Rental property tax rules can have a big impact on the amount of tax an individual will pay. There are a number of options.
Sole Trader (personal ownership)
If you are going to own the property in your own name, the simplest way to own a rental property is often as a sole trader. Once a year we’ll prepare accounts for the rental and offset any legitimate expenses against the rental income to work out if you made a profit or a loss. If your rental runs at a loss, you’ll be able to offset that loss against your own income. If you are on a PAYE salary, that may well mean a refund on the tax you have paid throughout the year. We do this by filing an IR3 return.
A partnership by its very nature requires more than one owner. It operates pretty much as a sole trader with any profit or loss split between the partners. The partnership needs to be registered with the IRD but this is a very simple exercise.
One of the prime purposes of a trust is to protect assets. They are reasonably expensive to set up and administer, at least when compared with the first two options. There may also be more tax benefits with the first two structures particularly if the rental is trading at a loss. This is because the loss is not available to be offset against individual tax returns. It is kept in the trust and can be offset in the future when the rental starts to trade profitably. So it may come down to a toss up between having asset protection versus the immediate benefit of a personal tax refund.
Another benefit of a trust is that you can allocate the income to an adult beneficiary who is on the lowest marginal tax rate, thus reducing the income tax paid overall.
Just as with a Trust, any losses can be carried forward by a company. A company has the added advantage that changes of ownership can be made inexpensively by transferring shares. Having said that, companies can be expensive to administer. If your rental is trading profitably, you’ll need to pay provisional tax. Conversely, losses cannot be attributed to shareholders- they are simply carried forward as with a trust.
Look Through Company (LTC)
The main difference with an LTC and an ordinary company is that any profit or loss flows through directly to the shareholders. That means that any loss can be offset against your own personal tax liability and may result in a refund. Alternatively, if a profit is made, you’ll pay tax on that at whatever marginal tax rate applies to you as an individual. The company itself doesn’t pay any tax. LTC’s are more expensive to administer than a normal company but these costs are tax deductible.
A major advantage of the LTC structure over a partnership is that you can change the shareholding and therefore the attribution of any losses. This isn’t possible with a partnership.
For instance, it’s common in families for one partner to stay at home to look after the children. In this case, we would ensure that the person working full time holds the vast majority of shares in order to maximise their tax advantage. If the other partner returns to work, we can realign the shareholding based on their income. As a very general rule of thumb, who ever earns the most should hold the most shares.
The other thing to consider is that single people are not excluded from setting up an LTC. Whilst there are some costs involved in terms of compliance, it is often substantially less that changing to the structure down the track when they meet the love of their lives.
In Summary then
If you want to enjoy losses flowing through to your own personal tax return, the sole trader, partnership or LTC arrangements are best. In the case of a LTC, any losses are attributed based on the shareholding in the company -the more shares you own, the bigger the share of the loss you get to enjoy. As a general rule, the person who earns the most will typically have the biggest shareholding as they will enjoy the greatest tax benefit.
But it’s not all plain sailing. There is a loss limitation rule which means that shareholders who do not provide any equity (such as security, personal guarantees or cash) may not be able to enjoy the full amount of any loss based on their shareholding.
As you can see, there’s quite a bit to consider so don’t hesitate to contact us to discuss this more fully.