Now that the dust has settled on what was one of the most anticipated budget announcements in recent memory, now is time to reflect on the impact of the announced and proposed changes on property investors.  In doing so I am going to focus on the specific impact of the tax changes and leave aside for the moment the wider macro effects of the impact of this budget on the economy.  Broadly speaking there are five areas where the tax changes will impact on property investors.  They are as follows:

• The drop in personal marginal tax rates;
• The removal of depreciation claims on buildings;
• Proposed changes to the LAQC regime;
• Raising GST to 15%;
• Extra funding for audit activity at the IRD.

For advice on how the changes impact you contact us.

Depreciation vs Tax Cuts

Let’s take an example of a typical property investor that has taxable income from their job of $75,000 per annum and owns two rental properties that are currently worth circa $700,000 but were bought in 2002 and 2006 for $550,000.  For the 2011/12 income year if depreciation was still able to be claimed on buildings they would have been expecting to make a circa $6,800 depreciation claim which would have a maximum tax benefit of circa $2,200.  At the same time due to the cuts in personal tax rates there is an increase to their after tax income of circa $2,400.  Following this, the investor is $200 better off in the 2011/12 year.  It is also worth nothing that of course depreciation is usually claimed on a diminishing value basis so the amount that would have been claimed on the building moving forward would be reducing over time.  Finally, there is also the fact that in many instances depreciation claims produce a timing benefit only in that it is then recovered on sale.

Following this, we see the removal of depreciation claims as being mitigated by the drop in income tax rates (of course there will be additional private GST costs).

LAQC Regime

The budget announcement also signalled that there will be changes from the 2011/12 year to the LAQC regime.  At the moment the proposals are at issues paper stage only which means they are open for public submission until early July 2010.  The philosophy behind the proposed changes are to align the tax treatment of qualifying companies and loss attributing qualifying companies with limited partnerships.  This means that some of the same aspects that LAQCs have now will be retained in that tax losses will continue to be attributed to shareholders in proportion to their relative shareholding.  However, it also means a number of changes to other aspects of the LAQC regime.  It will mean that taxable profit is attributed to shareholders rather than taxed at company level and there is also a proposal to limit the amount of tax loss that can be claimed to the shareholders’ exposure in the investment. 

If you have an LAQC that may become tax profitable, then contact us for advice.

At this point in time the rules are not finalised but we will be watching this closely and it may well be that many investors who currently have properties in an LAQC will need to consider whether this is the appropriate structure for them moving forward. 

If you have an LAQC with property in it, contact us for advice on restructuring prior to the rules changing.

The fact that depreciation on buildings has been removed, which may lead to a decrease in the tax losses (or perhaps even some properties even becoming profitable), along with the proposed changes to the LAQC regime mean that a review of structures is necessary.  If the changes continue to proceed as proposed affected investors would be best placed to restructure prior to 1 April 2011.

If you are selling property and want to know about the impact of depreciation recovery then contact us.

Likewise if you are buying property and want to know if the LAQC is still the right structure then contact us.

The rise in the GST Rate & Audit Activity

The rise in the GST rate will not have a discernible effect on residential property investors other than expenses that they currently incur that attract GST will increase without the ability for the GST to be reclaimed.  There will be an impact on property traders and commercial property investors however.

If you are a property trader you need advice on transactions occurring around 1 October 2010 when the rate changes.  Please contact us for advice.

It is also worth noting that extra funding is going to be provided to the IRD with one of the focuses being the property industry.  As a result we encourage property investors to make sure that they are involving professionals in the preparation and filing of their tax returns and making sure that they are getting appropriate tax advice in relation to property transactions.

If you are concerned about tax treatment on past transactions or need advice on current ones, then contact us

Overview

Overall we think the budget was a largely positive one for property investors even in respect to the tax changes.  Certainly leading into the budget there was talk of ring fencing of losses, which has not come to fruition and would have had a much more significant impact on the property investment sector.  As it is the removal of depreciation claims on buildings from the 2011/12 year will definitely impact on property investors, but perhaps for property investors any impact of this will be matched by gains to the drop in personal tax rates.

Matthew Gilligan
Director

Learn More about Matthew
Contact Matthew at mg@gra.co.nz
or call +64 9 522 7955

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Partnership Property: Buying Property With Friends & Family

One common theme that seems to be on the 'up' this year, is two or more investors coming together to buy property through small private partnerships, LAQC's or joint ventures.

Common examples include:-

1. Family members buying an asset from the deceased estate of a relative;

2. Family members or friends pooling resources of capital to get enough deposit to buy a property together;

3.  One partner has good cashflow, but no deposit. The other has equity in a home or a deposit, but no cashflow. Together, through a partnership they are bankable and safe investors, ticking both the cashflow and equity boxes and qualifying for finance.

4.  An 'asset rich, time poor' investor agrees to back an 'asset poor / time rich ' investor with skills in property. One funds the other, the other finds the deals. Together they can be a clever investing partnership, combining human and financial capital.

Combining Resources Can Make Sense

Combining resources can make sense for people in various circumstances, but care needs to be taken in setting up a good foundation structure. Any partnership agreement should deal with dispute resolution, and the rights and obligations of partners in advance of the partnership starting. Unfortunately over the years we have seen many a client spoil a relationship with a friend, business colleague or family member through bitter feuds in partnership.

Personally I have found partnerships very powerful and rewarding, allowing me to grow and extend my business and property interests. But in saying that I have seen a few train wrecks emerging in the client base too, with clients very bitter and angry with their business partners.

Partnership Agreement The Key To Avoiding Disputes

I have always found that where a clear partnership agreement is put in place ( for whatever your trading entity form eg LAQC, partnership, or joint venture), problems are less likely to arise because the parties to the agreement know their rights and obligations before they begin. If you like, the time to have the argument is at the start of a new investment or enterprise, rather than 'working out the issues as they arise'.

The latter approach is fraught with risk as to the respective parties view of what is right and wrong, what is fair and reasonable. And when the chips go down....sometimes you learn things about people that surprise you and 'moral agreements', 'handshake agreements', 'gentlemen's agreements', turn out to be disasters...a pathway to hell for some.

What should you think about in your Agreements?

Whether you are going to trade through an LAQC, trading Trust, general partnership, limited partnership, ordinary company, or joint venture.....the story is the same and the arguments that arise are similar.

Typically one party will say ' I am doing all the work ( or more of the work), so I should get all the money'. Another party will say 'I am doing all the funding ( or taking risk through securing bank loans) so I should get all of the money'.

Both parties likely have a point. Resolution lies in agreeing a remuneration formula which addresses both the issues of payment for work done, and payment for risk taken / capital supplied to a venture. By this method you simply agree over:-

1. Payment for work done: The fee for time spent working on the investment portfolio will be an hourly rate of $x, payment by agreed method ( either when the property is sold or week/monthly or as suitable between the parties). Where both parties agree that time spent is equal, they may elect not to draw remuneration. Where time spent is slightly unequal, the parties may agree that the party doing slightly more work will draw for their 'differential work' done. IE If one party does 7 hours work a month and the other 3 hours, then the party doing 7 hours gets paid for 4 hours and that addresses the imbalance.

2. Payment for risk / capital invested: The remuneration for capital invested is interest, paid periodically. By paying interest on partners advances at pre-agreed rates, no partner can claim any grievance for 'doing all the funding / doing more funding' because they have agreed to fund at that rate for the term of the investment. Where the capital is by way of security being provided, it may be appropriate to address the security risk by paying for it. Say your sister puts her house up as security for a loan in a joint LAQC to buy a rental property, pay a guarantee fee. Such fee may be say 5% annually, of the maximum security risk exposure. ( Example: Your sister provides a cross security of 20% for a $300k house purchase by your joint LAQC with her. At 5%, the annual fee is 5% of $60k = $3,000 annually).

Where one party is providing equity, and the other is providing time, it might be appropriate that by partnership you agree that one parties contribution ( time) offsets the other's ( capital risk). By putting numbers into the equation, you can maintain by partnership agreement a common understanding that if time goes up, or security risk goes up, then the imbalance is addressed by more wages paid or more interest or guarantee being paid for the emerging imbalance. This is fair, commercial, and stops arguments in their tracks.

Typical Partnership Agreement Considerations

Your partnership agreement should address the following as part of its scope:-

1. Funding obligations: Who's responsibility is it to fund and to what extent ? Is it based on proportion of entitlement ( pro-rata) or is it unequal ? Consider the funding obligation both in the context of initial advance and ongoing advances for any capital that is required to be injected in the future - what is the obligation to fund by the respective partners and in what proportion at what time frame?

2. Remuneration for time spent by partners: as stated above, what remuneration are you entitled to for time spent working on the portfolio and affairs of the company/partnership, if any. Will you draw the wages, or offset against the other parties contribution ( of time or capital) ? Where time spent is equal, typically no wage is drawn. Remember wages require tax considerations to be addressed so should be avoided if possible.

3. Default of a partner: What will you do if one party cannot pay ? Force a sale or exit from the investment ? If so what penalty should be paid by the defaulting partner ? In some joint venture agreement's I have written, I have provided in the agreement a provision that says the defaulting party loses their capital / shareholder's loan and all shares/units in the investment if they do not pay their dues. This is to stop people 'riding on the goodwill of others'. This is particularly effective between people that do not know each other well, as it provides real incentive to behave and meet obligations without stressing partners. If someone is interested in this concept, contact the writer (mg@gra.co.nz) and I can provide assistance here - this is a great idea that makes your partners behave properly and honorably.

4.  Voting rights and arrangements: generally when partnerships are going well, formalities of voting are irrelevant. But when disputes emerge you should have a clearly defined voting process and your voting rights should be set out. It may by that if you are the partner with the most at stake ( eg you are the funder), then you may require a 'governing directorship', giving you the ability to make unilateral decisions and force your will, if you believe the action of your partners is threatening your capital or security position.

5. Dispute resolution: going to war in court can be expensive. It's best to have a pre-defined mediation or arbitration process that is binding on the parties, or at least an obligation to explore mediation. It's also best to have financial consequences for not following the rules...otherwise there is no incentive to follow them. If something matters to you, define breaking the rule as a 'default' and apply the 'forfeiture of capital' rule in point 3 above.

6. Rights and entitlements / obligations on dissolution of the partnership: When you sell property, sometimes the costs have exceeded the sale proceeds. Who loses and in what proportion ? Should capital advanced rank in front of payment for work done by partners, should interest rank in front of capital gains ? Agree and write it down at the beginning, and you won't have a problem at the end.

7. Restraints: Are you allowed to steal tenants off the partnership, or resources for your own private activities? If not write it down.

8. Exit rights: Partnerships will always end. Someone will die, retire, go broke, remarry, or just have a change of heart. Give yourself the right to exit and stipulate when (at the earliest) this can be, how it will be done, and what penalty there will be for early exit. For example if you agree you will be in an investment for 10 years minimum, and someone exits at year 2 because they have a change of heart, perhaps they forfeit their deposit and shares ? It's up to you - you define the rules the way you want.

Summary

Investing with your friends and family is a powerful way to combine human resource and capital and get a great investing outcome. Make sure you think about what your rights, obligations and profit sharing agreements are. Set rules and consider penalties for rules not being adhered to. Do this upfront and you will be much less likely to have a problem later on when partners circumstances or the investment circumstances changes.

Anyone forming a partnership who would like a hand with the tax or agreement drafting, is welcome to contact me on mg@gra.co.nz

Thank you for reading this.

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