LAQC, own home, tax...again

[xris]

I was asked a question today.

A friend of a friend of a friend borrowed money to buy a rental property which she put into a newly incorporated LAQC from the start. So far so good.

This person changed her mind immediately after settlement and chose to live in the house long term as her main residence. This is where I jumped in and said: ‘Oh no, she should not claim expenses even if she chooses to rent from the LAQC. It is too risky.’ I was then told that she did not do that and to be quiet and listen to the end of the story.

I was told she has two other rental properties in her own name with little debt on them and has been told that the loan on her own home should be secured against those rental properties so as to make the interest deductible. At this point I cautiously said: ‘Yes’ as my mind was starting to move into second gear.

I was then asked the question.

She plans to raise funds to the value of the loan on her own home, secured by the other two rental properties; lend that money to the LAQC; the LAQC pays off the bank loan on its sole asset, her home; the LAQC distributes assets (ie her own home) to the shareholders (ie her).

Result: She owns her own home unencumbered and her rental property business has a larger debt, the interest on which is entirely deductible for tax purposes.

“So xris, what do you think?”

For someone as opinionated as me my silence at this point was deafening.

My hesitation arises because…

The purpose of the loan was clearly not to buy rental property, but…

it was also not to buy her own home. Rather, it was to lend to her company, which then chose to repay other company debt, namely the mortgage secured by the house in which she lives.

I thought this might make an interesting topic for a new thread, a variation on those eternal discussions about paying rent on your own home which is owned by your own company.

Does anybody know if this can this be done, with the loan interest being deductible?

xris

[RentMaster]

Another similar option which I know can be done is to sell her 2 rental properties to the LAQC. The LAQC gets a loan in order to purchase 2 rental properties, which means the loan is deductible. She then gives the proceeds of the sale to the LAQC, which chooses to pay off the loan on the property she is moving into. She then lives in the home without claiming income or expenses on it.

[CJ]

This one defiantely needs an account (preferable with a good indemnity policy).

The rule: What the loan is secured against is irrelevant. What the money goes toward is important.

Applying the rule: While the loan is not being used to buy the PPOR (not directly anyway), it is not being to purchase a rental either.

Decision: In the court of Judge CJ, I lower my gavel and say "not deductible".

Appeal: Anyone willing to appeal my decision??

[Dean@Massiveaction]

Hi CJ. I'm with you. It becomes an issue of "internal integrity" IMHO. Can she do it and get away with it? probably. Is she being "dishonest" in terms of the tax laws? definitely

[xris]

Just had a thought before bedtime.

I am also uneasy about this set up and so agree with CJ and Dean. Something does not feel right about it.

My late night thought? (I am an early to bed early to rise person). The purpose of the loan, the money borrowed: it is to be advanced to the company by the shareholder, not to purchase income producing assets. Does that make a difference? Does that mean the interest is not deductible?

Agree with CJ again. Definitely a question for an accountant.

xris

[tricky]

Isn't there another test that the IRD can do - something like 'commercial merit' or some such term? This is when you ask 'why would a business do this?'
If the only answer is 'to reduce tax' then the transaction lacks commercial merit (or whatever the term is) and can come under tax avoidance/evasion rules.
If a business would normally perform this transaction then it's a genuine transaction.
In this case, as detailed by xris, the transactions are only done to reduce tax. The market value of the properties are unchanged as is the rent. Why else would someone go to that much trouble and incur the expenses?
I wouldn't appeal Judge CJ's ruling.

[cube]

A company can borrow money to repay shareholder funds, and the interest on that is deductible, but the shareholders have to have loaned the funds to the company in the first place.

[roseneath_rat]

I've seen this done before too & it still makes me uncomfortable just like you xris. If it can be demonstrated that the primary objective of the financing structure is to reduce taxation liabilities then prepare for the IRD to extract the proverbial pound of flesh.

Many people appear willing to just 'take the risk' that they won't be audited & enjoy the taxation savings.

[spaceman]

Red herring

I don't think that what the loan is seccured against makes a difference as to if the loan interest is deductible or not ....this is a complete red herring ....it is what the money is used for. Saying the interest is deductible just because it is secured against a rental property is wrong ....yes it can be ...but it the purpose the money is used for that counts, not what it is secured against.

Also if I've read the case correctly ... It seems to me that the LAQC ends up with a debt and no asset ie:
The LAQC has a borrowed money from your friend and paid off the bank loan ....then disstributed the asset to the friend. Since the LAQC no longer has an asset how is it supposed to generate income????

This is tax evasion pure and simple ....as a director of a company you are obligied to ensure the company is viable one ... it can't be set up to make a continuos loss ...now how can the property company make money if it has a loan and no proerty.... the act of distributing the property to the shareholder puts the company in an insolvent position for which the directors can be held responsible.

If I have read this correctly ( i've re-read it a couple of times to get it straight in my head) then it's pretty simple and it would be a waste of time going to an accountant to get told that what you're doing here is illeagal.

I can see possible ways for the friend to live in the house owned by the LAQC and for it to be legal and above board, but not like this.

Please note I'm not a tax professional so if your friend goes ahead with plan of action and doesn't get screwed by the IRD. Feel free to point and laugh if you ever see me walking down the street

cheers
Spaceman

[CJ]

I think everyone seems to be in agreement.

I dont think you even need to come to the tax avoidance rules (as some suggest) as it doesn't even pass the deductibility test in the first place. The loan is made to fund an income producing asset (being secured over ones is irrelevant).

There is potential for a savvy property accountant to think up a way of doing it "by the book" but it may still fall foul of tax avoidance rules. Is there some shareholders loans that she could repay.

In this situation, I think I would be happier with her renting it from the LAQC for market rent (looks over his shoulders - "who said that???")

[murray-spi-investments]

I do like not the proposed approach. Nor do I like paying capital dividends on the increased value of investment properties to diminish personal debt.

We are it seems in agreement that the loan against the LAQC property which became a personal property cannot be claimed (interest, depn and expenses) nor should any rent the person pays themselves be taken up as income. The IRD and I agree conclude this is a Rort.

I do however believe if they brought with the sincere intent for the property to be a rental and perhaps two years passed and they then decided to live there instead an argument could be put forward which MAY be accepted by IRD. Obviously this is only useful to the investor if they loaded the debt onto their existing properties and left the new property debt free or with as little debt as possible for some other reason.

Conclusion if you go to an aggressive accountant you may get a solution. It may however come back on you eventually.

Best current solution is to put the other two investments on interest only and ramp up the principal repayments on the property currently lived in personally.

[spaceman]

maybe it's just me ... but

Maybe I got it wrong ... but as I read the original post.

The LAQC ends up borrowing money from the friend to pay off the bank loan and then distributes the property to the friend .... thus ending up with a loan but no assets.

Having a loan and no assets is were the deal becomes unstuck..... not who lives where and what is used as security.

Now if the LAQC keeps the asset (house) and rents it out to the friend there shouldn't be any problem.

There are plenty of cases where companies own property/houses and rent them out to staff/employees ...when I was in the army for one also teachers, police, DHB's plus many others. The act of a company renting property to it's staff isn't automatically tax evasion. FBT may be payable if the rent is deemed to be below market rent ... but this is completely above board as long as it is decleared and not hidden. So yes interest, expenses and depreciation can be claimed if the property is retained by the company and rented out to the friend.

That being said it could be tax evasion, especially if the sole intention of entering into the arrangemant was to avoid paying tax.

Another problem comes up proving your position to the IRD. You may well be technically correct to your and your accountants interpretation of the law. But would you be prepared to test that in a court of law if the IRD want to challenge you.
Some people have been in the past ... there was a case that went through several courts and appeals. Over if owner drivers of courier vans were contractors or employees of the courier companies ..... first the ird lost, appealed and won, the driver appealed the ruling and won...(of course the driver involved could only afford this as he was backed up by the courier companies lawyers ).....also there was some noise about real estate agents a while back as well but I'm not sure what happened on that one.

Cheers
Spaceman

[xris]

Thank you everyone for your replies so far.

Maybe I got it wrong ... but as I read the original post.

The LAQC ends up borrowing money from the friend to pay off the bank loan and then distributes the property to the friend .... thus ending up with a loan but no assets.

Yes, this is what I meant when I wrote up the post.

xris

[SuperDad]

Spaceman,

You wrote:

Now if the LAQC keeps the asset (house) and rents it out to the friend there shouldn't be any problem.

There are plenty of cases where companies own property/houses and rent them out to staff/employees ...when I was in the army for one also teachers, police, DHB's plus many others. The act of a company renting property to it's staff isn't automatically tax evasion. FBT may be payable if the rent is deemed to be below market rent ... but this is completely above board as long as it is decleared and not hidden. So yes interest, expenses and depreciation can be claimed if the property is retained by the company and rented out to the friend.

Are you sure that this kind of scenario applies to this case? As xris described the situation,

She plans to raise funds to the value of the loan on her own home, secured by the other two rental properties; lend that money to the LAQC; the LAQC pays off the bank loan on its sole asset, her home; the LAQC distributes assets (ie her own home) to the shareholders (ie her).

This sounds like the friend is the sole shareholder in (and perhaps sole director of) the LAQC that would distibute the asset (house) to her. If she leaves the property in the LAQC and rents it at market rent, as you suggest, it sounds like she would fall foul of the IRD's position on this activity. While all kinds of companies rent accomodation to employees, even where those employees might be shareholders, I suggest that the current situation does not allow sufficient separation of landlord and tenant (if you want to put it that way).

Its an interesting case xris.

Paul.

[Richmastery Canterbury]

Hello

Murray you said
"Nor do I like paying capital dividends on the increased value of investment properties to diminish personal debt"

I would be interested in knowing why you don't like this. Given that it is entirely allowable and above board.

Thanks in advance.

Sue