise ships. New or second-hand, their sale is subject to GST, although the margin scheme will apply.
  2. while the property is sold may have been a residence, if it is sold to a developer who will demolish it and use it for commercial purposes, or to a bed and breakfast proprietor, or to a professional who will use it for commercial purposes, then the vendor may be liable for GST and will need to ensure the contract passes all GST liability to the purchaser.
Sale and Purchase of Commercial Property

All property other than residential property will be liable to GST. It does not matter whether the improvements upon the property are new or second-hand, or whether the property consists of vacant land, commercial, commercial residential, industrial or office property or whether it consists of a mine or farming property.

However, in all cases, the owner/vendor may choose to have the property valued as of 1 July, 1999 and to adopt the margin scheme, that is to say, to pay GST only on the increase in sale price over and above the valuation as at 1 July, 2000. This is recommended.

The trade off for making commercial and all other types of property subject to GST was to be the abolition of stamp duty payable on the transaction, which adds about 5% to the price. However, the introduction of the stamp duty abolition has been indefinitely postponed. To add insult to injury, it is possible that the GST will be imposed on stamp duty increasing it by 10%.

Note these particular features:-
  1. Building and construction contracts which carry over beyond 1 July, 2000 will attract GST for payments made relative to work and materials incorporated in or affixed on the site after 1 July, 2000 (to the extent of the value of the work after that date).
  2. If the building contract was entered before 8 July, 1999 this does not apply so long as the work is completed by 1 July, 2005.
  3. The sale of farming land on which a farming business has been carried out for at least 5 years previously and where the purchaser intends to carry on a farming business on the land will be GST free.
  4. The sale of a business, including stock, and plant and equipment, is GST free whether it is a farming business or any other business if it is sold a going concern, that is, the plant and equipment necessary to carry on the business are sold and the business is taken over, as a business. If the sale of business includes the sale of the property, it is possible that it is GST free.
  5. No GST is payable by a vendor who is unregistered and who does not need to register (because their turnover is less than $50,000). This exempts small investors who may, for example, own 1 small commercial property from which they receive less than $50,000 per annum on rentals. A purchaser from an unregistered vendor will be unable to obtain a GST input credit.
Lease of Residential Premises

Leases are treated as the supply of services by the landlord to the tenant for GST purposes with the due date for payments of rent an invoice date. The landlord is liable to pay the GST to the ATO. If the lease so provides then the tenant can be made to pay the GST, on top of the rent.

Leases of residential premises for residential purposes do not attract GST. The landlord will not pay GST nor will the tenant be able to claim GST input credits.

For the exemption to apply, the premises must be used predominantly for residential accommodation. It does not matter whether the premises are new residential premises or second-hand residential premises - as long as the lease is not of commercial residential premises, then the exemption applies.

It follows that the landlord of residential premises cannot obtain GST input credits for goods and services supplied, such as repairs and maintenance, agents letting commission and council rates and strata levies. Note water and sewerage rates and charges are exempt from GST.

Lease of Commercial Premises

The landlord is liable to pay GST on rentals. If the landlord is entitled to a GST input credit for GST paid in items such as repairs and maintenance, rates and levies, insurance premiums, agents commissions, and the like as against the GST payable by the landlord. No GST credit is available for interest paid under a loan or mortgage - they are GST free.

On their part, the tenant may claim an input tax credit on GST payable in respect of their rental.

Because commercial leases can extend a number of years, many extending far beyond 1 July, 2000, the burning issue is what is the position for existing leases that have not made provision for the passing of the obligation to pay GST to the tenant. Special transitional provisions have been introduced for this purpose.

If the Lease was signed before 2 December, 1998, then the landlord will not be liable to pay the GST until "the first review opportunity" after 1 July, 2000.

If the lease was entered into after 2 December, 1998 then the landlord will be liable to pay GST from 1 July, 2000 regardless of whether the lease provides for its recovery from the tenant or not.

There is likely to be some controversy about what constitutes "the first review opportunity" - the GST legislation is in terms of the "conduct [of] a general review, renegotiation or alteration of the consideration" - which appears to be a reference to a market review as distinct from a CPI or fixed increase review.

The view of the Australian Taxation Office is that the GST will be reflected in market rentals (i.e. they will be set as a global figure inclusive of GST), and therefore the problem will be solved when there is review to market, even though the lease may not specifically provide for passing the GST on to the tenant.

Controversy will also arise as to whether the grant of a fresh lease pursuant to option to renew will present a "review opportunity" to pass on GST to a tenant, where a lease does not provide for it.

Again, it is worth remembering that if a landlord does not need to register for GST, then no GST is payable. Owners of one small commercial property may therefore not have to register or pay GST.

An issue arises with GST on outgoings. Although the liability for GST may be passed on to the tenant, that liability should only be passed on to the extent that the GST is payable. A landlord should not seek to recover GST on GST. For example, where a landlord seeks the reimbursement of an insurance premium, the amount of which already includes GST, then the amount recoverable from the tenant should be the same amount as paid by the Landlord for the insurance premium, not the insurance premium plus 10% for GST.

Recommendation: The clause in the lease which passes on the GST liability must be carefully drafted.

Summary: what is to be done?

Every person with a turnover of more than $50,000 from commercial property will need to register as a GST entity prior to 1 July, 2000. Forms of registration and forms of application for Australian Business Numbers (ABNs) are expected to be available in November this year. Note every entity will need to be separately registered - investment partnerships will need to be registered as distinct from the investors (if the investors carry on investment or business activities separately).

All commercial real estate, new residential real estate and real estate in the course of construction should be valued as of 1 July, 2000.

Commercial leases will need to be checked. If they provide for GST to be passed on, then invoices for rental from 1 July, 2000 are to be increased by 10% to include GST (assuming the owner needs to be registered for GST purposes). Otherwise GST will need to be factored into the first market review or the renegotiation of the lease.

In all property purchases, a check will be needed of the vendors GST status:-
  1. is the vendor registered and therefore liable to pay GST?
  2. is the vendor using the margin scheme, and therefore liable for GST on the sale amount of less than the value of the property at 1 July, 2000?
  3. has the property been used predominantly for residential purposes?
  4. is there a property management business, conducted in relation to the property, which can be sold as a going concern, along with the property?
Check the exemptions. The main exceptions to the GST are:-
  1. persons carrying on an enterprise (i.e. a business - this includes landlords) with a current annual turnover of less than $50,000. The persons need not be registered.
  2. vendors of second-hand residential property
  3. owners of property which is tenanted for residential purposes
  4. the property is a farm which is sold as a continuing farm
  5. business and property are sold together, as a going concern
The Effect of the GST on the Real Estate Market

As an overall conclusion, the GST legislation provides concessions and therefore incentives for the purchase and lease of second hand residential investment property, over commercial property, by reason of the fact that most residential property sales and leases will be GST free. This may lead to a slight reduction in relative values of commercial property as against residential property.

In terms of prices, the fact that GST will be payable upon new properties will bring up the value of established properties in both residential and commercial markets. The inflation effect of GST which Treasury estimates will be 2% to 2.5% to the economy overall. Private commentators in the property market estimate that for real estate it is likely to be 5% to 7%. The inflationary impact will feed through to commercial leases (through CPI adjustment clauses) and generally, to property values as property values consistently adjust for inflation.

The following represents some specific forecasts of the effect of the GST upon the current trends in the real estate market.
  1. a boom in residential property fuelled by tax free profits available to owner occupiers of residential property who build, renovate or improve homes. Effect: "buy before the GST increase": the GST will apply to the building and sale of new residential properties.
  2. continuing tax deductibility for interest payments on investment property; Effect: nil
  3. availability of finance, low interest rates has greatly assisted affordability for home owners and for investors, has enabled most property to be comfortably geared without negative gearing; Effect: GST will give consumers greater spending power through a tax reduction, leading to higher loan affordability, higher loans and higher prices. Interest rates might rise a little to compensate for higher inflation, as a partial offset to the increased spending power.
  4. building depreciation has produced a strong demand for new residential property, and to a lesser extent commercial property investments because it creates a strong tax deduction with no cash expenditure required; Effect: nil

Little apparent change in returns despite low inflation and low interest rates. Rental returns on commercial property between 8% to 12% retain their premium over rental returns on residential property at 4% to 6%; Effect: the GST may lead to a slight spread in the yields available between residential property and commercial property.

Cordato Partners can assist

  1. in developing strategies for minimising GST on sales and purchases of property
  2. in ensuring leases effectively pass on liability for GST to tenants
  3. in structuring transactions for sales and purchases of business to reduce or eliminate GST liability.

Important Notice

This article provides a summary of the law. It does not cover the whole of the relevant law and is not a substitute for professional advice.

Moreover, because it avoids legal language wherever possible, there may be some generalisations about the application of the law. Some provisions of the law referred to have exceptions or important qualifications.

Your particular circumstances need to be taken into account when determining how the law applies to you.

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