When buying an investment property, one of the most important things to consider is the ownership structure. The most popular options are buying the property in the individual’s personal name (or in joint names) or using a discretionary (family) trust structure. Each of these options has advantages and disadvantages.
Buying an investment property in the name of the individual
What are the advantages of buying a property in your own name?
– Tax benefits of negative gearing
If your tax-deductible expenses on the property, including interest on the loan and capital allowances, exceed the amount of rental income in a financial year, the loss gets offset against your income from other sources in your personal tax return. This reduces your taxable income and the amount of tax you pay.
– Discounted Capital Gain on disposal
Individuals are generally eligible for 50% discount on capital gain they make on disposal of a property if they owned the property for at least 12 months before the disposal. There are certain exception to the 12-months ownership requirement, such as where the asset passes to a beneficiary of a deceased estate or is transferred as a result of relationship breakdown. The 50% discount no longer applies to capital gains made by foreign or temporary residents after 8 May 2012.
– Potential eligibility for main residence exemption
If you use your investment property as your main residence at any time during the period of ownership, the property may be eligible for partial main residence exemption. There is also a potential to extend the period of exemption for up to six years after you move out, provided you do not treat any other property as your main residence during that period.
When you own a property in your personal name, you do not need to register a separate entity and apply for a separate tax file number. You will be declaring your share of profit or loss generated by the investment property in your personal tax return.
What are the disadvantages of buying a property in your own name?
– Little asset protection
Owning an asset in your personal name provides little asset protection. Your investment property will be exposed to creditors’ claims in the event of bankruptcy or litigation.
Buying an investment property in a discretionary trust
What are the advantages of buying a property in a trust?
– Greater asset protection
Placing your investment property in a discretionary trust can be an effective asset protection strategy. A well-constructed discretionary trust provides protection for the trust property from potential claims by beneficiary’s creditors if the beneficiary becomes bankrupt or is subject to a lawsuit. This is because the trustee, being the legal owner of the assets, has a discretionary power to distribute income and capital of the trust to beneficiaries. The beneficiaries have no proprietary interest in the trust property, they have a mere expectation to be considered by the trustee for making a distribution.
– Flexibility of income distribution
By placing your investment property in a discretionary trust structure, you can legally split income generated by that property in the most tax effective way. The trustee has discretion over income and capital distribution, which allows to minimise taxes by distributing income to beneficiaries in lower tax brackets.
– Ability to stream capital gains on disposal of the property
One of the main features of trust income is that it preserves its character when distributed to beneficiaries, which allows to pass tax attributes to beneficiaries. For example, resident beneficiaries can claim 50% discount on capital gain relating to a CGT asset held in a trust for more than 12 months. The trust tax provisions allow to stream certain types of income (capital gains and franked dividends) to particular beneficiaries who would get the most tax advantage from these sources of income.
What are the disadvantages of buying a property in a trust?
– Losses cannot be distributed to beneficiaries
If the investment property held in trust is negatively geared, and there is no other income in the trust to offset the loss from negative gearing, the tax loss cannot be distributed to beneficiaries. The loss must be quarantined until it can be offset against profit in subsequent years if loss utilisation provisions are met.
– Higher land tax payable in some states
One of the aspects often overlooked when considering choices of structures for holding investment property is land tax. Land tax is imposed by states in which the land is situated and the rules in each states are different.
For example, in NSW, discretionary trusts do not enjoy the benefit of land tax threshold applicable to other entities, such as individuals, companies, super funds and fixed trusts, and are taxed at flat rate of 1.6% of the taxable value of the property.
In addition, a trustee of a discretionary trust may be subject to a foreign resident surcharge as it may be deemed to be a foreign person for the purposes of land tax legislation if the trust has a potential beneficiary who is a foreign resident (whether or not they receive a distribution).
– Additional costs and compliance requirements
To be effective for asset protection and tax minimisation purposes, the discretionary trust must be properly set up and administered. Apart from registration costs and stamp duty, you may need to pay expenses or legal advice for drafting or reviewing your trust deed to ensure its terms meet your asset protection and tax minimisation objectives. There are also costs associated with managing the trust’s tax affairs, including maintaining proper records, lodging tax returns and preparing a separate set of financial statements each year.
There are number of issues that can arise from improperly running a trust structure resulting in adverse tax and legal consequences. Investors considering buying property in a trust should consult appropriately qualified professionals before making such decision to ensure they are fully aware of the implications.
Should you buy an investment property in your own name or in a family trust?
With each option presenting its advantages and disadvantages, the answer will depend on the balance of factors. You need to evaluate your personal circumstances, risk factors and long-term objectives you are trying to achieve before proceeding with the transaction. Changing structures later on can be costly as transferring property is likely to result in capital gains tax and stamp duty payable. It is essential that you seek the right legal and tax advice from the start to avoid unpleasant surprises.
Contact us today to make an appointment with our specialist tax adviser.