Yet another reason you should buy your properties in a trust
Investors are often advised not to buy property in a trust due to the high tax rates, but the ‘advisor’ often does not understand trusts or how the trust-related taxes work.
In a previous article, Should You Buy Property in Your Name, a Company or a Trust?, we discussed which entity to buy property in. However, this article focuses on the tax advantages of trusts.
The income tax of a trust is 45%, and the income tax of a company is 28%. The difference is the conduit principle that only applies to trusts. The conduit principle is one of the biggest advantages of using trusts and is explained as follows by the South African Institute of Chartered Accountants (SAICA):
“If income accrues to a trust and the trustees award it to one or more beneficiaries in the same year, the income retains its nature in the hands of the beneficiary.”
This means that whatever profit is made in the trust, whether it is capital or income in nature, can be distributed to any of the beneficiaries and the beneficiaries will pay tax in their personal capacity.
Let’s look at two examples.
Capital Gains
Let’s assume an investment property is sold and the capital gain is R400 000.
Scenario 1
You own the property in a company which has a tax rate of 28%. Therefore, the capital gains tax will be:
[R400 000 (Capital Gain) – R0 (Capital Gain Exclusion)] x 80% (Inclusion Rate) x 28% (Income Tax Rate)Total Capital Gains Tax = R89 600
Keep in mind that if you want to distribute these profits to yourself, you will still need to pay an additional 20% dividends tax on what you distribute.
Scenario 2
You own the property in a trust and let’s assume you have two children who need to go to university soon and you would like to use this profit/gain to pay for their studies. Both children don’t earn any other income yet. The capital gains tax will be:
R400 000 / 2 = R200 000
Child 1:
[R200 000 (Capital Gain) – R40 000 (Capital Gain Exclusion)] x 40% (Inclusion Rate) x 10% (Estimate Effective Tax Rate After Rebates at an Income of R160 000) = R6 400
Child 2:
[R200 000 (Capital Gain) – R40 000 (Capital Gain Exclusion)] x 40% (Inclusion Rate) x 10% (Estimate Effective Tax Rate After Rebates at an Income of R160 000) = R6 400
Total Capital Gains Tax = R12 800
It’s clear that even though trusts have a higher tax rate, you pay the least tax because of the conduit principle.
Net Profit
Now, let’s assume your property portfolio generated a net profit (rental income minus expenses such as interest on mortgage bonds, rental agency commissions, levies, rates and taxes, maintenance and administration costs) of R400 000 for the year.
Scenario 1
(The above assumptions for capital gains tax still apply)
R400 000 (Net Profit) x 28% (Income Tax Rate) = R112 000
Total Income Tax = R112 000 (plus the additional 20% dividends tax on any profits distributed)
Scenario 2
(The above assumptions for capital gains tax still apply)
R400 000 / 2 = R200 000
Child 1:
R200 000 (Net Profit) x 10% (Estimate Effective Tax Rate After Rebates at an Income of R200 000) = R20 000
Child 2:
R200 000 (Net Profit) x 10% (Estimate Effective Tax Rate After Rebates at an Income of R200 000) = R20 000
Total Income Tax = R40 000
Once again, it’s clear that even though trusts have higher tax rates, you pay less tax because of the conduit principle.
The conduit principle allows you to distribute to any beneficiaries, not only your children. You can also distribute to your spouse or parents if they are on a lower tax bracket. And if you don’t have children yet, your tax challenges will usually only come later once your property portfolio has existed for some years