If you’re a property developer, when it comes to property investment [or any investment really…] getting the structure right from the outset is crucial. The tax, transfer duty and legal costs to change the structure after you have acquired the investment can mount up and quickly spiral.
When dealing with property investments, similar to owning and making money from properties, they are often owned by trust people. Trusts tend to be set up in 1 of 2 ways [especially when different people are involved in the property deal]: a discretionary trust or a unit trust.
The money you make from the property, [which can include profits from selling it as ‘capital gains’, can flow to individuals. These individuals have the ability to access a special tax discount of 50% on the money they receive, but there are some rules.
One of the rules is that the property has to be owned for more than a year before you can get this discount. It’s like a tax benefit for holding onto your property for a while before selling it.
However, when dealing with property development, you’re unlikely to hold the property on capital account [i.e. subject to the capital gains tax rules and potential access to the 50% discount], particularly if the up-front intention is to acquire the property development and improve the property and then sell within a short period of time for a profit.
In these circumstances, the property is likely to be held on revenue account [i.e. more akin to business profits], and profit from the development activities will be taxed on the first $1 of profit, rather than tax on 50% of the profit in a capital gains tax context.
the pros and cons for each structure
Based on the assumption that the profits derived from the development are on revenue account [i.e. 50% CGT discount is not available] we have outlined the pros and cons for each structure.
sole trader pros and cons
Operating your development business as a sole trader is probably the simplest type of structure available as the set-up costs and administration are minimal. However, if the development fails, there’s no legal protection and it may put your other assets at risk. You may decide to operate as a sole trader for your first or second development when you are early in the development business process to avoid initial set-up costs.
- Easy to establish – you just need an Australian Business Number [ABN] and to register for GST if your turnover is over $75,000 in a 12-month period.
- Low administration costs – you include the development profits in your personal tax return and if you’re keeping good records [of development costs] you may not need separate Financial Statements for your development operation.
- You have access to your individual marginal tax rates on profits. Therefore if you have no other income in a year, the first $18,200 is tax-free and income up to $180,000 is taxed at progressive marginal tax rates before income is taxed at the top marginal rate of 47% [including the 2% Medicare-levy].
- There is no legal protection for sole traders, therefore if the business is sued, the individual business owner is sued as well. This can put other assets owned by the individual at risk.
- Every $1 over $180,000 earned by the individual will be subject to marginal tax rates with no ability to retain those earnings in another structure.
partnership of individuals pros and cons
A partnership is two or more individuals operating a business together, with a view to make a profit. Like a sole trader, operating as a partnership is simple to set up and administer, however again, there is no legal protection for the individuals, as they are jointly and severally liable for the partnership debts [meaning all partners are at risk for all the partnership debts]. Again, this structure might be ideal for partners starting out in property development, however as the business grows, this structure will not be ideal for long-term growth.
- Easy to establish – the partnership will need an Australian Business Number [ABN] and to register for GST if your turnover is over $75,000 in a 12-month period.
- Low administration costs – the partnership will require a separate tax return and the best practice would be to prepare separate Financial Statements. A partnership agreement would be recommended to document how the partners are allowed to conduct the business.
- Partnership profits are split between the partners based on their percentage of the partnership [i.e. 50/50] – therefore the individuals have access to their marginal tax rates.
- There is no legal protection for the individual partners, so if the partnership is sued, the partners will be jointly and severally liable for any debts arising from a legal issue or the business operations. This can put other assets at risk owned by the individual partners.
- Every $1 over $180,000 earned by the individual partners will be subject to marginal tax rates with no ability to retain those earnings in another structure.
- The administration costs are higher than a sole trader due to legal documentation and agreements that should be in place when operating a partnership.
trust structure pros and cons
Discretionary trusts are a common business structure for small family businesses. A trust is a legal agreement for a trustee to hold assets for the benefit of the beneficiaries. The trust deed governs the operation of the trust and generally has wide powers for the Trustee on the types of investments and businesses they can conduct. Trust law and trust taxation are complex and specific advice is required before establishing this type of structure.
- There is limited liability where the trust has a corporate trustee.
- The trustee has the discretion on where to appoint income and generally the classes of beneficiaries are wide and include individuals, trusts and companies in which the primary beneficiaries have an interest in. Therefore, you can take advantage of individual marginal tax rates, as well as distribute additional income to a corporate beneficiary.
- Trust structures are complex and you need legal and tax advice to establish the structure.
- There is additional administration for trust structures as the trust is required to lodge its own tax return and Financial Statements are highly recommended.
- When using a corporate beneficiary, the cash distribution must flow to the company to avoid additional tax compliance or adverse tax implications.
- You can accumulate earnings in a trust structure; however, tax is levied at the top marginal tax rate of 47% [including Medicare-levy]. This can be prohibitive if there is debt funding on the developments and you want to repay debt at a lower tax rate to re-invest in future developments.
company structure pros and cons
A company structure is a common structure used in property development, particularly where the business is established and has been operating for several years, or where the development is large in scale, size and value. A company is a separate legal structure from the directors and owners, they are taxed in their own right and have the ability to retain earnings.
Generally, for each distinct development, a separate company structure is recommended to quarantine risk from other developments. As a general rule, when the development is finalised and all profits are realised and debts paid, the company structure is voluntarily deregistered. You will commonly see these structures referred to as special-purpose vehicles.
The benefit of a company structure, particularly if the shares are held via a discretionary trust, means profits can be reinvested in the company environment at the company tax rate [either 25% or 30% depending on size and activities conducted by the company].
A company will return any profits, after paying tax in its own right, to shareholders [owners of the company] usually by paying a franked dividend. The shareholder then grosses up the cash dividend for the franking credit, pays tax in its own right and receives a credit for the company tax paid [being the franking credit attached to the dividend].
Where these profits are reinvested in the corporate environment the “top-up tax” [being the difference between the development company tax rate and the investment company] is limited to 5%. However, where these dividends are paid to individuals, and their income is over $180,000, this “top-up tax” can be up to 22% of the gross dividend [i.e. cash dividend + franking credit].
Where developments are partially debt funded, and funding from prior development profits, a company structure is likely the most tax efficient, as a company can loan to another company [in certain circumstances] without the application of the complex private company loan rules. This means being able to pay down debt at the company tax rate and reinvest in future development projects.
Structuring for reinvestment and having a company banker within your development group can be complex, therefore we recommend getting appropriate legal & tax advice upfront.
- A company provides limited liability for the owners of the company, in that the risk is generally contained to the development company.
- The ability to retain earnings at the company level.
- Ability to loan to other development companies without adverse tax implications [would require specific legal and tax advice].
- The company tax rate is 25% or 30% depending on the type of company.
- Set-up costs can be expensive, particularly where you have multiple shareholders and shareholder agreements are required.
- Tax and accounting compliance is more costly than other structures as the company must prepare its tax return and Financial Statements. The Australian Securities and Investment Commission, the department that regulates Australian companies, requires Directors to record and explain the company’s transactions and its final position and performance.
To close out this blog I’ve got some extra information in relation to tax and property development. The GST treatment of property for developments can be complex, particularly when using the Margin Scheme. To help you navigate this easily, we always recommend seeking advice, before signing the purchase or sale contract for your development. This will ensure you get the GST treatment correct in your contracts.
This blog wraps up our final blog in our legal property development series.
we’re here to help
As we mentioned earlier, getting your development structure right from the outset is the best way to minimise unnecessary tax, transfer duty and legal costs. businessDEPOT is here to help with your legal, structuring and tax, so if you need any help, contact us at firstname.lastname@example.org to get started, or drop us a line at 1300BDEPOT.
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general advice disclaimer
The information provided on this website is a brief overview and does not constitute any type of advice. We endeavour to ensure that the information provided is accurate however information may become outdated as legislation, policies, regulations and other considerations constantly change. Individuals must not rely on this information to make a financial, investment or legal decision. Please consult with an appropriate professional before making any decision.