We reqularly get questions about the pro’s and cons of borrowing for investment properties through different structures, so I thought I’d summarise the various ways you can structure your purchases and borrowings:
Borrowing in Individual Names
Definitely the most common structuring we see, and the simplest, with depreciation and negative gearing benefits clear. For couples, tax benefits can be maximised by using the highest income earner as the borrower, or by spreading the tax benefits unevenly by purchasing as tenants in common. The major downside is that servicing capcity will be reached a lot quicker for individual borrowers as when assessing loans, nearly all lenders will sensitise interest (assume the interest being paid is higher by say 2% than is actually the cas) on invidual debts and assess rents at 75-80% of actual rental. The other downside is with asset protection.
Borrowing in Company Names
Borrowing through a company is relatively straight forward if the entity is set up solely for property investment purposes. The company goes borrower on the loan and the directors and major shareholders are guarantors. The major benefits of this structure are that income is taxed at company rates (currently 30%) and profits can be held in the company, thus reducing tax. In terms of future borrowings, lenders would generally look just at the tax returns of the company, rather than the individual loans at sensitised rates and rent at reduced rates. Therefore, the impact of owning several properties in different companies on servicing is reduced. However this is only the case if different companies are used for different purchases. On the downside, a property portfolio with several companies could be quite labour intensive and difficult to manage. Another downside, is that properties owned for over 12 months in a company incur full capital gains, as opposed to properties held in individual or trust names, which carry a 50% discount on capital gains tax. Another downside is that there is no flexibility in income distribution, in that income is distributed evenly according to share holding, which may impact the tax effectiveness of a company structure in some cases.
Borrowing in Trusts
Many investors set up trusts in order to buy and sell properties and these structures can be effective for a number of reasons. With a trust, a property is held in the name of a trustee, which can be either an individual or a company entity. The trustee would be the borrower for any loan secured by the property and in the case of corporate trustees, the guarantors would be the directors of this entity. For discretionary trusts, most lenders will also require guarantees from adult beneficiaries and for unit/hybrid trusts, unit holders are also generally required to provide guarantees, a requirement that is often a surprise to investors. Most residential lenders are now happy to lend against trusts, however, when things get too complicated, ie) a number of trusts are involved, borrowers may need to be handled by business bankers. Trust structures can be tax effective vehicles, as they are eligible for the 50% capital gains tax exemption on properties held for over 12 months.With discretionary trusts, income can be distributed to maximise tax effectiveness (this can’t be done with unit trusts, as each unit holder must recieve a distribution in line with their share of units). In terms of effects on serviceablity, the use of corporate trustee is much the same as the use of a company borrower in that financials and tax returns for companies are required rather than actual individual debts (this benefit is not applicable for individual trustees as the borrower is the individual).
These are the main borrowing structures used for investors. The most appropriate structure depends on your particular investing strategy, but it is important to align your structure with your investing goals. It is also important to balance tax effectiveness strategies with your borrowing requirements, as the most tax effective structures may inhibit your borrowing ability. The best way to marry up these objectives is to make sure there is an open line of communication between your accountant and/or financial planner and finance broker.