Who (or what) should buy your next property investment?
Although first-time investors rarely consider their property ownership structure options, this is perhaps one of the most critical aspects that you need to get right from the start.
Often the decision to buy an investment property is accompanied by an assumption that the investor will make said purchase in their own name (solely), or in joint names if they decide to invest with a partner or spouse.
In many cases, this first property investment is all about testing the water, rather than actually committing to the creation of a full-blown real estate portfolio.
But when that one investment works really well for them, they decide to ramp up their investing activity, and it’s only at this point when they possibly start looking into different ownership structures.
The problem is, getting that initial acquisition right in the first place may allow you to make the second and subsequent purchases in a shorter timeframe and with better cash flow.
However if you have to spend a lot of time trying to set up a more complex ownership structure, such as a trust or company, you could be wasting valuable time in the market.
When buying an asset that costs hundreds of thousands of dollars and one you might own for decades to come, it’s logical that you should invest in top quality advice about portfolio structures.
It can be very expensive to correct structural mistakes. For example, if you change the ownership of an issue you will most likely trigger stamp duty and capital gains tax liabilities.
Here are the four main aspects of ownership structures you need to consider from the beginning of your journey:
- Tax benefits and liabilities. Negatively geared property generally attracts associated tax benefits, within the first ten years particularly. However, a lot of people don’t consider that once a property turns a profit you will have to pay more tax. So don’t be too seduced by short-term tax benefits.
- Cash flow. Different structures will have different cash-flow outcomes.
- Asset protection. Are your assets protected if you get sued?
- Estate planning. How will your assets transfer to your beneficiaries after your death?
Three out of the four issues above are financial planning concerns, which most accountants will not be able to advise on.
Which structure is best for me?
It’s understandable that many investors neglect this question, given that there are quite a few options and it can be difficult for the layperson to weigh up all the potential pros and cons for their particular circumstances.
Nevertheless, you do need to have a response.
Perhaps an even better question is; ‘Which structure is best for my next purchase?’
The reason I say that is often (but not always), one size does not fit all. In other words, it’s generally optimal for a client to use a number of different ownership structures.
For example, an investor might hold their own home in their personal name, a couple of investment properties in a discretionary trust and one investment property in a SMSF.
Ultimately, when developing the optimal ownership structure for any given client, there are many things to account for, including (but certainly not limited to):
- Number of years until the person would like to retire.
- Amount of income needed in retirement (to fund lifestyle).
- Risk of client being exposed to financial loss because of occupation or other matters (e.g. a medical practitioner in private practice may have higher risks than an accountant who is an employee).
- Level of current and future income (including income structure).
- Value and type of existing investments, including any equity in the home.
- Investable cash on hand.
- The existence of a spouse and/or other dependants.
- Future personal requirements (e.g. purchase or upgrade of a home).
- Overall risk profile and appetite.
Crunch the numbers… again
Often, the best way to determine the optimal structure is to prepare detailed financial forecasts and comparisons, including expected income and expenses that your property portfolio may generate over the investable term (say 20 to 30 years) and any tax liabilities.
This will allow you to ascertain the different financial outcomes each structure provides and even combinations of different structures. Different structures will affect your income tax, land tax, CGT and the like.
It’s worth considering calculating the Net Present Value (NPV) of each scenario. A NPV calculation determines the present value of future cash flows and accounts for the time value of money (i.e. it’s better to receive $1 today as opposed to $1 in 20 years).
Some structures deliver more net income in the earlier years than others. For example, one structure might provide you with higher income tax benefits now, but higher CGT if you sell the property investment, compared with lower income tax benefits now, with no CGT liability in the future.
It’s difficult to compare these two scenarios without completing an NPV calculation. Microsoft Excel has a NVP function, which automates this calculation – although I prefer to do it manually (the function will ask for a discount rate).
Normally, we suggest using your long-term inflation forecast. Given the RBA’s role is to manage monetary policy so that inflation remains in the 2% to 3% band, we recommend using 2.5% as a discount rate.
What is the ‘cash’ value?
In addition to looking at cashflow forecasts (via a NVP calculation), you need to consider the wealth effect. That is, the value of equity in your property portfolio.
It is wise to consider the cash value rather than the property’s value. For example, if you sold all of your investment properties, repaid any loans, and paid for selling costs including CGT, how much cash would you be left with? What is that cash worth in today’s dollars?
While you may never intend to sell any of your properties, it’s wise to consider how much money you would have in the bank if you did (as circumstances may require you to one day). Structures that minimise CGT in this regard actually provide more opportunities.
The important point I’m trying to make is that it’s unlikely ‘one ownership structure fits all’. Rather, the best solution for an investor is often a combination of different ownership structures, as each has different pros and cons.
Using a combination of different structures, you can often mitigate some of the cons at a property portfolio level. However, you can’t work this out without analysing all the numbers.
Portfolio structuring is one of the areas we specialise in here at Property Tycoon Finance.
So if you would like more information on how you can profit from investing in Australia’s residential real estate sector by establishing clear investment strategies and structures, contact us or subscribe to receive regular post updates and industry insights.
Stuart Wemyss is a chartered accountant and founder of Property Tycoon Finance. Email: firstname.lastname@example.org
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