When purchasing a rental property, one of the key decisions to make is which business structure is the best for you to own the property.
There are advantages and disadvantages for each type of structure and the most appropriate structure will depend on your circumstances. Engaging legal and accounting advisors early in the process will assist you with this decision.
There are five possible structures, which can be used.
A sole trader is an individual trading on his or her own; and controls, manages and owns the property in his or her name.
This is the simplest structure available and generally, there are no formal or legal processes to set this up. Any losses or profit incurred from the rental investment at the end of the year is recorded in your personal income tax return.
This structure generally has the least compliance costs. However, the owner is personally liable for all business taxes and debts.
A partnership is an unlimited liability business agreement between a minimum of two entities. There are no shares in the business to own because the business does not exist as a legal entity. The income flows through to the individual partners and they account for any tax liability on their share of the income.
It is prudent to have a partnership agreement detailing each partner’s rights, especially if the other party is not your spouse but a business partner.
If you do not have a partnership agreement, the Partnership Act 1908 applies by default. This requires any profit or loss to be divided equally among the partners. If this is not the case, it must be clearly stipulated in the partnership agreement.
Companies are separate legal entities to their shareholders and allow the owners limited liability. A shareholder in a limited company is not personally liable for any of the debts of the company, other than for the value of their investment in that company.
It is simple to rearrange ownership in a company as the shareholding of the company can be changed if required, avoiding expensive Conveyancing fees.
There are certain tax implications if you change any shareholding. Therefore, always discuss this with your accountant first.
You should be aware of several issues while structuring a company.
If the property makes a loss, this will be retained by the company and can only be used if there is another source of income to offset. Otherwise, it will be carried forward against future income.
If you sell the property, accruing capital gains will be trapped in the company. The only way to access this tax-free is to liquidate the company.
Where you have several properties in the same company, you can have an expensive restructure to release the capital gains out of the company tax-free.
Look Through Company
Look Through Company (LTC) works in way similar to the erstwhile Loss Attributing Qualifying Company (LAQC) with the ability to allocate losses to shareholders. For tax purposes, LTC is treated like a partnership, with shareholders deemed to derive and incur its income and expenses.
The Inland Revenue Department (IRD) has introduced a loss limitation rule.
The amount of loss a shareholder can claim from an LTC is limited to the extent of their ‘investment.’ Net surplus cannot be retained by the company but must be passed to the shareholders and taxed in theirs hands.
You should exercise caution if you decide to sell the shares in an LTC. This triggers a deemed sale of the underlying property for tax purposes and could result in depreciation recovery.
A Trust is similar to a company in some aspects. Assets are owned by a Trust, although you may be a trustee, you do not personally own them. It is beneficial in that it can provide asset protection. It is a popular vehicle for owning your family home as it protects your assets for you, your children and even grandchildren.
The main disadvantage of the Trust owning your rental property is that if any loss retained by the Trust and you will not be able to use the losses to reduce your personal income tax liability.
A Trust must be administered properly; otherwise it may be argued by IRD that it is a sham; also known as an ‘Illusory Trust.’ Therefore, you should maintain a separate bank account and not use it as your personal bank account to meet daily expenses.
Trustees should meet regularly and discuss decisions to be made in the best interests of the beneficiaries.
There are advantages and disadvantages of each structure available when purchasing a rental investment property. You should consider all the facts applicable to your circumstances and obtain advice from your accountant before taking a decision.
When completing a sale and purchase agreement, as a purchaser always enter your name followed by and /or nominee. This will give your advisors the flexibility to prepare a deed of nomination if required to hold the property in another name or vehicle.
Anit Patel is an Associate Director, Business Advisory Division at DFK Oswin Griffiths Carlton Limited based in Auckland. He can be reached on (09) 3793890. Email: firstname.lastname@example.org
DFK Oswin Griffiths Carlton Limited is a firm of Chartered Accountants providing the full range of business advisory, auditing and taxation services. Its experienced staff can advise you on all aspects of business from both domestic and international perspective.