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Restructuring Options

7 May 2019

 

Restructuring options
 
Jack and Jill are in a new relationship and going to buy a new personal house. This is an example of some of the things we could look at.
 
Facts:

  • Jill owns her current personal house worth $600,000 with $250,000 debt. It is planned for this to become a rental.
  • Jack owns a rental property, purchased (settled) November 2017 for $400,000 and now worth $500,000 with $200,000 debt.
  • They have $100,000 combined savings.
  • Buying a new personal house for $650,000, and they want to spend $50,000 on renovations.
  • Jill owns a small florist business, and rents a premise.
  • Jack is a builder, and hopes long term to have his own house building company.

 
Some options:

Option 1.  They should seek relationship property advice from a lawyer. They would generally seek independent advice. This is the best way to help protect assets and a lawyer will often suggest a Relationship Property Agreement.

Option 2.  Long term outcome. Ideally we would want to have the new personal house with no debt and all the debt on the rental properties.


a) Jill's house
 

  • First, is this a good rental? Need to look at what the cash flow is long term and does this rental help achieve Jack and Jill’s goals? What is yearly cash flow? What is cash flow predicted over next 10 years?
    • Need to consider Jack and Jill's personal debt, which will be nil, and therefore, how much principal they could reduce long term.
  • If we keep as is, the rental has a low debt, so likely a profit and tax to pay. Say a $7,500 profit or approximately $2,500 tax to pay each year.
  • Therefore, from a tax perspective, we would normally restructure this property. This means sell the property from Jill to a new LTC for $600,000. The LTC would normally then try to borrow 100% or $600,000.
    • Could be from one bank with cross security over new personal house.
    • Or could use two banks (I prefer two banks). Bank A lends 70% to LTC or $420,000 secured over rental property. Bank B that also has the personal house, lends 30% to LTC or $180,000 with security over personal house.
    • This would likely turn the rental into a loss, lets say $6,000 loss.

 
Reset BrightlineThe Brightline would then be reset for this property. So, if the LTC sells within 5 years, any gains will be taxable. So need to be planning to hold long term, otherwise no point restructuring!
Ring FencingWith ring fencing expected from 1/4/19, it is unlikely that Jack or Jill will get any tax refund from the new loss, but it does still save the $2,500 tax Jill would currently be paying without a restructure.
Break feesNeed to check these, and best to ask bank or mortgage broker to confirm before any restructure.
Tax avoidance - IRD have confirmed in QB 12/11 that this restructure is not tax avoidance.
BenefitImportant to check the benefit is more than the cost. In this case, presuming there are no break fees, it is likely to cost around $1500 in legal fees, plus form an LTC for $160, to get a tax saving of $2,500 per year, plus a long term benefit of having the $6,000 property losses accumulate, that can be offset against future property profits.
 

 
b) Jack's house
 

  • First, is this a good rental? (same as above)
  • If we keep as is, the rental has a low debt so likely a profit and tax to pay. Say a $7,000 profit or approximately $2,300 tax to pay each year.
  • Ideally, we would like to do a restructure. BUT – Jack is caught by the Brightline test. This means if he sells to an LTC, he would have a $100,000 taxable gain and have approximately $33,000 tax due!
  • So it would make sense to delay any restructure until after the Brightline period.
  • In this case, it is 2 years, as before 29/3/18. The 2 years is the shortest possible. So, from settlement of the purchase to the date on the sale agreement, needs to be over 2 years.
  • After this period, then we would look at the restructure.
  • This would likely turn the rental into a loss, lets say $3,000 loss.
  • Loans – important to keep these short term so that can restructure and rearrange after the 2 years.

 
Reset BrightlineThe Brightline would then be reset for this property. So if the LTC sells within 5 years, any gains will be taxable. So need to be planning to hold long term, otherwise no point restructuring!
Ring FencingWith ring fencing expected from 1/4/19, it is unlikely that Jack or Jill will get any tax refund from the new loss, but it does still save the $2,300 tax Jack would currently be paying without a restructure.
Break feesNeed to check these, and best to ask bank or mortgage broker to confirm before any restructure.
Depreciation recovery – Need to consider as used to be a rental. But in this case, purchased well after Building depreciation stopped, so no recovery.
Tax avoidance - I like to have a commercial reason for any transaction. In this case, there would be two reasons to do the restructure. 1) have one rental entity for Jack and Jill and  2) Asset protection (see more below).
BenefitImportant to check the benefit is more than the cost. In this case, presuming there are no break fees, it is likely to cost around $1500 in legal fees, plus form an LTC for $0 (already set up for Jill), to get a tax saving of $2,300 per year, plus a long term benefit of having the $3,000 property losses accumulate, that can be offset against future property profits.
 


Option 3.  Personal House 

Both Jack and Jill have considerable risk. Jack is a builder so could have Health and Safety risk at some point. Plus risks of running his own business long term. Jill would have had to personally guarantee the Florist lease, so also has a reasonable amount of personal risk, plus possibly some Health and Safety risks with the business.
 
Therefore, ideally we would want the personal house owned by a Trust.
 
So the Trust would buy personal house for $650,000 by borrowing:

  • $100,000 cash from Jack and Jill
  • $350,000 cash from Jill, due to the restructure of her rental
  • Long term, after Brightline period, another $200,000 from Jack, plus $50,000 for renovation.

 
Jack and Jill would normally gift these loans to the Trust, so that long term the Trust owns the personal house with no debt to the bank, and no debt back to Jack and Jill either.
 


 
Option 4.  Asset Protection a step further 

Who should own the LTC?
 
In the past, often we would have the LTC owned by Jack and/or Jill, so that any loss could offset their personal income, resulting in a tax refund.
 
With Ring Fencing expected 1/4/19 and both parties having reasonable risk, a smarter idea would be to have the LTC shares owned by the Trust. This would provide asset protect!

  • Any profit/loss or capital gains/losses would flow to the Trust.
  • Initially, this would create losses in the Trust, but as Jack and Jill pay down the rental debt, this loss should change into a profit and use up the losses.
  • If Jack or Jill were sued, and this structure had been maintained correctly, then the personal house and rentals would be separate and safe in the Trust.
  • Long term, if they have children, the Trust could allocate some income to children, or to lower earner if one of them is working less.

 
Initially, Jack would still have a $50,000 shareholders current account, and the LTC would still owe him $50,000. This debt could be transferred to the Trust and also gifted.
 
As Jack and Jill introduce other cash, this could also be transferred to the Trust long term and gifted.
 

 
Option 5.  Rest Home subsidies 

If Jack and Jill gift over $27,000, they will not be entitled to rest home subsidies under current rules.
 
My opinion:

  • A lot of people do not go into rest homes.
  • These rules are likely to change over next 10 years.
  • Better for Jack and Jill to gain full asset protection now by full gifting, then to try to gift $27,000 over next 28 years. Plus over the next 28 years. there is likely to be more to gift, so would require more years!

 

Hopefully this scenario highlights a few of the issues. A few key ones to be aware of are:

  • Brightline 5 years resetting
  • Effect of ring fencing, and in some cases this will stop a restructure being worthwhile
  • Asset protection with ring fencing coming in – disadvantage of a Trust in the past has been ring fencing of losses!
  • Cost vs benefit



Kind regards
Ross Barnett

 
 
 
 

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