What is the most tax-efficient way to build up wealth through real estate?
Creating wealth through property and / or land is certainly one of the most proven methods used in recorded history. As humans, we naturally tend to feel more secure being able to see and physically touch the assets we are invested in, giving them a sense of realism that a diverse portfolio of people may lack. securities.
Like all investments, however, there are some pros and cons in the way you structure your portfolio. You specifically need more information about the tax structures you have identified: personal ownership, trust or through a business. Let’s look at each of them.
Buying real estate on your behalf will be the easiest structure to put in place. From a tax point of view, the net rental income, after eligible expenses, is added to your personal taxable income and the tax payable will be calculated in accordance with the individual income distribution tables (PAYE).
If the assets are in your personal name at the time of your death, depending on the size of your estate, they may be subject to inheritance tax of 20% of the value of your taxable net estate. In addition, if your property is left to your children, your death will trigger a “deemed” sale of the property which will result in a capital gain and possible tax on this capital 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 included in your taxable income in the year of your death.
Setting up a trust
Depending on the long-term management of real estate assets, a trust can be an effective, albeit more complicated, structure for building a family real estate portfolio. Trusts have their own set of advantages and disadvantages, and these should be carefully questioned before deciding to go ahead.
For example, if you want to buy the property in cash, you will need to transfer those funds to the trust first and then the property will need to be purchased in the name of the trust. This transfer will create a loan account you can trust yourself. Section 7C of the Income Tax Act now provides that an annual gift is triggered in the hands of the person granting the loan. The amount of the grant is the difference between the interest actually charged on the loan, if any, and the interest that would have been payable by the trust if the interest had been charged at the current “official interest rate”.
This donation is subject to normal donation tax rules and you can use your annual exemption of R100,000 to offset or reduce any potential tax implications of donations. Keep in mind that this loan account would be included in your estate as an asset, which may trigger an inheritance tax liability.
If the purchase is funded by a bond, the property is still purchased in the name of the trust and the bank should therefore agree. Invariably, the bank would then ask you to act as personal guarantor of the bond. If you contribute to the repayment of the bonds, this will be done through the trust and then you will again create a loan account between you and the trust.
However, a potential advantage with a trust structure is that the income generated by the trust can 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 according to the principle of the conduit. The beneficiary may have very low or possibly no taxable income, effectively reducing the net tax payable on rental income.
It is important to note that section 25B is subject to the provisions of section 7 of the Income Tax Act. In short, this section deals with anti-avoidance structures for determining who is liable for income tax. This can lead to a situation where even though the income is distributed to the beneficiary of the trust, that income could be deemed to be that of the donor.
Depending on the size of the trust’s property portfolio, you could save considerably on inheritance tax and capital gains tax in the event of death, since only your contingent trust loan account is included in your estate. Any capital growth on the property values over time is immune to when they become assets in the trust and your death is not a trigger event for a deemed disposition of the property for the purposes. capital gains tax.
Be aware, however, that if property belonging to the trust is sold for any purpose, the inclusion rate for the calculation of capital gains tax is 80% of the gain, unlike your personal capacity where this rate is 40% and there is no exemption for a trust. Again, this negative impact can potentially be reduced by allocating the proceeds of the sale to the beneficiaries of the trust.
Creation of a company
Using a corporate structure to establish and grow a real estate portfolio can be a very effective balance between maintaining control of the assets while keeping limited liability between your personal affairs and those of the real estate assets. Again, depending on how you plan to acquire the real estate assets, certain personal guarantees may be required by financial institutions when financing these acquisitions, however, these may be taken out with certain insurance policies to limit the risk.
When setting up the company, you can decide who, and in what proportions, will be shareholders of the company. The value of your stake is included in your estate on your death for possible inheritance tax and execution costs, while if you sold all or part of your stake during your lifetime, you would potentially be subject to tax. on capital gains.
From an income tax point of view, the net income of the company, after eligible expenses, will be subject to normal corporate tax. Subsequent after-tax profits that would be distributed to shareholders would first be subject to a 20% withholding tax on dividends.
The above points are a very general overview of these three main structures. There will always be a good dose of nuance applicable to each person’s personal and family situation. I would always recommend that you do your homework and consult with a professional financial planner and / or CA (SA) charterholder who can help and guide you through the complexities of the tax consequences of each option.