Changing the ownership of a property is typically cost-prohibitive. This is mainly due to the potential stamp duty and capital gains tax liabilities that can arise.
Therefore, it’s vital to carefully consider the ownership structure right from the start. Once you’ve made that decision, it is likely that you will have to live with the consequences for as long as you own the property.
Essential factors to consider
When deciding on the best ownership structure for your investment property, there are several key factors to consider:
- Tax Implications: For long-term investors, maximising income tax benefits generally outweighs minimising capital gains tax (CGT) liabilities. This is due to the time value of money; a tax saving today is significantly more valuable than one in 20 years. However, if your investment strategy involves selling the property in the future, CGT becomes a more important factor than it typically is. Additionally, keep in mind land tax implications, as investment-grade properties are often land-rich, making this an important consideration.
- Borrowing Capacity: Most investors use borrowed funds to invest in property, so it’s important to ensure that your chosen structure allows for borrowing. It is best that you have access to a broad range of lenders and be aware of any product restrictions, such as limitations on using offset accounts.
- Estate Planning: Consider how the property ownership structure aligns with your overall estate plan. It should facilitate the smooth transfer of wealth to your beneficiaries in a straightforward and tax-efficient manner.
- Exit Strategy: Define your plan for the asset and its associated debt. Will your investment strategy require you to sell this property in the future? If you need to reduce debt, how can you do so in a tax-effective way?
- Asset Protection: Evaluate any asset protection risks, especially if you work in a higher-risk occupation or are a director of a high-risk business.
Ultimately, no single factor stands alone as the most important. The best approach is to find an ownership structure that effectively balances all these considerations.
Owning property in personal name/s
Most property investors choose to hold their investments in personal names because it’s the simplest and most cost-effective ownership structure. However, this approach has downsides, particularly in terms of future tax planning flexibility.
- Tax implications: Owning property in personal names often allows for maximum negative gearing benefits if the property is held by the highest-income earner. However, if income levels change in the future, you may not be able to optimise tax benefits. Additionally, CGT and land tax liabilities are fixed based on ownership, which limits future tax planning options.
- Borrowing capacity: Generally, there are no negative borrowing consequences associated with holding property in personal names.
- Estate planning: In the case of joint ownership, if one owner dies, the property automatically transfers to the surviving owner/s, which will keep the asset out of the estate, if desired. However, if the property is owned as tenants-in-common, ownership transfers into the estate, which can be beneficial when co-owning with individuals who aren’t beneficiaries of your estate.
- Exit Strategy: When it comes to repaying debt, you must do so using after-tax dollars, which can be uneconomical.
- Asset Protection: Any net equity in the property is at risk if the owners become personally liable to creditors.
In contrast, a tenants-in-common structure offers more flexibility than joint or sole ownership. For example, we typically recommend that both spouses be listed on the title, even if one spouse only owns 1% of the property. This arrangement prevents either party from unilaterally selling the asset in the event of a relationship breakdown, which statistically is the most common asset protection risk.
Additionally, if clients have cash savings or expect to accumulate them, we may suggest splitting ownership between spouses to maximise negative gearing. For instance, if a client purchases a $1 million investment property and has $300,000 in cash savings, we might allocate 35-40% of ownership to the lower-income earner’s name, using a combination of cash and a small amount of debt. The remaining share would be placed in the highest earner’s name, funded entirely by debt. While this approach doesn’t change the total borrowing amount at the family level, it allows the highest income earner to maximise their gearing and, consequently, their income tax benefits. It will also help spread any future CGT liability across two individuals.
Owning property in a family trust
We generally advise against owning property in a family trust, particularly for clients who are PAYG employees, as they miss out on the immediate tax relief benefits of negative gearing. Additionally, one of the main drawbacks of trusts is that they typically incur higher land tax rates.
- Tax Implications: A family trust cannot distribute losses, which means that any negative gearing benefits become trapped within the trust and can only be carried forward to offset future income. This could result in investors waiting over 20 years to realise these tax benefits. Unless you are self-employed and can distribute other taxable income into the trust to absorb property income losses, a family trust is usually not the best ownership structure. On the plus side, discretionary trusts offer flexibility in distributing capital gains, allowing you to spread the gains among multiple individuals and/or a company, to minimise tax. However, as mentioned earlier, discretionary trusts often attract higher land tax rates in most states.
- Borrowing Capacity: Borrowing through a non-trading family trust typically poses few challenges. However, only a limited number of lenders permit trust mortgages to include an offset account.
- Estate Planning: Controlling a trust is an effective way to transfer wealth since it can continue to exist after your death. To facilitate this, you can name a replacement appointer of the trust in your will, ensuring a smooth handover of control.
- Exit Strategy: Like owning property in personal names, any debt must be repaid using after-tax dollars, which can be uneconomical.
- Asset Protection: A family trust can provide strong asset protection benefits because no individual can claim the trust’s assets unless the trustee decides to distribute them, assuming there is a corporate trustee in place.
Owning property in a company
The most cited downside of owning property through a company is that companies do not qualify for the 50% CGT discount. However, if managed effectively, this can be mitigated and potentially lead to an even lower CGT liability. Therefore, I believe the most significant drawback is that any negative gearing benefits are trapped within the company, making it a suboptimal choice unless you are self-employed.
- Tax Implications: Income losses incurred in a company must be retained and carried forward to offset future taxable income. This means that unless you are self-employed and can distribute income into the company, this ownership structure is generally not favourable. Companies incur a flat tax rate of 25% or 30% on income and capital gains, and they cannot utilise the 50% CGT discount. While a company may incur a tax liability of up to 30% on net capital gains, it does receive a credit for this tax paid, as explained here. This allows the company to progressively declare franked dividends to shareholders, effectively spreading the CGT liability over several tax years. In theory, this could result in shareholders receiving tax refunds and paying very little (CGT) tax overall. Regarding land tax, companies are typically taxed at the same rates as individuals.
- Borrowing Capacity: If directors provide personal guarantees (which is common), a non-trading company borrowing to invest in property should be relatively straightforward. However, most lenders do not allow offset accounts to be linked to loans in a company name.
- Estate Planning: The succession of company directorships should be addressed in wills. The ownership of shares will dictate what happens to the company and its assets upon an individual’s death.
- Exit Strategy: If you distribute taxable income into a company, it will be taxed at either 25% or 30%, and the remaining after-tax funds can be used to reduce debt. This structure is generally more tax-efficient than other ownership structures.
- Asset Protection: The level of asset protection for property held in a company depends on who owns the shares. If the shares are owned personally, and that individual incurs a loss, the assets in the company could be at risk.
Owning an investment property in a company can be a beneficial structure for self-employed individuals. However, for PAYG employees, it is generally not the right choice.
Owning property in an SMSF
I typically prefer to own geared property outside of superannuation, while keeping ungeared shares and other investments inside super. This strategy helps maximise the tax benefits associated with negative gearing.
- Tax Implications: As mentioned earlier, maximising negative gearing benefits from an investment property is crucial for enhancing investment returns. When holding property outside of super, the after-tax holding costs are lower, which maximises investment returns. The downside of owning property inside super is the lower tax rate of 15%, which means the negative gearing tax benefits can be up to three times less compared to property held outside of super. This is a significant drawback. However, the advantage of holding property in super is the flat CGT rate of 10% during accumulation and zero in retirement. So, if you don’t plan to hold the property long-term and expect substantial capital gains, an SMSF can be an attractive option. Generally, SMSFs do not incur higher land tax rates.
- Borrowing Capacity: Borrowing within an SMSF can be more challenging, as capacity is driven solely by the fund’s historical income, including super contributions. Additionally, interest rates and fees tend to be higher than those for standard mortgages, typically around 1% p.a. more.
- Estate Planning: Your superannuation balance does not form part of your estate. Instead, it is distributed according to your death benefit nomination.
- Exit Strategy: Planning your SMSF investment strategy is crucial. Repaying debt can be challenging since your capacity to do so usually depends on your ability to make additional contributions to super which are capped. Moreover, since investment-grade properties primarily generate returns through capital growth and property is an illiquid asset, you might find yourself in a situation where you are forced to sell the property to cover minimum pension payments.
- Asset Protection: SMSFs offer strong asset protection benefits, as the assets are protected from claims in the event of bankruptcy.
No structure is perfect
Choosing the most suitable property ownership structure involves assessing your existing investment assets and having a clear understanding of your long-term investment strategy. The goal is to weigh the pros and cons of various ownership structures against your other investments, ensuring they work together to optimise tax efficiency, cash flow, and overall investment outcomes at the portfolio level. This process requires a multifaceted approach (tax, mortgages, financial planning), supported by a team that has a deep understanding of both property and shares.
Warning: The information provided is accurate as of the date of this post, but please note that laws and tax regulations are subject to change.
