Get it Wrong at Your Peril!
Deciding on the best structure for your property development can get complex, but this simple example highlights two reasons you need to get it right.
The most important thing to consider is risk. Every property development carries with it a level of risk, some of it can be insured but insurance does not always cover every single possibility.
Let me give you an example:
Bob decides to subdivide his large block and sell the surplus land. Bob owns the land, including his freehold family home on the front and it’s currently around $1m. Bob thinks he will be able to sell the new vacant lot for around $300,000 and estimates his development costs to be $150,000 which he will borrow to fund. Because he doesn’t intend to build on the land, the development is about as low risk as property development gets, right?
Bob was realistic about the project, had plenty of equity to fund the development, and had engaged a good surveyor and consultant to help him through the consent process.
Development approval was easy enough although it cost a bit more than Bob anticipated, luckily he had negotiated a great price for the ground and infrastructure works. Unfortunately the contractor was not up to scratch, he failed to identify underground power cables and a number of other failures resulted in him being sued for a total of $1.2m. Bob, as property developer, was also named as a respondent in all matters as he was the property developer.
The courts awarded damages against Bob totaling $600,000. Now instead of retiring with an unencumbered house worth around $1m and his $150,000 profit from his land project Bob had a mortgage over $800,000 and further costs of $120,000 if he wanted to complete his subdivision.
How Would Structure Affect This Outcome?
As a Sole Trader, all of the risk of the project would rest with Bob. His entire wealth is exposed to the risk of the project and although this example is a little bit exaggerated he had no choice but to mortgage his family home to meet the damages claim. There was no recourse to the contractor who operated through a company which was quickly liquidated.
Had Bob taken structural advice, he may have been presented with the following options:
1. Set up a company to do the development: There are a few logistical options to get the land into the development company and these may trigger Stamp Duty or Capital gains Tax but with a bit of creative planning these could be deferred. The costs to establish a company are around $1,000 and with a company Bob may well have avoided the damages claim altogether because it was the developer who was found to be remiss in his duty of care to the plaintiff(s).
2. Set up a trust to do the development: The logistics are similar to those using a company but the risk protection can be just as strong and the risk outcome identical to that achieved above.
The reason Bob could have chosen a trust as opposed to a company is the more flexible tax planning options available through a discretionary trust. Basically the profits from a development undertaken through a discretionary trust can potentially be distributed to anybody, partners, parents and even children.
3. Establish a Joint Venture to do the development: Joint venture arrangements are often misunderstood. Essentially they are a contractual agreement between two or more persons whom each provide something (in Bob’s case he would provide rights to the land) in return for something (typically a share of the development income or profit).
Joint ventures may or may not provide adequate risk protection in Bob’s case above but that could be addressed separately. Where a joint venture really excels is when there are specific funding, income and/or capital distributions to consider. Importantly it may be possible to use superannuation funds to invest in a development through a joint venture.
This is a fictitious scenario and is very much simplified but the outcome is clear; The right structure can save you a lot of time and grief.
The second consideration is tax. Here is a simplified example to show the different tax outcomes for Bob’s project had he managed to complete is as planned and realised a taxable profit of $150,000.
|Tax Payable||$ 61,500||$45,000||$ 50,100|
|Effective Tax Rate||41%||30%||33%|
|Income Streaming Flexibility||None||Some||Complete|
We have made a few assumptions above but the outcome is clear; The right structure can save thousands of dollars in tax.
We know it is never this simple but the critical message is clear, “Get your structure right before you start your development and you can maximise your outcomes”.
This article should not be taken as advice nor relied upon for your own structural decisions. We are happy to help and offer all mastermind clients a FREE NO OBLIGATION structural assessment. To arrange a time to have a chat just call our office on (07) 54391600 and let us know Rob sent you.