With all the media hype you could be forgiven that Property Investors are well and truly in the crosshairs:-
But just let’s reflect for a moment we have:
- No capital gains tax
- No ring fencing of tax losses
- No land tax
- No deemed rate of return tax
- No stamp duty
- No death duty
- And now, the removal of gift duty.
So, aren’t we the still the lucky country?
The only thing that has happened is the removal of depreciation and that was an absolute slap with a wet bus ticket!
Depreciation was always subject to recovery in due course, and at the same time they dropped the tax rate from 38% to 33%, 5 cents in the dollar. That is massive – it’s a huge tax cut and all of you who are sitting on massive accumulated depreciations you’ve got the opportunity to wash them back in due course at 5% less than what you claimed them at, how’s that bad news?
So again I guess it’s that glass half empty half full thing.
We have still got a lot to be thankful for in terms of with our tax system.
To give it to you in a nut shell, there’s a solution here for everybody in some shape or form, so no one needs to panic about it.
The new look LAQC is going to be a Look Through Company (LTC). Now the essence of the LTC is that your losses will still be able to be attributed just as you’ve always been used to with your LAQC company, but so too will your profits So there’s the thing, your losses will come out, but so do your profits when your company turns the corner. I don’t think that’s the end of the world to be honest, I think we can live with that.
But it does create some interesting planning opportunities. Because you’ve actually got to do something if you want to become an LTC.
You’ve got to file an election to become an LTC within six months of balance date, so for most of you that means 30 Sep 2011 is your last opportunity to say yes I want a transition to become a look through company. That will almost certainly be the option you’ll want to tick if the claiming of losses is still important to you. The default option, what’s going to happen to me if I do nothing, is that your company will continue as a qualifying company but it won’t be able to attribute losses.
Now a lot of people will say what’s the significance of being a qualifying company then, will rememberit’s the qualifying company status that allows your company to make a capital gain on the sale of the property, and then distribute it to you tax exempt.
A normal company that isn’t an LAQC, when it pays a dividend out for the capital gain that is TAXABLE. So there’s still real value to remaining a qualifying company, even if it can’t attribute losses. So the obvious thing you have got to do in order to work out what you want to do with your LAQC is to think whether you are going to make a profit or a loss in the absence of depreciation. For those of you who have been rolling off big mortgages on high interest rates and in some cases, going from 8.5% down to 6.0%, think about what your interest bill is going to be in the future. It might only be a year or two back when you were paying significantly higher interest rates. Interest rates have come down by a third. You have never been more profitable, in terms of what you have been producing off your investment properties. So you have to look at what your profitable position is.
Now this is where it gets a bit tricky because a lot of times it’s kind of a bit break even and you think the rents covering the out goings and without depreciation, I’m a bit marginal. Well if you remain as a qualifying company that can’t attribute losses, you are going to be able to have those profits taxed at the low tax rate 28 cents in the dollar. That’s the lowest rate going. Trusts are going to be at 33% and you going to be at 33%. The company is 5% cheaper, but there’s a little hook with this, which I will just explain.
If you have got your company paying a 28% tax rate down here, at some point you are going to want to get access to that tax paid rental profit that your company is producing.
Now, at that point, you pay out a dividend and the dividend comes up into the hands of the shareholder. Now the shareholder (will be you typically) will have a 33% tax rate, so at the point you pay the dividend, you have got to top the tax up from 28% to 33%. So again that 28% corporate tax rate is just a timing advantage. Now if you are of a mind to use your net rental profits to continue to reduce your debt in the company, you will be able to enjoy that ride for some time, so at some point you will want to think about passing out the dividend, then you have got to cop that extra 5% tax. So it is an incentive to reinvest rather than distribute and spend.
So that should be weighing on your decision with the whole look through company/qualifying company. There are kind of two main options and a couple of other options:
1. Is to abandon your LAQC status completely and revert back to being a normal company, I did think that this is the option that many people are going to go for simply because the biggest problem is how do you get your capital gain out of your company without paying tax on it?
The only solution is to wind your company up and liquidate it. What if you’ve sold one property and you have got four or five still in the company? Problem, right, So, I don’t really think that is an option.
Now, there are a couple of other quirks in the look through company (LTC) that you need to think about.
The first one, and one that makes everyone go “oooh, yuk”, is that there is a loss limitation rule included in the new legislation and this was not there in the LAQC rules. So what does this mean? You will essentially only be able to claim your losses at a personal level if the investment you have in your company exceeds the amount of loss you are looking to claim. The question becomes, how do you calculate the investment you have in your company?
It is essentially made up of two things:
- The first is your current account balance. Money you have lent your company to prop it up, the 20% deposit you have put in, the money you have put in to prop up tax losses. That represents a current account balance. It is money you have at risk in your company, so that counts as your investment.
- The next thing that counts is the bank debt that your company has, that you have guaranteed. So if you have provided a guarantee for the company’s debt that is money you have at risk, that factors into the calculation of your base calculation. Now it’s very hard to see in a practical sense how property losses exceed the amount of investment you have in the company, because typically the loss incurred these days will be real, it won’t be boosted by depreciation.
So it’s making a loss, it has to be funded somehow. You are either going to fund it by putting some of your own money in, or you are going to borrow some money. Either way, that should factor into the base calculation.
I can see one trap in this that I will point out to you. It’s got something to do with the removal of Gift Duty. Many of you might be aware that on 1stOctober this year, the Government will remove Gift Duty, remembering that about 30thOctober there will be a General Election.
So there is a little window of opportunity, current government, current policy, maybe you would want to get in and gift everything that you haven’t gifted to your trust. But where does all this relate to LAQC’s? Well, coming back to this amount of debt that you have guaranteed – What the actual legislation says, is that the base calculation is the lessor of the amount that you have guaranteed verses the amount of your own personal assets. So for example, if you have guaranteed your LAQC’s $100,000.00 mortgage, but if you have no personal assets of your own, what is the guarantee really worth? NOTHING.So it won’t then factor into your base calculation.
So, if you have taken the opportunity to have gifted away everything that you have into your trust, it might actually be quite difficult to prove an argument with the IRD that you still have an exposure to your guarantee. So these are the sorts of things that we are grappling with at the moment.
But on the face of it, I don’t see the base calculation/loss limitation rule being too problematic.
So what else do you have to think about if you are considering becoming a Look Through Company (LTC)? Well, there is one very, very important thing,
The new Legislation is coming in on the 1stof April, so our timeline looks a bit like this:
We have 1stof April essentially your next balance date. We are sitting here at January, so there are a few months to go before then and the election date for your Look Through Company (LTC) will be 30thof September.
So there’s are a lot of people thinking “I’ve got nothing to worry about”, 6 more months after balance date, I will worry about it then. The thing you have to appreciate is one of the features of the LTC is, if you change your shareholding in your LTC, you are triggering an underlying deemed disposal of your share of the property assets.
So picture a situation where you’ve got 99 shares held by the husband, who is on a $150K salary, Wife holds 1 share because she is at home looking after the kids. That structure was put into place when tax rates were really high, interest was really high, depreciation was really high and you were claiming a lot of losses against the high income earners tax rate.
Now, of course, that situation is completely reversed. When you do your calculations, you might find that the attribution is going to push profit into the high income earner tax return, which is exactly the opposite of what you wanted when you set it up.
So the thing to appreciate once you are an LTC is, if the husband was to transfer 49 shares back to his wife, he has to account for a depreciation recovery of 49% on everything he has accumulated.
So if that is your situation, and I can tell you it is extremely common, you have got to do somethingbeforethe 1stof April, 2011.
Because the new rules come in on the 1stof April, you need to think about changing your shareholding structure between now and the new legislation. Now, it is not as simple as going online to the Companies Office and whacking through a share transfer. There is proper documentation that has to be done. It has to be done on the strength of a valuation of your company. To value your company, you first have to value your properties. What about the matrimonial agreement you’ve got with your wife? How is it going to impact on that? Right, so you wouldn’t want to leave it until the last week! So start thinking about what you want to do.
We are furiously busy in the office right now, consulting with client’s day in, day out, trying to strategise as far into the future as we can, in terms of what the issues need to be.
My number one message is: If you have an LAQC, get in to see your Accountant, open the balance sheet up on the desk and go through it. Don’t just focus on what it tells you then and there. Think about what you are going to do in the next few years:
Are you going to buy a home for yourself?Do you want to refinance some of the equity out of the company?Are you going to sell a property?Is that going to trigger a depreciation recovery?Who’s going to have to have that income flowed to them? Lots of questions you need to ask and it isn’t a situation where one size fits all!
Okay, so what is the last option the Government has offered with the LAQC transition? They have basically said if you don’t like the look of an LTC and if you don’t like the look of an LAQC, we will let you transition your LAQC back to being a Partnership, that of course, will be the case if you had another shareholder in the company, or a Sole Tradership, if you are there on your own as a shareholder.
So here we are, back to the future, back to what we used to know, the good old Partnership.
Now they have offered a little carrot and they have said “If you want to make this transition again, you have to let us know by the 30thof September, 2011”. But you also have to do another thing, which is to wind up your company within 2 years of the balance date.
But the thing you’ve got to appreciate here is it is quite a costly process. For every property you have in your company, you are going to have to pay your Lawyer to convey it back into your own personal names. That is typically about $1000 a pop. All of your mortgages are going to be completely re-documented. What if they are fixed? Will the bank charge a break penalty? A mortgage broker said to me, don’t assume that you wouldn’t have to reapply. Now, for a lot of people, that’s a cage best not rattled, in terms of refinancing debt.
So then you’ve got to change all of your tenancy agreements, all of your banking arrangements and formally put your company into liquidation within 2 years.
At best, it is a giant hassle, at worst it is a really expensive hassle.
So that equally doesn’t seem to be an option that is coming through as a favourite.
By far, the majority of people I have spoken to so far, are opting to transition to the LTC. Those who are in a position when they are becoming profitable and they don’t believe they are going to ever make losses in their LAQC are taking this option and say “I will stay where I am. I will enjoy the 28 cent corporate tax rate and that will do fine”
Those are the two overriding options.
Posted on Tue, 1 February 2011
by Shawn O'Grady