Having the right structure will help ensure you protect your investment while saving on tax at the same time. Eddie Chung explains
When it comes to structuring, whether it’s for property investment, property development, a business, or any other activity, there’s no one-size-fits-all solution. This is because everyone’s individual circumstances are different and we need to take into account those differences in coming up with a structure that is fit-for-purpose for the specific situation at hand.
Key issues to consider
The key issues I normally consider when I put a structure together for my clients include the following:
1. Asset protection
Whether we like it or not, life is full of potential liabilities. The more dealings you have with other parties, the higher the probability you might run into legal disputes with others, which might, in turn, expose your hard-earned assets to risk.
Structuring investment properties needs to take into account and quarantine these potential liabilities to the maximum extent possible, eg, you may consider ‘locking’ your valuable assets in an entity that is difficult for creditors or the trustee in bankruptcy to make a claim against you if you get sued.
While taxation should not be the sole or dominant motivator in any structuring exercise, the failure to take into account taxation could cost you plenty. A tax efficient structure ensures that the overall taxation position of your group is optimised. For instance, there is little point owning a negatively geared investment property in a discretionary trust that does not derive other income to take advantage of the negative gearing losses.
Likewise, if your investment property is returning net taxable income each year and you have tax losses in another entity within your group, where possible, your structure should be set up in such a way that the income can be offset against those tax losses to minimise your overall tax liability.
3. Multiple parties
Structuring for a single family group is a very different exercise to structuring for multiple parties that come from different family groups. Multiple families introduce more complex dynamics and some of the commercial variables, eg, taxation, may dictate how the group may be structured. For example, using a discretionary trust to hold an investment property for two unrelated families may cause potential taxation issues such as the potential inability to recoup tax losses or for the trust to distribute income to both families without incurring the Family Trust Distribution Tax.
4. Succession and exit strategy
As we don’t live forever, any structure you put together needs to take into account future succession in addition to present considerations. This will raise questions such as – how would you like nominated people to inherit and manage your assets?
A common structure people use is a testamentary trust, which is essentially a trust created upon your death by your will. The terms of the trust allow you to lock in who will control the trust upon your passing, which may also provide certain ancillary taxation benefits. Similarly, if you have a reasonably clear exit strategy for your property, you will need to ensure that the structure you put together now will accommodate that eventuality.
5. Costs and complexity
I have seen plenty of ‘Frankenstein structures’ in my time. Sometimes the structure evolves as the underlying owners change over time while more entrepreneurial people tend to make snap decisions to get a deal done and they simply bolt on extra entities to an existing structure without giving much thought to streamlining it.
While the size and complexity of a structure are virtually limitless, having a complex structure translates to higher upfront establishment and ongoing maintenance costs. Having more ‘moving parts’ may also introduce additional technical complexities to the structure. To that end, I am a strong proponent of the ‘KISS principle’ when it comes to structuring – keeping the structure relatively simple will save you both money and headaches in the long run.
Having regard to the above, tensions may sometimes exist between the different desirable features in a structure. A common example pertains to control and ownership versus asset protection – you may want to have absolute control and ownership of an asset by owning it in your own name but if you are a director of a company and are therefore exposed to the directors’ duties provisions in the Corporations Act, it may be better for you to not own the assets or at least only have partial ownership or control over the assets, just in case you get sued.
The building blocks
The most common building blocks for structuring include an individual, a company, a trust, a partnership, and increasingly more popular, a self-managed superannuation fund (SMSF). A structure is built by combining one or more of these building blocks together.
Owning an investment property in an individual’s own name is by far the simplest and cheapest option. Despite the lack of asset protection, any negative gearing losses generated from the property may offset the income of the individual, which will be particularly attractive to high income earners. If the property is sold and a capital gain is made, the 50% CGT discount will be available, provided that the property has been held by the individual for at least 12 months before it is sold.
A company is a separate legal entity at law. Accordingly, if an individual sets up a company to buy an investment property, the individual does not own the property, so if the individual gets sued, the property will not be exposed to risk as it legally belongs to the company. However, whoever owns the shares in the company indirectly owns all of the assets of the company. Therefore, if an at-risk individual owns all the shares in the company, which in turn owns the investment property, the structure may not provide the intended asset protection feature.
Any net rental income derived by the company will be taxed at the corporate tax rate of 30 per cent, which is substantially lower than the current highest marginal tax rate of 49 per cent applicable to individuals (inclusive of Medicare Levy and the Budget Repair Levy). However, if the cash representing the net profit is extracted from the company as either a loan (unless the loan is subject to a special loan agreement) or a dividend by a shareholder of the company or their associate, the relevant shareholder will generally be subject to tax on the net profit as if they have derived the profit themselves but the tax already paid by the company on the same profit will reduce the tax liability of the shareholder.
However, any negative gearing loss incurred by the company will be stuck inside the company and cannot be used to offset another entity’s income, albeit the loss can be carried forward indefinitely, which may be used to offset the company’s future income and capital gain if the property is sold, subject to the passing of certain loss recoupment rules applicable to companies. Also, a company is not eligible for the 50% CGT discount on any capital gain derived, which could make a material difference to your return on investment.
At law, a trust is a relationship under which the trustee looks after the trust’s assets for the benefit of the beneficiaries.
If it is set up properly, a discretionary trust may offer reasonably effective asset protection as the beneficiaries of the trust are generally not presently entitled to the income and/ or capital of the trust until the trustee makes a resolution to distribute the income and/or capital. Therefore, if an at-risk individual uses a properly established discretionary trust to buy a property and the individual gets sued, creditors do not generally have any recourse against the assets held by the trust because no one really has beneficial ownership of these assets. To further protect the assets, a corporate trustee that does not carry on any activity in its own right may be used.
For taxation purposes, a discretionary trust provides maximum flexibility in terms of the annual net rental income of the trust as the trustee has the discretion to distribute different amounts of income to different beneficiaries, having regard to the respective tax position of each beneficiary from year to year. The same applies to capital gain. If the trust makes a capital gain and has held the property for at least 12 months before it is sold, the 50% CGT discount will be available if the capital gain is distributed to an individual or another trust.
Having said that, similar to a company, any negative gearing loss generated from a property owned by a trust is stuck in the trust, unless the trust has other income to offset the loss. While the trust can carry forward tax losses for an indefinite period, the losses can only be recouped if certain trust loss recoupment tests are satisfied. These rules may be simplified by way of the trust making a ‘Family Trust Election’ but once the election is made and a trust distribution is made to an outsider who is not part of the family group for which the election is made, the Family Trust Distribution Tax will apply.
Unlike a company, which is a separate legal entity, and a trust, which is a legal relationship, a partnership is a contractual arrangement under which at least two parties carry on a business in common with a view of profit. A legal partnership will always be considered a partnership for tax purposes; however, an arrangement that is not a common law partnership may still be a partnership for taxation purposes because the tax law specifically defines a partnership to include an association of persons who are jointly in receipt of income without necessarily the carrying on of a business. In other words, two people who jointly own an investment property will effectively be a tax law partnership for income tax purposes.
Each partner of a common law partnership is jointly and severally liable to the liabilities of the partnership. Therefore, the personal assets of the partners may be exposed to risk if one of the partners is exposed to litigation in respect of something they do in the name of the partnership.
For taxation purposes, each partner of a partnership is entitled to their share of any net profit derived and net loss incurred by the partnership, so if the property owned by a partnership is negatively geared, the relevant partner may offset their share of the net loss against their own income. Also, if the partner is an individual or a trust, the 50% CGT discount will apply if the property is sold and a capital gain is made, provided that the property has been held for at least 12 months before its sale.
The above provides a bird’s-eye view of the main issues to take under advisement when the ownership structure for an investment property is being considered. While a SMSF may be used, the complexities involved warrant discussion in a separate article. As SMSFs are heavily regulated, professional advice is crucial before any arrangement is implemented.
is Partner, tax & advisory, property & construction, at BDO (QLD) Pty.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.