Recently, we published the first of three articles regarding the proposed NSW Government Property Tax reform. Following that analysis, which was on residential investment property, this article turns the spotlight onto commercial property.
Background – Tax on commercial property under the two regimes
Almost all purchases of commercial property in NSW are subject to transfer duty at rates ranging from 1.25% to 7% applied to the property sale price or market value (whichever is higher).
Land tax applies to the aggregate value of all taxable properties owned. It applies at the rate of 1.6% on the unimproved value of land above the tax-free threshold of (currently) $755,000. Note that discretionary and other special trusts do not have a land tax free threshold. The rate rises to 2% for the aggregate value of taxable properties above the premium rate threshold of (currently) $4,616,000.
Under the proposed regime, the commercial property purchaser can choose that neither transfer duty nor land tax will apply. Rather, an annual property tax would be payable at the rate of 2.6% of the unimproved value.
The prospective commercial property purchaser has three questions, being:
- Can I elect the annual property tax on my acquisition?
- If so, which regime will provide the best tax outcome long term? and
- Should I delay acquiring a commercial property until the new property tax regime is in place?
Can I elect the annual property tax?
A core part of the announced policy is to allow the prospective purchaser to choose either the new annual property tax regime or the current transfer duty/land tax regime. However, the NSW Government recognises that the attraction of not having to pay the upfront transfer duty might cripple the state budget until a significant portion of the landholder population is paying the annual property tax.
To prevent this, the transitional plan is to prevent purchasers of high value properties from electing the annual property tax. The current guidance is that the top 5% by value of commercial property purchases will remain subject to the current transfer duty/land tax regime. At this stage there is no indication how long the NSW Government will maintain that restriction and at what threshold purchase value it will apply from.
Before answering the other questions, it’s worth noting the outcome of some modelling we have performed to calculate the amount of annual property tax that would be payable on typical commercial property purchases under the proposed regime. We then compared that amount of tax with the combined tax payable if the property purchased was subject to the current tax regime. The modelling findings are below:
If the NSW Government’s proposal is implemented, we expect that the choice to elect the annual property tax will be available from some date during the second half of 2021.
Assumptions & premises:
- The purchaser is not subject to foreign person duty and land tax surcharges
- The comparison was between three properties to be purchased in 2021 for market values of $500,000, $1,000,000 and $2,000,000 respectively.
- The unimproved value of the properties was 50% of the market price (hence $250,000, $500,000 and $1,000,000).
- The tax-free threshold and the unimproved value rose by the same percentage each year and other assumptions were made to simplify calculations of the current land tax.
- An annual property value growth rate of 4% applies (this is a conservative rate chosen because the choice of a single range to apply across the wide range of commercial property types is problematic in a COVID affected economy)
- We also applied the calculations over 10 and 20 years under scenarios:
- Where the current land tax free threshold was available in full.
- Where it was not available for the property purchase in question and the 1.6% rate applies or instead where the property purchased would be subject to the 2% annual land tax premium rate because of the purchaser’s other taxable properties.
The total tax paid after both 10 and 20 years were compared.
Which regime provides the best tax outcome long term?
The critical finding from our modelling is that most purchasers will be significantly better off under the current transfer duty/land tax regime. That finding applied to most property values and medium to long term investment time frames.
The critical factor is the very high proposed annual property tax rate of 2.6%. Even when applied to the unimproved land value the extra annual property tax compared with current land tax inevitably dwarfs the upfront transfer duty liability (even if it were at 5.5% of the market value).
Where the land tax free threshold would otherwise be available, the total annual property tax will exceed the upfront duty liability within 4 years. It is hard to perceive a scenario where the annual property tax would benefit a commercial property purchaser for whom the land tax threshold would still be available.
Where that tax-free threshold would not have been available, then the annual property tax will exceed the combined duty and land tax after just 8-11 years of ownership. From then on, the purchaser will always pay more annual property tax than it would the current land tax.
To challenge these findings, we modelled two further extremes. Firstly, we looked at a $1m property purchase where the unimproved value was just $200,000 (20%). This is not an uncommon scenario for small strata titled office spaces or small retail spaces in apartment buildings. In this scenario, it took 16 years before the annual property tax exceeded the sum of the transfer duty/land tax.
The second scenario was where a $20m property was acquired by an investor who already faced the premium land tax rate of 2% (having existing holdings with an unimproved value exceeding $4.616m). It was assumed that the unimproved land value of the newly purchased commercial property was just 40% of its market price ($8m).
Despite the considerable upfront transfer duty liability of more than $1m, by the 17th year, the sum of the annual property tax assessments exceeded the total of the transfer duty/land tax combined.
This suggests to us that the only commercial property purchases that will benefit from the new regime will be those:
- Where the unimproved value is only a fraction of the market value of the land, and
- Where the purchaser only wishes to hold for the short to medium term. (This would include developers of commercial property which should expect to increase their margin for short-term developments).
Ironically, the high value property purchases that meet this criterion are the ones most likely to be prohibited from electing the annual property tax during the transition period.
Should I wait for the new property tax regime before acquiring commercial property?
For the majority of prospective purchasers, there is no reason to wait. The current upfront duty and land tax regime leads to a lower total tax cost in the medium to long term.
Our modeling does highlight the importance of treating the potential new property tax as an area of necessary research before acquiring commercial property. Further, given the high level of annual property tax, caution should be applied before concluding, for example, that it can simply be passed onto commercial property tenants as an outgoing.
The consultation period for the new tax regime has now ended. Refinement of the property tax model is underway and further NSW Government announcements are likely in April. Within the next month, we will issue an article with our comparative calculations for a prospective purchaser of owner occupied residential property.
Should you require further information, or advice in relation to these matters, please contact our Indirect Tax specialist Stephen Baxter, alternatively you can contact your usual Mazars advisor via phone or the form below:
Author: Stephen Baxter
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