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
|Taxable income||Tax on this income|
|0 – $18,200||Nil|
|$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|
Lets say you have have 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
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 lets 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 it’s income, which equals $10K. This $10K is added onto 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 eaqual =
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 where by 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 what ever 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 it’s 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 shareholders 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 share holder 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 any more.
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. Lets 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 loop hole where by trust’s could distribute money up to the tax free threshold for minors and get away with it. You can’t do this any more.
If you still have income left over in the trust after your 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.
Slight mistake about the below guys. As Adam from the comments pointed out to me, companies are not eligible for the 50% CGT discount. So I have changed my example to use income produced by the assets instead of capital gains.
Lets say you buy a house for $60K in 1980 and sell it 30 years later for $660K. That’s a capital gain of $600K. If you were to sell that house and trigger capital gains tax you could be paying north of $135,000 dollars in tax (assuming you received the 50% CGT discount).
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 straight forward as possible so it’s easy to follow.
The CGT discount means you are only paying tax on half the amount, which equals $300K. $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. Even if you buy with your spouse, because it is such a big capital gain you are most likely going to hit the highest threshold of 45c to the dollar for most of it.
If you had bought that asset in a trust however, you would have the ability to distribute portions of that
capital gains income stream to multiple people and to a company which is taxed at 30%. Lets 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 investor who live 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 negative 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 exist 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