Martin: Welcome to The Business Owners Podcast where we throw aside taboos and share strategies for growing, protecting and exiting your business. My name is Martin Checketts and I represent Mills Oakley’s Private Advisory team.
So, hello everybody! Today we are commencing a series on tax for business owners and we are going to traverse a broad spectrum of interesting tax issues which we hope you will enjoy. And particularly where the focus is on the practical application of those tax issues to your business and also your personal assets and structuring. So I’ve got here in this studio with me today my tax partner Ross Higgins.
Ross: Thank you Martin, good to be here.
Martin: So Ross is one of Australia’s premier tax lawyers, he has over 30 years in the game, he is both a lawyer and an accountant so he has worked in some of the large law and accounting firms, and he is certainly a colleague I very much enjoy working with on these issues. So, thank you and welcome!
Ross: Thank you, Martin
Martin: So, to kick you off, Ross for this first episode in the season I would like to talk about real property.
And as we know in Australia there are a number of tax dynamics around a real property from capital gains tax to GST, through to stamp duty and land tax, and I know that you are of course a master of all of those areas! Let’s kick it off with maybe one of that I see a lot in my practice, which is business owners who own a family home in their own name. Talk to me about that, do you see that often?
Ross: Yes, well, we recommend of course in many cases that if you run a business, business represents risk and therefore it’s generally best for business owners to try and avoid having personal assets in their own name. One of the key exceptions you see all the time, of course, is family home. And that is because the family home is exempt from the capital gains tax. And for many people of course apart from their business, it is a key personal asset, often the most valuable personal asset that people have. So, you want to keep it separate from the business, yes having it in your own name can be separate from the business where you ensure that the business is carried on through the entity. And that’s what we generally suggest, you shouldn’t run business in your own name, you should run it through the entity and that entity should have a corporate face. So it should either be through a company or a trust with a corporate trustee.
When you have a main residence in personal names, you can sometimes have a choice and that is – you can put it in one person’s name or you can put it in combined names. And often people by default, husband and wife for example, or other partners, take the view “well, we are equal, we have this relationship, we will put it in joint names” but generally if one of them in particular is exposed to the business risk and, say, the other isn’t it makes much more sense to put the home in the name of the low risk spouse. In that way if something goes wrong, if personal liability, personal guarantees, things related to the business leak through the limited liability shield out to the individual, if the individual has a personal residence in their name then it’s a risk. Where it’s in the name of the low risk spouse then it protects it from risk.
Martin: That’s great Ross, thank you. There probably are few people listening to you right now, thinking “Oh Dear, I am in that boat, I own the home with my spouse”. Are there steps that people can take to change that?
Ross: Yes, fortunately. In Victoria you can transfer from one spouse to another without stamp duty. Now there are some changes on foot on that, but in relation to the principal residence that is still going to be the case. Also of course from an income tax point of view when you transfer the joint interest to the other spouse there is no income tax because it’s your principal residence. So therefore you can do it without a stamp duty and without income tax. And importantly also the duty exemption applies whether you have consideration or no consideration. And you can make a choice and in some case you might decide to in fact have consideration and then possibly secure that consideration or that loan back through an entity to have security over the property to provide even more risk protection. Now if an entity, like a family trust, holds a loan and the security over the property then even I something happens so that the person who owns the property, say, goes bankrupt , if you have a security over it back to a family entity then you can protect your investment.
Martin: So thank you Ross. Let’s try to pick it apart a little bit for people who are listening. So talk me through the steps, so say if I own a property with my wife as joint tenants and that property indeed is my home, what exactly do we do to get that protection that you have just spoken of?
Ross: Yes, what you can do is one spouse could make a loan to a family trust. Or rather than it could be a contribution to the family trust of capital and might even be a promissory note so that you simply own money into that family trust. That family trust then can lend to one of the spouses who is going to buy the interest and amount of money and that can then be used as consideration to buy out the other spouse, so you get a transfer of the interest. So that money that’s been lend out from a family trust can be secured over the property itself. So therefore you had created an obligation to a family trust from one of the spouses, there is loan out to the other spouse and there is a transfer of the property with a consideration and you’ve got security over it. So if the person goes bankrupt there is a security priority interest back to your family trust which will protect the property.
Martin: Yeah, so as you say Ross, it’s like a double whammy, isn’t it? Again, take an example of myself and a wife owning a property jointly. Well step 2, as I am the one who exposes the business risk, I can get rid of my interest in the property. So if I am ever sued because I’m a director of a company, well that asset is not in my name. But further more you are saying there is a second step we can take? I don’t have to give it to my wife; I can sell it to her. But of course that money remains unpaid and can be locked up with a mortgage if you like.
Ross: Yes, that’s correct. And that gives you that double protection. Now it might be even more relevant in some cases where the principal residence is held in joint names but both parties husband and wife, or both partners are potentially subject to risk. And they could be both directors of the companies, run businesses, or they could be partners in professional firms and therefore they are both at risk and that’s where even transferring from one spouse to another might not be a great solution. And so therefore the creation of security back to a controlled family entity like a family trust with a corporate trustee basically for the value of the property is the better way to go in terms of protecting your asset.
Martin: And what about if you’ve already got a mortgage, because that’s kind of seems to me to be more complex. I mean, if the property is already mortgaged to the bank, can you do these strategies?
Ross: Yes, you can absolutely do these strategies. Obviously you have to do it with the permission of the bank. The bank makes sure that it has priority for each mortgage over yours and you have a few costs in dealing with a bank and arranging this, but all of this could be and has been done many, many times. And of course as the bank mortgage gets paid down, you can replace it with the mortgage that is coming from the family trust. So as the protection in a sense of the property goes down as you pay off your loan to the bank, your loan from the family trust goes up and covers in many cases the value of the property and protects your investment.
Martin: Let’s talk about the own residence duty exemption, Ross. Because you have mentioned this earlier, this is the rule that says that whenever you sell your family home you pay no capital gains tax, which you know that’s been wonderfully beneficial to Australians, over the last couple of decades house prices have risen massively and they can sell their house and pay no tax. The one thing that you said to me the other day when we were chatting (we are a bit nerdy we like sometimes to shoot the breeze on these matters) and .. in the tea room, Ross, you were saying to me that in fact the own residence exemption isn’t as clear as cut and isn’t as solid as a lot of people believe. Can you talk to us about that?
Ross: Well, one of the quirks in the legislation, and I might say it’s about the longest group of provisions in Income Taxes Act, all the stuff to do with the principal residences.
Martin: Seriously? It’s the biggest part of the Act?
Ross: Well, yes, for a single issue like this, it is one of the longest sections in the Act.
Ross: So there is quite a bit to it. One of the quirks is that there must be a dwelling on the property, when you dispose of it. So that means, for example, if you had your principal residence post capitals gains tax, for say 30 years, and then you had an offer too good to refuse and someone said: “Look, house built on a double block but the house is a bit old, can you demolish the house and then we buy two blocks from you? And that’s the way how you get you best return” and if that was done it could be a real problem because at the time you sell it hasn’t got a dwelling on it and therefore you don’t get the principal place of residence exemption. And you don’t get it pro-rata based on when you demolish the residence in fact it has been your principal residence for the last 30 years. You actually lose it for the all 30 years. So it’s a very blunt instrument in a sense the way the Act is written. But you know we don’t write the law, we just say this is how it is, so you have to be very careful when you are treading around it. And, for example, one way to deal with that when the house is in one spouse’s name and you are thinking the best way to deal with realisation of the highest amount of the property is to demolish the dwelling, you can transfer that dwelling from one spouse to the other. And when you do so, you lock in the principal residence exemption at current market value and then the other spouse can immediately put it on the market and sell it. And that way, after they demolish the dwelling, the actual principal residence has been locked in even though you have a plan to demolish the dwelling. So there might be a way around it depending on facts and circumstances.
Martin: That’s so clever, Ross. And I just want to summarise these really two important points so that the people who are listening get them. So firstly, if you knock down the house, you are going to lose the exemption, that’s just massive. And you could just see circumstances in which somebody, who doesn’t understand that very important provision (and I didn’t know that either until you mentioned it to me a week or so ago) that could be a disaster. But then, as you say, what a clever way to get around it. So we just use exactly the law you have spoken about 5 minutes ago – the ability for one spouse to transfer to another free of tax, free of stamp duty. And that locks in and crystallises the gain, because of course then it’s been transferred at that higher amount. So any additional amount for which the spouse then sells it presumably going to be little or nothing, and therefore little or no gain.
Ross: Yes, and another possibility is that might want to develop their principal residents so they might want to demolish the existing dwelling and they might want to put a couple of townhouses or something like that to realise it at the best benefit. And in that case another alternative to lock in the principal exemption is to transfer the property to discretionary trust for the purpose of the development. Now in this case you lock in the principal residence exemption, there will however be duty. Sometimes it’s a cost that has to be worn for a greater benefit, so that the development entity buys in the property, you lock in the principal residence exemption, you pay duty, that becomes part of your costs base for the development, so in a sense you get a deduction for the duty that you incur, you develop the property and then you sell it. And there are smart ways of going about these things if you know the rules you can avoid falling into traps.
Martin: This is just a massive insight Ross. I think of a number of people, business owners or just normal people with normal jobs, who have got a big block they live on and they want to do a development to help themselves, get ahead and they would completely stuff it up. Absent that kind of insight that you have just given, that’s very powerful. And of course it sounds self-serving, but there is just a massive learning here about getting advice before you turn the first sod in the new developments.
Ross: Yes, that’s right. The key to a lot of tax advice is to get it very early, because if you make a move and then go and see a tax adviser after, it may be too late.
Hey, Ross we are running out of time on this episode but there is one more aspect of the own residence exemption that I would like you to explain, because again I think it’s something that’s not well understood. This is the question about what if you leave the house rented out? For example you move interstate for a year or two with work and then you come back, have you lost the primary residence exemption in that situation?
Ross: Fortunately not if you lived in the residence and ordinarily lived there and made it your principal residence. Generally the guideline is that if you are there for 6 months or more and that also works for land tax, so that then if you are absent it could be because of an overseas or interstate transfer, but not even be that. It could be just be that you have decided that the house is too big, based on the financial circumstances, you think it would be good to rent it out and perhaps moving to smaller accommodation for the time being. And if you rent it out there is a 6 years absence rule, so you can be away from the residence for up to 6 years and then move back in and these whole 6 years is treated as if it continued to be your principal residence. Now, when you move in back again, you could stay there for another couple of years and then you could move out again, and you move overseas for 4 years and then came back and that would again come within the 6 year absence rule. It’s just a requirement if you don’t have another principal residence at the same time. Now of course, when you buy your principal residence you don’t put in a nomination, it’s based on fact. Was it your ordinary residence and you really in a sense make that choice when you decide to sell. So when you decide to sell you can look at these absences and you can treat the particular residence that you have as your principal residence when you sell it. So that’s the way you treat it in your tax return when you sell it, that effectively is the nomination of which is your principal residence. So if you bought another residence in the meantime, it just means that you can’t have two principal residences at the same time. But if you choose the most valuable one, the one with the greatest occurring gain as the one to be a principal residence, then you effectively have a choice.
Martin: That’s fascinating Ross, so there could be all kinds of strategies. Like, for example people who really dig deep to buy a dream home, but maybe they can’t afford to live in it yet, maybe they don’t have a family yet so they don’t need to live there and think “Well, I will rent it out and I will be myself living in rented accommodation for a few years and once we pay down a bit of the mortgage we can move in” so there might be a strategy there “We’ll actually just move in first for a bit, move in for 6 months, lock it in and then rent it out” Then you have 6 years, right?
Ross: Yes, absolutely right, and you then get a positive cash flow of the rent, you get deductions in relation to the right offs the building, depreciation of assets potentially, you get to write off importantly of the interest costs on your loan and another costs from time to time, like repairs, and of course the managing agent’s costs for managing a property for you. So generally it will add both significant positive cash flow to you and tax benefits as results of renting it out.
Martin: That’s brilliant Ross, thank you. Look, my head is spinning a bit but only because we’ve received just so many valuable insights for business owners around the family home. So, just a very quick recap…
Think about risk, think about separating valuable assets from risk, which for those who are regular listeners will know is a very key theme of these podcasts, set it up right. Think about which spouse owns the family home, we just talked about the offensive player – the spouse who takes the risks and the defensive player who holds the assets, so set it up right. Think about some of these gift and loan strategies which would allow you to be like the bank for your own home and have some extra protection. And also before you develop your home, knock it down, do anything like that with it, always see a tax adviser because there can be a difference between a great outcome and a rubbish outcome. So thank you very much Ross, and we will enjoy speaking again soon as we progress through this season.
Ross: Thank you Martin