Structure Guide for Property Investors under the new rules from 1 April 2011

Posted on Wednesday, March 9 2011

Now that loss attributing qualifying companies (LAQC) will no longer exist after 31 March 2011, I have revisited various property ownership options to determine their advantages and disadvantages for property investors going forward so that you are armed with the information to make an informed decision about the best ownership structure for your rental properties.

Before you can make a good decision about the best ownership option for your situation, you need to do three things:

(1) Complete a projected profit and loss for your rental properties to determine the amount of profit or loss that the property will make.

(2) Determine the expected taxable income of each investor.

(3) Determine whether asset protection is more important to you than being able to offset any rental loss against your taxable income to get an immediate tax refund.

Once you have done those three things, you’re armed with the information to make a good decision.

If your rental property will be making a profit, then I would generally recommend purchasing the property under a trust. As well as providing asset protection, a trust allows you to allocate the rental profit to a beneficiary that is on the lowest personal tax rate or to pay tax on the rental profit at the trust tax rate of 33%.

In this situation, the only disadvantage of the trust is the setup cost and ongoing compliance. If that is of concern to you, then owning the property in your personal name might suit you better.

It’s worth noting that as deprecation can no longer be claimed on buildings, it’s now more likely that a rental property will make a profit.

If your rental property will be making a loss and you would rather have asset protection than an immediate tax refund, then I would generally recommend purchasing the property under a trust. In this situation, a trust will provide asset protection and the loss will be carried forward and accumulated under the trust until it begins to earn profits (probably from future rental profits when/if some of the loan on the property is paid off) which can then be offset against those losses.

If your rental property will be making a loss and you would rather an immediate tax refund than asset protection, then your options include a normal company, a look-through company (LTC) or personal ownership.

By using a norman company, the company would issue shares to the value of the purchase price of the rental property. You would borrow that same amount under your personal name and use those funds to purchase the shares in the company. The company would then purchase the property using those funds.

The company would end up with a rental property with no debt so would be making a profit. This profit would be paid to you as the shareholder by way of dividends. As the shares were purchased by you for the purpose of deriving dividends, the interest on the loan you drew down to purchase the shares will be tax deductible.

The advantage of this option is that any funds you loan to the company would be able to be refinanced at any stage in the future. However, this is not likely to ever happen as the company will be making a profit so you will not be required to ever loan funds to the company.

The disadvantages of this option is that it is complicated, the company will need to pay provisional tax, you would receive imputed dividends and you would need a liquidation to avoid paying tax on any capital gain (which is only a problem if your company owns more than one rental property).

As the disadvantages outweigh the advantages, this option is not recommended in this situation.

Now that we have discounted using a normal company, that leaves a LTC and personal ownership as the remaining two options.

The following is a comparison of the advantages and disadvantages to help you decide on whether to use an LTC or personal ownership.

Whether your rental property is owned by an LTC or under personal ownership, any loss will be included in your personal tax return. The only difference is to how that loss is split.

The losses of an LTC are distributed according to the number of shares each shareholder holds. The shares should generally be held by the person that earns the most income to allow the losses to be allocated to the person that will get the greatest tax benefit. As with most arrangements aimed at achieving a better tax result, there will always be questions over whether the IRD would challenge a shareholding split of other than 50/50 in the case of a husband and wife if all assets and funds are held 50/50. However, the IRD have never questioned LAQC shareholding splits of other than 50/50 for a husband and wife in the past so there is no reason to expect them to challenge it under the LTC rules.

In contrast, the losses of a property personally owned are distributed based on the ownership of the property which may or may not result in the optimum tax outcome.

If a property was purchased by two people as a joint tenancy (which is often the case with married/de facto couples), then the IRD would expect any loss to be allocated 50/50 between those two people. If you wanted to depart from the typical 50/50 split then you must have a formal partnership agreement and have a valid reason for the different split (ie. contributing differing amounts of capital) rather than simply agreeing a different split because this achieves a better tax outcome.

If a property was purchased by two or more people as tenants in common, then the ownership of the property can be done in unequal shares (ie. 75% to one person and 25% to the other). In this case, the IRD would expect any loss to be allocated 75/25 between those two people. However, case law suggests that the loss is not just split according to the registered owners of a property. The other determining factors include who is liable for the mortgage and who contributes monetary funds towards the property. So, if a personally owned property is to be split 75/25, then the mortgage and contributions should also be split that way.

While you can purchase a rental property under your personal name and have the loss allocated to achieve the best tax outcome, I believe this is achieved more easily with a LTC without as much doubt over the loss splitting ratio. An LTC also allows you to both be directors despite potentially having an imbalance in shareholding.

The losses from an LTC are subject to the loss limitation rule whereas there are no loss limitation rules for personal ownership.

The loss limitation rule effectively limits a shareholder’s claimable loss to the amount of their potential economic loss. The potential economic loss includes the cash introduced into the LTC and includes the extent of any security or personal guarantee provided towards the LTC loans. If a guarantee is provided by more than one person, then the amount of the guarantee must be divided between those people.

So, while the loss limitation rule is unlikely the effect the majority of LTC shareholders, there are situations where it will take effect. For example, if you and your son own a LTC as 50/50 shareholders but your son does not provide any cash, security or personal guarantees, then he may be unable to claim his entire share of the LTC loss.

Another example is where a husband and wife have a share split on 99/1 but the security and guarantee is provided from relationship property on a 50/50 basis. In this case, there is a higher possibility that the higher shareholder could have some losses limited.

Once you purchase a property under your personal names, if you want to change the split of the losses, it requires your lawyer to alter the certificate of title and is likely to require your bank to redraft documentation which means it a time consuming and expensive process.

A benefit of using a LTC is that you can change the split of rental losses by way of a share transfer which is easy and inexpensive. However, to avoid triggering a deemed sale of the underlying properties (and therefore depreciation recovered), the value of the shares transferred cannot be $50,000 more than the shareholders share of the net book value of the LTC net assets.

Under personal ownership, you are personally liable for all debts relating to the rental property. An LTC is a company so it provides limited liability protection against all creditors except your IRD income tax.

However, you are unlikely to be protected from your main creditor which will undoubtedly be your bank as you will generally be required to provide personal assets as security and to sign a personal guarantee anyway.

So, a LTC really only provides protection if you were ever sued for damages caused to tenants by your property (ie. say by maintenance that was negligent) which is highly unlikely.

The administration of a LTC is more involved and costs a bit extra. Our cost for incorporating a company, registering it with an IRD number and LTC election is $299 (incl gst). Annual minutes and annual returns must be prepared each year as part of complying with the Companies Act 1993.

The accounting costs involved with an LTC are greater due to the more complex tax rules and financial reporting requirements.

Our annual accounting costs for an LTC will generally be $200 more than personal ownership costs.

After a few years of renting out a property, I’ve seen investors who decide that they want to live in the rental property. The IRD consider it tax avoidance if you live in a property owned by a LTC so it’s best to transfer the property from the LTC at that time which is a time consuming and expensive process.

On the other hand, a property owned personally can easily go from being a rental property to an owner occupied property without causing any such problems (although there might be depreciation recovered at that time). So, personal ownership offers greatly flexibility in this area if there is a possibility that you may live in your rental property at some stage.

If the rental property you purchase will always be a rental property, then this won’t apply.

Whether you decide on an LTC or personal ownership depends on several factors. However, if your situation is fairly typical such as those facts described below, then I can provide some general guidance.

(1) You are purchasing a rental property using a 80-100% bank loan obtained by providing an existing home as security
(2) The rental property will make a tax loss given the high gearing of debt on the property
(3) Receiving a tax refund is more important to you than asset protection

If you fit the assumptions above, I used to recommend using an LAQC. The main reason for this was the ability to get the LAQC to repay any funds you have loaned to it earlier and making the interest on those funds tax deductible. This is no longer a benefit under the LTC.

Now, there are only three benefits of a LTC. The first is the limited liability protection of a company although this is almost never required by residential property investors. The second is that there is less doubt over the loss splitting ratio. The third is that it’s easier to change the loss allocation than personal ownership although you still need to meet the $50,000 equity test.

If you are single, you will not need to change the loss allocation so personal ownership is best.

If you have a partner and need to split the loss in the most tax efficient manner then you could consider a LTC if you wanted to split the loss 99/1. Personal ownership with only one partner on the certificate of title and mortgage documents is another option to avoid the extra compliance costs of using a LTC.

You could also consider having a different loss split under a tenancy in common arrangement (ie. 75/25) while bearing in mind that the initial loans and ongoing contributions should also be made those same proportions.

Tony Thorne

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Expert's Bio

Tony Thorne

Thorne Accounting has been providing specialised accounting and tax services to residential and commercial property investors since 2004. Our mission is to provide the highest quality tax and accounting services to property investors. We are constantly fine tuning the way we work with property investors so we can provide this superior service at competitive prices.

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