*Always seek the advice from a professional if you’re thinking about setting up a trust. The below is not legal advice, only my thoughts, andopinions.
I have decided to start a series of posts that will detail some of my methods of minimising the amount of tax you have to pay. Some of these techniques will apply to the way you invest but there will also be tips for people who are not at the investing stage just yet. And I’ll preface this post by stating very clearly
There is no legal way to pay no tax at all
Yes, you can negative gear your pants off but I’m not the biggest fan of that method. The idea is to minimise the amount of tax you pay by utilising legal methods. I love Australia and don’t have any problems paying my taxes to keep this awesome country running…BUT! That doesn’t mean I’m going to be donating extra money because lets be honest, sometimes the government doesn’t spend the tax payers money in the most efficient of ways…
Just like income tax you pay on your wages, you have to pay tax on the income produced by your assets and also the capital gain IF you sell the asset and realise the gain (more or that later). Income produced by an asset that’s in your name is added on to your regular salary income and is taxed accordingly. Below is the ATO tax rates for 2015-16
Tax on this income
0 – $18,200
$18,201 – $37,000
19c for each $1 over $18,200
$37,001 – $80,000
$3,572 plus 32.5c for each $1 over $37,000
$80,001 – $180,000
$17,547 plus 37c for each $1 over $80,000
$180,001 and over
$54,547 plus 45c for each $1 over $180,000
Let’s say you have had an investment property that is earning you $20K from rent after all expenses including depreciation (that some serious cash flow!) and your normal 9-5 job earns you a salary of $65K. In this situation, the ATO look at your income and conclude that you earn $85K and tax you accordingly. Below is a break down on the taxes you pay on the extra $20K income produced by your investment property
15,000 * 32.5% = $4,875 PLUS 5,000 * 37% = $1,859
=$6,725 The last $5,000 dollars you earned were taxed at a higher rate of 37c for each dollar because you went over the $80K threshold.
Buying With Your Partner
Now let’s assume that you’re buying that asset with your partner and you are each allocated 50% ownership of the asset. Your partner only works 2 days a week and earn $12K yearly.
Now the ATO look at your taxes very differently.
Because you only have 50% ownership of the asset you only earn 50% of its income, which equals $10K. This $10K is added to your income which gives you a grand total of $75K. Your partner is given the other 50% which brings their income up to $22K. Now, this is where the tax savings come in. The $10K that was distributed to you was taxed at a rate of 32.5c for every dollar.This equals 10,000 * 32.5% = $3,250 in taxes paid to the ATO. Your partner, however, is very different. They only earn $12K which is too low to be taxed at all. Adding the $10K bring them up to $22K. They have to pay 19c for every dollar they earn over $18,200. $22,000 – $18,200 = $3,800 dollars. $3,800 * 19% = $722. The total tax you paid on the $20K as a couple is now $3,250 + $722 = $3,972
Simply buying with your partner in this scenario will save $2,753 in taxes every year for this couple. If they have the property for 30 years the money they would save would equal =
If you think that’s impressive, wait until I show you how trusts work
Buying Assets In A Trust
There are actually a few different sorts of Trust that you can set up for different reasons. I’m only going to be talking about discretionary trusts (Family trusts) as that is the vehicle I’m currently using and what I have experience in.
What is a trust anyway?
A discretionary trust is a trust relationship whereby the trustee is obligated to hold assets for the benefit of the beneficiaries of the trust. This obligation is defined in the trust deed which the trustee must enter into. It’s basically a written agreement on how assets are held and distributed among the people that that should get them. You need the following to set up a trust:
The person that creates the trust. Usually is someone who will have no more involvement after the trust is set up. I used my accountant as the Settlor for my trust.
The legal entity that owns all assets held in the trust. This can be a person OR a company. Yes, that’s right. A company can be the trustee of a trust. Now, why would you want a company being the legal owner of assets?
Because this is how you achieve asset protection!
If you buy in your own name and for whatever reason go bankrupt. The creditors have full access to anything that you own to get their money back. But what if you don’t actually own any assets but simply control them? What you can do is set up a company and be the only shareholder of it so you have complete control of its decisions. You then set up a trust and have the company be the trustee of the trust. The company is now liable for the assets held within the trust and not you!
If something goes belly up the creditors will have access to all assets that the company owns including all assets within the trust but not outside of it. This makes sense when you think about too. If you invest in a company that goes bust, you’re going to lose your shares most likely but the creditors are not going to try to recoup their loss from the shareholder’s personal assets. That would be illegal.
And it works both ways too. If you were personally sued and lost the case. They could not go after any assets held within the trust because technically you don’t own them. The company does upon which you are simply a shareholder of 🙂 . I plan to have multiple trusts set-up eventually to limit the losses if something went drastically wrong in one of them.
The person who appoints the trustee of the trust. Has the power to remove a trustee and appoint another one. Needed in case the current trustee dies or doesn’t want to be trustee anymore.
The beneficiaries are the entities that benefit from the trust in forms of distributions.
The real magic of the trust is its ability to distribute income to multiple beneficiaries at the most efficient rate that suits for that financial year. Let’s say that the trust earns $40K. This can be from rent income or capital gains. The Trust has the ability to choose where to distribute this income to. If you lost your job one year and didn’t earn anything. The trust could distribute you $18,200 dollars and you wouldn’t pay any tax on it. You can distribute income to your children but it won’t be tax-free money, there are special tax rates for individuals under 18 who receive money from a trust. Back in the day, there was a loophole whereby trusts could distribute money up to the tax-free threshold for minors and get away with it. You can’t do this anymore. If you still have income left over in the trust after you have distributed most of it to the beneficiaries in a tax effective manner there is another beneficiary that you can distribute to whose tax rate never changes no matter how much they earn. That is another company. You can actually distribute income to another company whose tax rate is locked at 30%.
This is massive.
Lets say you buy a house for $60K in 1980 and over the next 40 years it produces $300K in cash flow after all deductions and losses ($7.5K positively gears per year)
For simplicity, I have left out a bunch of things here but we are trying to keep it as straightforward as possible so it’s easy to follow. $300K taxed at 45c (assuming that the surplus of money is tax at the highest rate) to the dollar equals $135,000 of tax to the ATO…OUCH.
If you had bought that asset in a trust, however, you would have the ability to distribute portions of that income stream to multiple people and to a company which is taxed at 30%. Let’s say both you and your partner are currently at the 32.5c threshold and you have no children. It would be more strategically advantageous to distribute the whole $300K to a company at 30c to the dollar which would turn out to be $90K instead of $135K.
That’s a $45K saving in tax by simply having the asset in a trust.
And the more you earn, the greater the savings are going to be. Income redirection along with asset protection is the reason I utilise this method. It gives me flexibility and security of my assets. I have used the above examples with properties but the trust works the same for shares.
Downsides Of A Trust
While I have painted a picture of milk and honey for trusts there are some disadvantages
You cannot receive the main residency capital gains exemption tax which basically is when you sell your own home and don’t pay capital gains on it. This can be a strategy for an investor who lives in an investment for one year before selling to avoid CGT. You cannot do this with a trust.
There are costs associated with setting up a trust and company and running them. It cost me $1500 to have a trust and company professionally set-up. You can do it yourself for around $600 bucks but I don’t think it’s worth it in case you stuff something up. It’s $200 a year to register the company and an extra $300 bucks a year my accountant charges for doing the accounting for the company and trust which are slightly more complicated than a normal tax return. Considering the advantages I have outlined above it was a no-brainer for me to pay a little extra now and set it up right to reap the benefits in the years to come.
You cannot negatively gear in this structure. You cannot distribute a loss. You can carry it forward and offset any future gains but you can’t offset your personal income through a trust. This doesn’t really bother me because I don’t plan to negative gear when I buy assets. They might be slightly negative when I buy them but turn positive after 1 or 2 rental increases over time.
I hope you have gained a little more knowledge by reading this post. Investing through a trust is not for everyone or every strategy. But knowing it exists is beneficial in case you ever feel you could take advantage of it. I bought my first IP in my own name when I had no idea about trusts or how they worked. Unfortunately transferring an IP from your personal name to a trust will trigger CGT (if any has occurred) and you will be up for stamp duty again. For this reason, I will keep my first IP in my own name. I planned to buy all future IP’s in the trust I have set up. I will be paying slightly more upfront costs this way (running the trust) but will hope to reap huge benefits down the track.
If you have a better way to buy assets I’d love to hear about it in the comment section below as I’m always looking to do things better learning from people smarter than myself
Not a lot to report during the last month. I was able to save a bucket load of cash simply from the fact that I didn’t do anything that cost money other than necessities. I am going on a international holiday at the end of September so I won’t be able to save as much that month.
Unless you have been living under a rock I’m sure you have heard of the term negative gearing. Some swear by it, others say that it is responsible for the outrageous house prices in the Sydney and Melbourne market. At the time of writing this, the current median house price in Sydney is $1,000,616 and Melbourne is $668,030! But what is Negative gearing, why do I think it’s for dummies (most of the time) and why doesn’t Negative Gearing’s cooler brother Positive Gearing get as much attention?
Negative Gearing Explained
The first thing to understand is the term ‘gearing’ which simply means to invest on borrowed money. Why would someone invest on borrowed money? Because investing on borrowed money allows you to get bigger bang for your buck (technical called leveraging), for example: If I invested $50K straight into an Exchange Traded Fund that returned 10% annually I would make $5K in one year. But if I used that $50K as a down payment for a house worth $250K that increased in value to $275K over the course of one year I have successfully used leverage to my advantage. You see, even though the ETF had a better return on investment (ROI) of 10% compared to the house ($250K to $275K is a 9% ROI), the leveraged investment was able to return $25K compared to $5K from the ETF. This is possible because you are investing the same amount of capital but are acquiring a much larger asset. Of course I’m leaving out a ton in the above example but that’s just to explain the basics and how gearing is meant to work.
OK so now you understand what leveraging\gearing is and how it’s meant to work. If we continue with the above example and break down the costs associated with holding the asset for one year and the income it produces (rent) it might look something like this
Which would mean that the investment is negatively geared because the outgoings are greater that the income produced by the asset. You are basically losing $9,180 dollar a year to hold this asset. Why would anyone buy something that looses them money? Because they think they can make it back through capital gains. Which in the above example is correct since the house gains 25K and only loses around 9K.
While some people like to invest like this, it ain’t for me. The reason I don’t like this way to invest is because every year you loose REAL money out of your account and it affects cash flow position which impacts your lifestyle. You might not be able to go on that holiday every year if you were consistently having to fork out 9K on the investment property. You never see the capital gains money until you sell the house, your gains are only on paper until you actually sell. The house might be worth 25K more after year 1 and then 25K more again after year 2 but then the market slumps and your house is suddenly worth 40K less after year 3. Meanwhile your negatively geared asset has consistently been draining you of 9K yearly. It comes back to the basics of investing and for me my light bulb moment. You buy assets that make you money. Negative gearing is buying assets that loose you money with the hope of making that money back and more when you sell… No thanks
Pay Less Tax
What is unusual about negative gearing in Australia is that the law allows you to offset the tax you pay on your wage with the losses from an investment. Not all country’s allow you to do this. I’m not going into a lot of detail about taxes because it’s just too hard with so many different situations but the gist of it is that you can claim a deduction in your tax return from the loss you made on an investment property. For example, if you earned 70K a year and you lost 9K with a negatively geared investment property the tax man looks at that and allows you to offset your salary of 70K by 9K thus your real earnings that financial year is 61K and not 70K. And this difference is the reason you can get a big tax return at the end of the financial year. Because you paid tax on the whole 70K throughout the year the tax man refunds you the tax you would had paid on the 9K which equals $2,925* using the income tax rates 2014-2015.
BUT!!!! You have to remember that even though you paid less tax and got a tax return of near 3K, you still lost 9K to do so. When you hear people bragging about ‘My tax return was $12,000 dollars this year how smart am I!’ just remember that they would have had to have lost a heaps of money in order to offset their salary to get that big of a return. The aim in property investing is not to pay no tax at all. It is to make the most money possible in the shortest amount of time with the least aggravation. There are ways to minimise the amount of tax you pay but your goals should never be paying not tax at all. Ideally you want to be paying loads of tax each year, because if you’re paying heaps of tax that means your making bucket loads of money. If you live in this wondering country of Australia you’re going to have to pay tax. Get over it.
When is it OK to Negatively Gear?
I’m going to sound like a massive hypocrite right now but all my properties are negatively geared BUT have positive cash flow increasing my ability to save cash for the next deposit. Huh? Didn’t I just say that negatively geared properties lose you money each year? Yes I did but there is one key category to the expenses of a property that makes it different from the rest. Depreciation! When you buy/build an investment property you should get a depreciation report made. This is basically paying a professional depreciator to come to your property and work out how much value things are going to depreciate by each year. The carpet might lose $200 value each year for the next 15 years, the deck might deteriorate by $400 a year for the next 20 years and so on. They value everything on the property and give you the value that the property loses throughout the next 20 or so years. Below is from a report of one of my own properties
The total depreciation at the bottom of every financial year is what my accountant is after to use in my tax return. The reason why depreciation is different to every other expense is that it does not affect cash flow. I technically make a lose on paper but I don’t actually have to give 8K to anyone, it’s simply what the property has lost in value during that time. My own cash flow position with my properties is that my rent covers ALL expenses and leaves me with a little left over. But when you factor in the depreciation I’m technically negative gearing even though I have a positive cash flow. For example:
Technically I am losing $3,200 dollars holding this property. BUT the big difference with the above is that if you take out the loss from depreciation I actually have a positive cash flow of $4,400 dollars. Deprecation puts me in the negatives which is OK because that means I can then claim the loss on my tax return and get even more money in my pocket! The entire time I’m holding this asset I am having $$$’s flow into my bank account and not out of it PLUS I’m not even factoring in capital gains which may or may not be occurring. Capital gains is the gravy on top for me though, as long as an asset is cash flowing I continue to buy more of them.
And now finally onto the my favorite way to invest, Positive Gearing. You may have figured it out by now but just in case you haven’t. Positive gearing is when the rent you collect covers all costs including depreciation and leaves you with a surplus. You have to pay tax on this surplus but that’s OK because it’s extra money in your pocket and for me it’s better to be earning $1 dollar more and paying 37c tax than it is to be losing $1 and saving 37c tax.
So if positive gearing is so bloody fantastic, why is everyone doing it? Because it’s not easy to find positively geared properties straight off the bat. You can find them in places like mining towns and in the country but mining towns are usually extremely reliant on one industry and if the mine shuts you’re screwed. Country towns are OK but often lack that capital growth seen in the capital cities.
There are only two way to make money from Real Estate. Having positive cash flow from the rent (positive gearing) or having the price of the asset increase from when you bought it (capital growth). Nirvana is purchasing a positively geared property that will have big capital gains in the future. The thing about capital gains though is that you can’t really control it from the market perspective. Sure you can do a reno to increase the value of the house or something, but if outside factors come into play such as China slowing down, Australia going into recession or Europe going down the drain and the buyers market gets spooked and stops buying. Economics 101 ‘supply and demand’ tell us no matter how much you’ve improved the property it may be worth significantly less than what you’ve paid for it. In a rough time like this your cash flow will either help see you through so you can hold the asset until the market rebounds or it will cause you significant grief as you continue to fork out $$$ each week for an asset that is continually losing money. Cash flow is more manageable and easy to predict. You can see roughly what the properties similar to yours is renting for, work out the costs for repayments, rates, water etc. and get a rough idea if the property will be negative, neutral (doesn’t lose or make money) or positive. Outside influences that affect cash flow are usually less volatile too (interest rate, rent prices etc.).
Negatively geared properties should eventually turn into positive over time as rent rises. Realistically, neutrally geared properties in a highly sought area with good potential for growth are the ones I’m interested in. They don’t drain your pockets as the property looks after itself and with every rent increase you are slowly turning the property into the positive area while also having a property with great upside for growth. I would love to get a positively geared property with big upside for growth but the bottom line is they are extremely hard to find in a capital city without lucking out somehow. It is very possible to get neutrally geared properties in up and coming areas which will turn positive over time.
Negative gearing saves you paying tax but you lose more than you get from you tax return. If you are negatively gearing you must be 100% confident that the property is going to go up in value whilst your holding it. This is the only way you can make money through negative gearing. Next time you meet someone who is paying little to no tax using negative gearing just be aware that they are actually losing money until they sell and most likely don’t realise this. I only advocate negative gearing if you still have positive cash flow which is the method I’m currently using. Positive gearing is where it’s at and all investors should be striving to get to this state because there is no good reason not to. The asset produces more income than expenses. Simply investing really, buy things that make you money. Positive gearing does this. Yes you pay tax but if you’re planning to become rich through Real Estate guess what? You’re ganna have to pay tax!
Thoughts, feelings, questions and emotions in the comment section below.
*Assuming that this person falls in the $37,001 – $80,000 tax bracket and is paying 32.5c for every dollar they earn