Rental Units In Trust: Tax Traps
01 February 2007
Posted by: Author: Peter O"Halloron
Rental Units In Trust: Tax Traps
In the marketplace, specialist advisors are operating and some advise clients to place these proper ties in trust.There are even organisations where developers, trust attorneys, accountants, letting agents and bond originators have formed alliances and work closely together.Some of the advice given to investors is as follows:
1. Purchase the properties (residential blue collar properties) in trust, using the bank's money only.
2. As the value of the property increases, re-bond or re-finance the property and utilise the capital thus obtained as income or to purchase new units.
3. Shortfalls in rentals are covered by the client and these are also repaid to him when the property is re-financed.
4. As the rental income is often less than the costs of interest and capital repayments on the bonds, a loss is made in trust for tax purposes.This loss is ongoing as the re-financing of the property will increase the bond repayments into the future.
5. The scheme is said to be extrememely tax friendly.
What the average investor, however, is unaware of is that there are numerous tax traps that are to be found in such an arrangement, which will seriously hurt the unwary.Given the fact that the trustees of such trusts have to sign personal sureties for the initial bond as well as each time the re-financing takes place, clients would be well advised to be extrememly cautious.
The first tax problem is found in the fact that, in terms of section 11(a), read with section 23(g) of the income tax act, interest that is paid, not in the production of income, will not be allowable as a tax deduction by SARS.
Thus, if a person has a good property portfolio in trust and re-finances the growth in value of the properties in order to make and enjoy a capital distribution to the beneficiaries, it is a fact that the interest that is generated by such refinancing will not qualify as a tax deduction.
The taxpayer will then have a situation where the rental income has to cover not only the increased repayments in terms of the re-financing, but will also be liable for the income tax that is generated through the lack of a tax deduction on the same interest.
A cash flow problem is the likely result.In CIR v Elma Investments CC 58 SATC 295 a close corporation actually made distributions to its members, but on condition that these would immediately be lent back to the corporation.The Commissioner disallowed a portion of the deduction of interest paid by the close corporation to its members on loan account, on the basis that it was not in the production of income since it was used to finance a profit distribution to its members.
The court held that the interest payable on such loans was not deductible as the purpose in acquiring the loan was not to produce income, but to safeguard the future tax position of the members.The close corporation gained nothing from the scheme; it stood to lose as the scheme created an additional expense for the corporation with no additional income
The second tax problem revolves around the fact that in a situation where the property is continually being re-financed, there will be an ongoing loss for tax purpose.Should the entire interest repayments be found to have not been made in the production of income; due to the fact that the taxpayer is blatantly avoiding tax through continuous re-financing of the property, the problem, once again, is that the taxpayer will have tax to pay, into the trust, as the funds have not been distributed to beneficiaries and the bond repayments will be payable as well.
Clients can thus find themselves in unenviable positions due to a combination of sureties signed and severe cash flow difficulties.In his book, titled "Taxation principles of Interest and other Financial Transactions”, Professor TE Brincker explains that if interest is generated by transactions which do not give rise to taxable income, then SARS could (will) disallow such interest.Professor Brincker refers to ITC 112 4 SATC 61, in which case funds were borrowed at a certain interest rate and on-lent at a lower interest rate.As the arrangement could produce nothing but a loss, it was held that the interest could not be regarded as expenditure incurred in the production of income as the transaction could be productive of nothing but a loss to the taxpayer.(Taxation Principles of Interest and other Financing Transactions, Lexis Nexis Butterworths, at page A-2).
In situations where the trustees habitually increase the bonds and in so doing ensure that there is an ongoing loss for tax purposes, it would appear that a real danger exists that SARS would apply the same ratio as in the above case and disallow the interest expenditure.
Source: By Peter O"Halloron (TaxTALK)