Many people think the secret to success in property investing is simply choosing the right property. They spend hours, weeks, even months, painstakingly analysing a thousand different options. I have noticed however that people often overlook one very important decision, one that could literally change the outcome of their investing by tens of thousands of dollars. That decision is: “WHO should buy the property?”
By that I mean of course, who should be the legal owner of the property. You or your partner? Your company? Your super fund? Or a family trust? The decision you make here has so many financial and taxation ramifications that it in itself could turn a well selected property into a costly financial exercise or conversely take an ordinary looking investment property and have it give you a tremendous boost to your wealth.
Critical factors for consideration that can affect this outcome include:
- How long do you intend to hold the property?
- When is it projected to become cash flow positive?
- When will the “high” income earner in the family, if there is one, retire or become a “low” income earner?
- When will your children turn 18?
- What are the ages and expected incomes of any other beneficiaries?
- Is there a prospect you may be subject to litigation that could expose the asset to risk?
Answers to all these questions can guide you in determining which structure (Personal Names, a Trust or a Company) to buy the property within. It also lets you know with confidence your likely capital gains tax to be paid on the forecast growth of the asset. Importantly, tax is often the biggest cost in an investment property’s outcome so it’s worth a look, don’t you think?☺
In some cases, you may need to forgo asset protection to gain tax effectiveness or vice versa, but the decision needs to be made on a case by case basis with a clear picture in mind of the possible end results, as there is no simple right way or wrong way to do it. Your best bet is to evaluate it by looking at the possibilities. Once they are known you can move forward with confidence.
Let’s look at some of the various ways open to you to buy property and the issues associated with them.
Ownership by an individual or couple
Many people who buy properties in their own names or joint names, simply don’t know they can do it any other way, or they become fixated on the short-term taxation benefits and then lose sight of the bigger longer term picture.
For most people buying an investment property gives them tax benefits in the first few years, because they are often negatively geared. However, as the rent continues to rise and if interest payments fall, like they have recently, you can get into a positively geared situation fairly soon.
If a property is held in the name of a high income earner, as it sometimes is, tax will need to be paid by them on any surplus income. And if the asset is sold for a profit, then even more tax needs to be paid by the high income earner.
The benefit of ownership by an individual with a negatively geared property can be in the order of thousands more dollars in your tax return, particularly for a high income earner. For a low income earner however, the tax benefits of negatively geared property on a short term basis may produce little to no benefits.
The problem with this structure (personal ownership) is that you have little to no asset protection. Anyone who is suing you, from a tenant injured in your property to a business associate, can attack the assets you hold in your name or your share of whatever is held in joint names.
A summary of the advantages and disadvantages of Investing in Property in your personal names include:
- Tax effective – allows tax deductions to be offset directly to an individual
- Low cost to administer.
- Asset Protection – virtually non-existent
- If joint investment lending is done, future assessments for each individual include the entire sum of the investment debt, thus reducing future borrowing capacity
- Capital gains tax – a large lump sum tax could apply to a single individual.
Ownership by a company
A company is a separate legal entity that can exist forever. It can own assets, borrow money, it can sue and be sued. The most common type of company is a Proprietary Limited Company (Pty Ltd), where the company is divided into ownership “portions” called shares which individuals own, and which gives them ownership of part of the company.
So a company can buy an investment property. There is some degree of protection for the assets owned by a company, but in certain circumstances the directors of the company, who are not necessarily the shareholders, can be held personally liable for debts of the company and the “corporate veil” that often isolates directors can be pierced, leaving them vulnerable.
Again tax issues can matter here, due to the difference between the personal tax rate applicable and the corporate tax rate, and also the fact that losses can be trapped inside a company and only offset against other income that the company earns.
Asset protection issues, when the property is held by a company, are different than when it is held by an individual, because of how the company is set up and who or what owns the different portions (or shares) of the company. For example, someone suing a company has rights limited to the assets in the company – where the company was not set up after the potential litigation became apparent.
Some possible advantages of using a company to invest are:
- Tax rate internally in the company is capped at 30%
- The directorship of the company can leave out the spouse, therefore allowing the family home to be owned outside of the realm of possible litigants.
Disadvantages of a company could be:
- Expensive tax returns
- Companies do not receive the Capital Gains Tax Discount (50% CGT discount).
- Directors are often required to personally guarantee lending.
Ownership by a trust
A trust is an entity set up for 80 years, during which time it can hold a property for the benefit of the beneficiaries of the trust. Beneficiaries are the people for whom the trust was set up and are the ones who will “benefit” from what the trust disperses to them, hence the term beneficiary.
The difference between a company and a trust is that the beneficiaries of the trust cannot be held accountable for the actions of the trust and there is no actual individual who owns the trust.
This means that while the trust can sue and be sued, it is not as straightforward a process when suing a trust to get access to its assets when compared to suing an individual.
This is why trusts are often used to protect assets as well as providing some tax minimisation benefits. Importantly, a trust is taxed in the hands of the beneficiaries. Different types of trusts include Unit Trusts, Discretionary Trusts & Hybrid Trusts.
The differences between these types of trusts are fairly complex and it would be best to sit down and discuss them with you, if you were interested in finding out more about how a trust or other structure could benefit your property investing strategy, to better manage your tax and protect your assets over the long term.
The key message I wanted to give you today, was simply that, buying an investment property can be a very wise decision to help generate future wealth for you and your family. But the structure you purchase the property under can radically affect the outcomes for you.
So even if you’ve already chosen a property, it’s not too late to have a chat to see which ownership structure might suit you best. A quick chat could resolve it for you. Conversely, if you are considering property but have not actually chosen something yet, having a discussion about the possible ownership structures open to you, may reveal ways to obtain a better long term tax outcome, find a better property asset or even set up a portfolio faster than you thought possible.
Either way, feel free to contact me at firstname.lastname@example.org
to arrange a no-obligation appointment.