Get this decision right and you will maximise your returns and tax deductions long-term. Get this decision wrong and you will be very sorry and may suffer financially.
Once you realise you made the wrong decision about ownership structure it is too late. This is because generally the only way to fix it and change the ownership structure is to sell the property to another entity/person and incur stamp duty and capital gains tax expenses. Therefore, it is important to get the right advice about property ownership structures before you sign the purchase contract.
Questions you should ask yourself when deciding on a structure:
- How important is asset protection?
- Do I want to be able to offset losses against my income?
- How long do I plan on holding the property for?
- What am I going to do with the property now and in the future?
- Will the property be negatively or positively geared?
- Will our personal situation change in the near future? (e.g. reducing from 2 incomes to 1)?
It is important to note that different ownership structures will suit different people and different circumstances. It is common for investors to have multiple different property ownership structures within their portfolio as their property portfolio grows.
Ownership Structure 1 – Private Ownership
Private ownership simply means that you own the property in your own name, either as an individual or jointly with another person. If you are purchasing with another person you can choose to purchase it as Joint Tenants (equal owners, and if/when one of you pass away the deceased’s share of the property will automatically be transferred to the survivor) or Tenants in Common (the percentage of ownership and tax benefits of each party can be determined at the time of the purchase and each owner must nominate who their share of the property will go to in their will).
This is a very popular among the property ownership structures as it is the easiest and cheapest ownership structure. It allows the investor to offset their property losses against other personal incomes. Therefore, negatively gearing your property, having high taxable income and being on a high tax rate will be beneficial for private ownership. You also may receive a 50% discount on capital gains tax when selling investment properties that you have held for more than 12 months.
On the other hand, there are two main downsides to owning an investment property in your own name. Firstly, there is no asset protection, which makes it a dangerous choice for many. This especially involves those who are self-employed or in high-risk occupations. For example, all assets held personally may be at risk if a legal battle involves you.. Another disadvantage is that there is no flexibility over how the property losses/gains will be distributed. For example, if the property starts profiting, the owner has no flexibility over how that profit is taxed.
Ownership Structure 2 – Trusts
There are different types of trusts available depending on your personal situation. In essence a trust is where the legal owner of the property (the trustee) is looking after and holding the property for the benefit of other people (the beneficiaries). Note that the trustee can also be one of the beneficiaries. Creating a trust may help to protect your assets and legally minimise your tax liabilities.
The two main types of trusts that property investors use include discretionary trusts (sometimes referred to as family trusts) and unit trusts. Also worth mentioning are hybrid trusts which this article will be disscussing below.
Overall, establishing a trust is relatively inexpensive, will give you greater control and flexibility to manage your portfolio in a tax-effective way (especially when your property portfolio is making a profit and/or as your property portfolio grows and land tax starts to be a problem), will give you extra asset protection and may help you to minimise your tax (including land tax).
Ownership Structure 3 – Companies
Rather than property investments, setting up companies are frequently for business structuring. . A company is a separate legal entity. Having the same rights as a person, it can inccur debt, sue and be sued. The company’s owners (shareholders) can limit their personal liability and are generally not liable for company debts. A company can either own property in its own right or can be trustee of a trust that owns property.
A benefit to having a company is the tax rate on profits may be lower than your personal tax rate. This is because the company tax rate applies rather than the marginal personal income tax rates. It also offers strong protection of assets.
The main disadvantage of using a company structure for property investing is that companies do not get a 50% discount on capital gains tax (CGT) on the sale of investments like individuals and trusts. Companies are also only able to offset losses against future income. A company structure is quite costly to establish and operate due to the high cost of tax returns and administration.
Ownership Structure 4 – Self Managed Super Funds (SMSF)
What is a SMSF?
A Self-Managed Superannuation Fund (SMSF) is a superannuation trust structure where the members are also the trustee of the fund. SMSF’s allow members more control over investment decisions on their superannuation. It give members the opportunity to borrow money to purchase investment properties within the SMSF.
The advantage of SMSF is the ability to allocate your retirement funds to property investing before you hit retirement age. It also enables you to get a 33% discount on CGT when you sell the property after 12 months. However, the tax savings get even better if you buy a property with your SMSF and hold the property until you reach retirement age, when your tax rate drops to 0%, meaning you pay no tax on either the capital gains if you sell the property or the rent if you continue to use it as an investment property and the property is positively geared. Another benefit of an SMSF is the tax rate for SMSF’s is only 15%, which is significantly lower than personal tax rates.
Investing with SMSF
As well as the obvious attractive tax structure, using your superannuation to invest could be a great way to grow your property portfolio. With the limitation on your personal borrowing capacity, this is especially true.
When assessing a lending application for a loan to purchase a property within your SMSF, the lender will focus on the income and expenses of the SMSF and will not take into account your personal income and expenses. As a result, you may be able to borrow money in your SMSF, if the income received by your SMSF (i.e. through rental income and other income of the SMSF) is sufficient to service the debt.
It is important to note, that whilst borrowing through an SMSF is always limited recourse (meaning that the bank’s ability to recover lost funds resulting from default are limited to the assets of the SMSF), many lenders require the beneficiaries of the SMSF to personally guarantee the loan. Therefore, if your SMSF fails to be able to meet the loan repayments you may be personally liable.
On the downside, SMSF’s are an expensive ownership structure to establish and maintain.This is due to their highly regulated and complex nature. SMSF’s are also the only ownership structure that you can’t use equity growth to fund or borrow against for future investments. This is a big limitation for investors in the acquisition phase of their investing journey. There are also strict limitations regarding what improvements you can make to the properties in the SMSF. Therefore, this is definitely not the right ownership structure for properties you plan to add significant value to.
It is advisable to get the right advice before entering into an SMSF arrangement. There are various ongoing compliance and audit requirements and heavy penalties for getting it wrong.
If you’d like to speak with one of our amazing brokers about property ownership structures, contact us here!