A Comprehensive Guide to Purchasing a Rental Property in a Trust: Maximizing Tax Efficiency
Introduction:
Investing in rental properties can be a lucrative venture, providing a stable source of income and potential long-term wealth accumulation. When considering the purchase of a rental property, it’s important to carefully evaluate the most suitable ownership structure to optimize tax efficiency. This blog aims to provide guidance for individuals with incomes exceeding $70,000 who are planning to buy a property within a trust and subsequently rent it out.
Choosing the Right Ownership Structure:
If your income surpasses $70,000, it is advisable to purchase the rental property under either a trust or a company to benefit from lower tax rates. If you already have a trust in place, purchasing the property under the Trust account is recommended.
Tax Rates and Structure Comparison:
1. Company Structure:
- Companies typically face a tax rate of 28%, which appears advantageous compared to the trust tax rate of 33%.
- However, it’s crucial to consider potential scenarios where the company might need to be wound up or equity needs to be drawn down. In such cases, a dividend must be declared, attracting an additional 5% Dividend Withholding tax (DWT) payable to the Inland Revenue.
- Consequently, the overall tax liability ends up being 33% in the end, and the 5% DWT can be viewed as a timing difference.
- It’s important to note that if dividends are declared to the shareholders, an extra 6% tax is levied on individuals earning over $180,000;
- There will be an extra 6% imposed on dividends paid from 1 April 2024 to Trusts if the Trusts are shareholders of the company due to the changes in the Trust tax rate. Thus, a total of 39% tax (28% Imputation credits, 5% DWT, and 6% extra tax paid personally or by the Trust is the taxable profit is retained in the Trust) would be incurred.
2. Trust Structure:
- Opting for a Trust structure entails a flat tax rate of 33% (39% from 1 April 2024) on rental income.
- Additionally, it offers the flexibility to make distributions to beneficiaries, allowing the utilization of their marginal tax rates, provided they are over 16 years old. Minor beneficiaries, on the other hand, are subject to a flat tax rate of 33% or 39% from 1 April 2024. Please note, we are yet to see if the new Trust tax rate is implemented if a new government is elected in October this year!
- Any profits generated by the rental property can be retained within the Trust and taxed at 33% or 39% from 1 April 2024.
- Trusts also offer greater flexibility for drawing down equity, subject to the agreement of the trustees and ensuring that all major transactions are properly documented and executed in the best interest of the beneficiaries.
- Trusts are great for asset protection and wealth or succession planning.
The Advantages of a Trust Structure:
Considering the tax implications and flexibility offered, a Trust structure emerges as the most advantageous option for tax savings in this scenario. By purchasing the rental property within a Trust, you can benefit from the following advantages:
- Utilizing Marginal Tax Rates: The ability to distribute income to beneficiaries allows for potential tax optimization by utilizing their respective marginal tax rates. Whereas, under a company structure, any dividends declared are only to the shareholders and any distribution has to be in proportion to the shareholding of the company.
- Flexibility in Equity Drawdown: Trusts offer greater flexibility in accessing equity, subject to the agreement of trustees and adherence to fiduciary responsibilities. Whereas, as mentioned above, a company will require a declaration of dividends if equity needs to be drawn down.
Conclusion:
As you embark on the journey of purchasing a rental property, it’s essential to consider the long-term tax implications and choose an ownership structure that aligns with your financial goals.
