What’s the most tax-efficient way to build wealth through property?
I want to create a financial wealth portfolio that I can enjoy in my retirement age, and that will enable me to leave something behind for my children. I would like to invest in one or two properties as wealth creation, but I’m unsure of the South African tax laws.
Kindly advise of best legal ways of paying the least amount of tax. What are the tax implications/benefits if I was to buy property in my own name? Or should I create a family trust or buy in a registered company name? Or are there other better ways? Please advise of the best ways whereby I – as well as my children when they eventually inherit the properties – will pay the least tax legally possible.
Building wealth through property and/or land is certainly one of the most tried and tested methods used throughout recorded history. As humans, we tend to naturally feel more secure being able to physically see and touch the assets we are invested in – giving them a sense of realism that a diversified portfolio of securities may lack.
Like all investments, however, there are certain advantages and disadvantages in how you structure your portfolio. You are specifically requiring more information around the tax structures you have identified: personal ownership, a trust, or via a company. Let’s look at each of these.
Purchasing property in your own name will be the simplest structure to put in place. From a tax perspective the net rental income, after allowable expenses, is added to your personal taxable income and the tax liability will be calculated in line with the individual pay-as-you-earn (PAYE) tables.
Should the properties be in your personal name at the time of your death, depending on the size of your estate, they may be subject to estate duty of 20% of the value of your net dutiable estate. In addition, should your properties be left to your children, your death will trigger a ‘deemed’ sale of the property which will cause a capital gain and possible tax on this gain depending on the size. Currently, on death, the first R300 000 of capital gain is excluded from tax with 40% of the balance of the gain being included in your taxable income in the year of your death.
Setting up a trust
Depending on the long-term handling of the property assets, a trust can be an effective, although more complicated, structure of building a family property portfolio. Trusts come with their own set of advantages and disadvantages, and these should be thoroughly questioned before deciding to move forward.
For instance, if you wish to purchase the property in cash, you will first need to transfer these funds to the trust and the property must then be purchased in the name of the trust. This transfer will create a loan account to the trust from yourself. Section 7C in the Income Tax Act now provides for an annual donation to be triggered in the hands of the person who provides the loan. The amount of the donation is the difference between the interest that is actually charged on the loan, if any, and the interest that would have been payable by the trust had the interest been charged at the prevailing ‘official rate of interest’.
This donation is subject to the normal donations tax rules and you can use your R100 000 annual donations exemption to offset or reduce any possible donations tax implication. Remember this loan account would be included in your estate as an asset which may trigger an estate duty liability.
Should the purchase be financed with a bond, the property is still bought in the name of the trust and therefore the bank would need to agree to this. Invariably, the bank would then ask you to stand personal surety for the bond. If you are making any contributions to the bond repayments this would be done via the trust and you would then again be creating a loan account between yourself and the trust.
However, a potential advantage with a trust structure is that the income the trust generates may be distributed to the beneficiaries of the trust under Section 25B of the Income Tax Act.
In summary, this income is therefore taxed in the hands of the beneficiary by means of the conduit principle. The beneficiary may have a very low or possibly no taxable income which effectively lowers the net tax liability payable on the rental income.
It is important to note that Section 25B is subject to the provisions in Section 7 of the Income Tax Act. In short, this section addresses anti-avoidance structures in determining who is liable to pay tax on the income. This may result in a circumstance where even though the income is distributed to the beneficiary of the trust, this income could be deemed to be that of the donor.
Depending on the size of the portfolio of properties in the trust, you may stand to save substantially on estate duty and capital gains tax in the event of your death, since only your possible loan account to the trust is included in your estate. Any capital growth on the property values over time is sheltered from the time they become assets within the trust and your death is not a trigger event for a deemed disposal of property for capital gains tax.
Be aware, however, that should a property within the trust be sold for any purpose the inclusion rate for the calculation of capital gains tax is 80% of the gain, unlike in your personal capacity where this is at 40% and there is no annual exemption for a trust. Again, this negative impact can potentially be reduced by vesting the proceeds of the sale in the beneficiaries of the trust.
Establishing a company
Using a company structure to establish and grow a property portfolio can be a very effective balance between maintaining control over the assets while keeping a limited liability between your personal affairs and those of the property assets. Again, depending on how you intend on acquiring the property assets certain personal sureties may be required by financial institutions when funding these acquisitions, however, these can be underwritten with certain insurance policies to limit the risk.
When establishing the company, you may decide who, and in what proportions, will be shareholders in the company. The value of your shareholding is included in your estate upon your death for possible estate duty and executor fees, while should you sell all or a portion of your shareholding in your lifetime you would potentially be subject to capital gains tax.
From an income tax perspective, the company’s net income, after allowable expenses, will be subject to normal company tax. Any subsequent profits after tax that are to be distributed to the shareholders would first be liable for dividend withholding tax of 20%.
The above points are a very general overview of these three main structures. There will always be a fair amount of nuance applicable to everyone’s personal and family circumstances. I would always recommend you do your homework as well as consult with a professional financial planner and/or CA(SA) charter holder who can assist and guide you through the complexities of the tax consequences of each option.