Property investment – correct structuring is very important
When considering investing in the residential property market most people undertake some level of due diligence on properties and when they find a property they apply for finance. The property is usually purchased in a couples joint names or that of the highest income earner, and all this done without consulting their accountant or financial planner. When undertaking any investment part of the due diligence should include obtaining professional advice. After all there is a lot of money involved and you wish to minimise risk whilst maximising return.
Every property investor might well have a number of different structuring options that can be used for their advantage. However in most cases, they need to know about them before setting up the initial arrangement.
While investors may not find immediate benefit in some functions of a particular structure, it will generally have to be in place from the date of purchase in order to optimise the portfolio’s long term viability. That’s why you must consider what you want to achieve over the ownership period from the outset of your acquisition (as opposed to being short-term focused like many people and only thinking about the next three to five years).
When looking at your next (or first) property investment it may pay to consider the following alternative ownership structures. I strongly recommend you discuss these and other options with your accountant or financial advisor before undertaking your next investment:
Consider a Super Fund (SMSF)
It can take 15 to 20 years (or more) for a property portfolio to produce enough cash flow, over and above expenses, to fund retirement lifestyle (assuming debt is maintained on an interest only basis). A strategy you can adopt to accelerate a property portfolio to be cash flow positive is to sell one property in retirement and use the proceeds to repay the portfolio’s debt.
Buying a property is a SMSF with the intention of selling on retirement is one potential strategy, as CGT will be zero and this will leave more money to extinguish most (if not all) debt.
If you choose to implement this strategy when buying a property investment though, it’s important that you’re mindful of your intention to sell within a relatively short period. For example, buying a property that you can renovate and improve to ‘create’ equity may be an appropriate strategy for this purchase. You should recognise that this strategy carries regulatory risks, in that the government might change retirement benefit taxes one day. However, it’s likely that super will always be concessionally taxed (the rate just might not be zero that’s all).
A discretionary trust could be for you!
A good way of capping your tax rate at 30 per cent is to establish a discretionary trust with an “investment company” as the primary beneficiary. The trust will also own the shares in the investment company.
The investment company is just a proprietary limited shell company. The benefit of this structure is that once each individual has exhausted their 30 per cent or lower individual tax rates (i.e. each individual has a taxable income of not more than $80,000 each), the trust can distribute any remaining profit into the investment company, which will pay tax at the company rate (currently 30 per cent).
In the future, the investment company can then pay a dividend to the shareholders (i.e. the trust) and the trust has the discretion to distribute the dividend to another beneficiary (while still preserving imputation credits). This essentially allows you to ‘park’ profit in a company, pay 30 per cent tax rate and then eventually (possibly) distribute that profit to a beneficiary that has the lowest tax rate (and maybe get a tax refund via imputation credits).
It allows you to spread your profit over a number of years to ultimately minimise tax.
Potential benefits of tenants in common.
Owning a property as tenants in common can provide some flexibility, in that you can potentially allocate all the cash deposit to the lowest income earner and gear the highest income earner’s share at 100 per cent (plus costs). For example, if you and your spouse have $200,000 as a deposit and would like to buy an investment property for $500,000, you could consider the following structure:
- the highest income earner would own 62 per cent of the property and the lowest income earner would own 38 per cent.
- the overall cost of the purchase would be $525,000 – 62 per cent of this overall cost is $325,000.
- therefore, you would establish one loan account in the highest income earner’s name for $325,000
- as we can borrow 80 per cent of a property’s value (or $400,000 in this example), we can establish a second loan for $75,000 in the lowest income earner’s name.
- however, we have borrowed more than we need so the couple will have $75,000 cash left over (loan of $325,000 plus loan of $75,0000 plus $200,000 cash gives them $600,000 in total, but the overall cost for purchase is $525,000)
- therefore, the lowest income earner deposits the $75,000 surplus cash in an offset account linked to their $75,000 loan,
With this loan structure, the highest income earner’s investment is geared at 105 per cent (loan $325,000), whereas the lowest income earner has zero gearing for all intents and purposes (as the loan is fully offset). Having the lowest income earner owning as much of the property as possible, while not forgoing any taxation benefits (to the highest income earner), provides a good outcome, because when the property produces a taxable profit (maybe seven to ten years), as much of that profit as possible will go to the lowest income earner. At this time, the lowest income earner can withdraw the $75,000 from the offset, claim a deduction for the interest charged on the loan and use the cash elsewhere.
This structure will maximise tax benefits when the property produces a loss (i.e. negatively geared) and minimise tax when the property produces a taxable profit.
Stay on the right side of the tax man.
It’s essential to remember that the dominant reason for developing any ownership structure cannot and should not be to ‘obtain tax benefits’, as this may contravene anti tax avoidance provisions.
You must have viable reasons, other than tax benefits, to justify structuring your investments in a certain way. Notwithstanding this, structuring investments solely around tax consequences is foolhardy, as you must consider other financial planning issues.
For example, the reason for the structure mentioned above could be that the lowest income earner wants the lowest gearing level (because of their lesser capacity to service debt). In this structure, the dominant reason for this particular structure was to manage risk. You (or your advisor) should document the reasons for any recommendations to ensure no anti tax avoidance provisions are contravened (and you don’t want to end up in jail).
The above structure are just some of many options available. I work with my clients and their accountant &/or financial advisor to ensure their finances are structured to meet their individual requirements, short, medium and long term.