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The Investor’s Guide to
Buying Property
In whose name do you buy your next property?
Question: Do you buy investment property in a
personal name, or use a property investment structure such
as a company, a family trust or a self-managed super fund?
Answer: Choose the one that suits your needs best:
to be simple, safe, tax effective and inter-generational.
This newsletter looks at the pros and cons of buying
property in a personal name, a family trust and a super fund
for investment.
This is a general guide. Because everyone’s circumstances
are different, professional advice should be obtained before
acting. Cordato Partners Property Lawyers provides that
advice.
PERSONAL NAME
Buying the family home in a
personal name is attractive ... because
- Simplicity – any person over 18 may buy property in their
personal name.
- Easy to finance – with a genuine savings record for at least
5% (often 10%) of the price, 24 months full time employment
and a clean credit record, a person can borrow up to 95% (or
90%) of the price as a loan repayable over 30 years.
- No capital gains tax is payable on the sale of the family
home so long as it is the main residence for the owner.
- No land tax is payable on the family home. Pensioner
concessions or rebates are available for council rates and
water rates.
- First Home Owner Grants and stamp duty exemptions
are
sometimes available.
- Easy inheritance – the family home passes to the surviving
spouse, then to the beneficiaries without death duties or
stamp duty being payable.
Buying investment property in a personal name is attractive
... because
- Negative gearing - the investor can offset the loss from the
negative geared property against their personal income, and
so reduce their personal tax.
- Loans – A lending ratio of up to 90% of the purchase price
is available to investors who buy in their personal name.
Note: This only applies to investors on a salary (PAYG) and
for a small number of properties. Otherwise, a lending ratio
of 80% applies.
- Transfer taxes - If the property is already in a personal
name, it is best to not transfer it to a structure because
stamp duty is payable and capital gains tax
might also be
payable.
But there is little asset protection for properties in
personal names
These are some suggestions to limit asset exposure for
properties in personal names -
- Ownership - either buy the family home in the
spouse’s/partner’s name, or buy jointly with a the person
with most exposure taking a token 1/100th share in the
family home.
- Insurance – homeowner insurance covers not only the risks of
storm and tempest and fire, but also covers the risk of
injury sustained on the property by visitors who might slip
on a path, trip on a stair or walk into a glass door.
- Avoiding cross-collateralisation – a home owner might decide
to buy an investment property. The lender might offer one
loan with security over both the family home as well as the
investment property – this is cross-collateralisation. To
avoid exposing the family home to loss on the investment
property, take out two separate loans – one for each
property.
- Neutralising the equity –The equity in a family home will be
a target in litigation. Some financial advisers recommend
that a second mortgage be registered to ‘neutralise’ the
equity. This will work if it is a genuine loan. But often,
this ‘protection’ fails because the loan for which the
second mortgage is registered is not a genuine loan.
FAMILY TRUSTS AND SELF-MANAGED SUPER FUNDS
Business owners, professionals, builders and traders are
particularly exposed to litigation personally because they
sign personal guarantees, incur business debts and suffer
partnership break ups. Sometimes, the financial exposure is
so great that bankruptcy results and personal assets are
lost.
Asset protection is the number one reason why lawyers and
accountants recommend that investors set up property
investment structures for buying investment property. That
way, if anything goes wrong, the damage is limited to the
structure and the personal assets are protected.
How do companies and trusts provide asset protection for
investors?
This is how companies and trusts work to keep investor
assets safe -
- Companies - it’s been said that the introduction of the
limited liability company in the UK Companies Act of 1862
was the greatest single breakthrough for commerce in modern
times. Why? Because a company provides a limited liability
protection for its owners (the shareholders). That is why
the words Pty Ltd (Proprietary Limited) are used in the
name.
A company is a stand-alone legal entity. A company may trade
in its own right, or act as a trustee company for a trust or
as an investment company or as a nominee company. Even
though a company may go into liquidation, receivership or
administration, none of these events expose the shareholders
to personal liability.
- Trust Structures – the English Law also developed the law of
trusts. A trust is a legal relationship where the trustee
administers trust assets for the benefit of beneficiaries of
the trust. The trust assets are often money, which is given
to a trustee.
Illustration: in 1711, in Brown versus Litton, the Court of
Chancery distinguished a trust from a loan. The facts were
that a ship’s captain (Litton) was entrusted with 800
dollars on a voyage. The captain used the money to trade,
and greatly increased it. At the end of the voyage, the
captain offered to pay back the 800 dollars with interest,
as if it were a loan. But the Court ordered the captain to
pay back all of the money, less a ‘proper salary’ for his
pains and trouble, because the Court said that Litton held
the money in trust for Brown. This trust was a bare trust
because the trust assets were returnable on demand.
Why are trusts the favourite legal structure for property
investors?
Most of the 660,000 trusts in Australia are family trusts
(also known as discretionary trusts). There are almost
500,000 Self-Managed Superannuation Funds (SMSFs) which are
also trusts.
Serious property investors favour family trusts and SMSFs
for property investment because -
Asset Protection
In a family trust, the trustee company buys the property and
borrows finance in the trust name. If the family trust is
caught up in litigation concerning the property, it is the
trustee company is sued, not the family members. In most
cases, property insurance will shield the trust assets from
outside claims.
In a family trust, a creditor pursuing a family member for a
debt cannot lay claim to the trust assets. The trust assets
are shielded from creditors for the legal reason that none
of the family members has any ownership rights in the trust
assets in a discretionary trust.
In an SMSF, a member has a retirement fund in their name,
which they cannot access until they retire. SMSFs provide
complete asset protection because a member’s fund is not
available to their creditors by law if they (the member)
becomes bankrupt – see section 116(2)(d)(iii)(A) of the
Bankruptcy Act 1966. This does not protect extraordinary
contributions which made to put assets out of reach when
bankruptcy is on the horizon.
Tax Effectiveness
Family trusts are tax effective investment vehicles because
profits can be split in different ways each year. The
trustee decides how the profits are distributed at the end
of each year.
Profits can be streamed to ‘smooth’ the taxable income of
the family: to a low income family member, rather than to a
high income family member, and therefore take advantage of a
lower income tax bracket.
As a tax shelter, SMSFs reign supreme. To have an income tax
rate of 15 cents in the dollar, a capital gains tax rate of
10 cents in the dollar, and with zero tax in retirement
mode, once required a trust to be set up nestled in a clump
of palms in a tax haven somewhere in the Caribbean! Now, all
that is needed is to set up an SMSF in Australia. As a
bonus, contributions of $25,000 per annum per person to the
SMSF are tax deductable.
Trusts are best suited for positively geared property,
unless there is a cash flow from other sources within the
trust to offset the losses, because losses in a trust are
not able to be used by the members personally. Trust losses
are able to be carried forward to future years.
Estate Planning to preserve wealth for the next generation
In a trust, the control of the trust assets passes to the
next generation according to the trust deed, outside of the
will.
In a family trust, on death, control passes to the next
appointor. The trust assets do not need to be sold or
transferred on death, and no death duties or taxes are
payable.
In an SMSF, on retirement, the SMSF must pay an annual
pension to member. This means that not long into retirement
mode, unless there is a pool of cash available, the trust
property which is real estate will need to be sold or
distributed to the member. Therefore SMSFs are of limited
value for inter-generational wealth transfers. On death, if
the member’s fund passes according to a binding death
benefits nomination, no tax is payable.
 Family Trusts are like cruise ships
The captain and the crew run the cruise ship, just like a
trustee runs a Family Trust. The passengers enjoy the
cruise, just like the beneficiaries profit under the trust.
All the passengers are a “family”. In port, the captain
allows a tug boat to tow the cruise ship, just like a trust
might appoint a nominee company to represent the trust. A
new captain and crew might replace the old, just like a new
trustee can replace an existing trustee.
Which trust structure is best for you? A family trust or an
SMSF?
The best trust structure for you depends on the property,
the financing, the tax effectiveness, and personal
circumstances. These are some considerations -
Family Trusts (investment trusts / discretionary trusts)
Family trusts excel for tax effectiveness, for preserving
wealth and for asset protection.
- Family Trusts are set up with a Deed of Settlement. This is
usually a long document which contains the rules for how the
trustee is to manage the trust, particularly the trustee’s
powers for investment. A family trust can make loans to, and
buy assets for, the family. A family trust can be set up
under a will – if so, it is called a testamentary trust.
- The trust deed will describe the beneficiaries – the family
members who may benefit. The trust may be a ‘dynasty trust’
- restricted to bloodline family, or may extend to their
spouses and partners. The trustee has the discretion to
distribute profits to each family member.
- Family trusts are not well understood by all lenders, so
choosing the right lender is essential. Lenders will lend no
more than 80% of the price to a family trust.
- Family trusts should own real estate indirectly in NSW
because direct ownership will mean more land tax liability.
Therefore, for land tax in NSW only, a family trust uses a
nominee company as the name in which to buy real estate.
This nominee company holds the property for the family
trust, as a custodian trust (a bare trust) under which the
family trust may call for the nominee company to transfer
the property to it any time. Nominee companies and custodian
trusts are also used by SMSFs when purchasing property with
a loan.
SMSFs (retirement trusts)
SMSFs excel for asset protection and tax effectiveness.
- SMSFs are set up with a Deed of Settlement. The Deed is
similar to a family trust deed, but it has the single
purpose of providing for the member’s retirement.
- SMSFs members must wait until they retire to access their
funds. When they retire, members must draw a minimum income
stream of 4% of their retirement fund annually. Only 4
members are allowed. These rules limit the flexibility of
SMSFs for next generation wealth preservation.
- SMSFs are restricted when it comes to investing. They cannot
run a business, cannot buy family homes or holiday homes,
and cannot loan more than 5% of their assets to the
beneficiaries. Buying and selling investment property
occasionally is not running a business.
- SMSFs use a custodian trust when borrowing to buy property.
An SMSF Custodian Trust Deed allows the nominee to own,
borrow and mortgage the property. When the loan is paid out,
the nominee transfers the property to the SMSF, without
stamp duty. Lenders often lend 65%, and no more than 80% of
the price to SMSFs.
Conclusion – Buy in personal names for simplicity, buy in a
family trust for asset protection and tax flexibility, and
buy in an SMSF to set up a tax sheltered cash flow for
retirement.
The Investor’s Guide to Buying Property has been produced by
Cordato Partners Lawyers, as part of its Property Law
practice. We can meet all your conveyancing needs.
To join the free mailing list for the Guide (mail or email),
Contact us by email –
info@propertyinvestmentlawyer.com.au
or by phone (02) 8297 5600 (speak to Sally Wade).
Our office
is located at Level 5, 49 York Street, Sydney NSW 2000 (near
Wynyard Station).
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