Tax Office Position Paper - Wraps

From: Dale Gatherum-Goss


Hi

I thought I'd let you know that I've just received something that does not officially exist.

The tax office are preparing a "position paper" that deals with wraps and I have received an advance copy to review.

It's 17 pages long and I'll have a good look tonight. Looks interesting and comprehensive.

Have fun

Dale
 
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Reply: 1
From: Simon St John


Keep us posted Dale - sounds very interesting.....

Cheers,

Simon
 
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Reply: 1.1
From: Dale Gatherum-Goss


Hi

Here is my summary of the tax office draft position paper.

I hope that you find it helpful

Dale
 
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Reply: 1.1.1
From: Felicity W.


You're a legend Dale!
Lots of interesting points to mull over there.
Keep smiling
Felicity :cool:
 
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Reply: 1.1.1.1
From: Andrew D


Thanks Dale,
Looks interesting look forward to finding out more..

Enjoy

AD

Hurdles are but stepping stones to the successful.
 
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Reply: 1.1.1.2
From: Andrew D


Thanks Dale,
Looks interesting look forward to finding out more..

Enjoy

AD

Hurdles are but stepping stones to the successful.
 
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Reply: 1.1.1.2.1
From: J Parker


Thanks for that Dale- look forward to seeing the final result.
Q5 has me puzzled, however. Does this mean that, if you had a rental and then converted it to a wrap then then it is taxed differently? Profit-wise, what would be the better option- renting it out first and then wrapping or wrapping from the start? (in your opinion)
Cheers, Jacque :)
 
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Reply: 1.1.1.2.1.1
From: Dale Gatherum-Goss


Hiya!

I'm not convinced their interpretation is correct. As I understand it, common law in Victoria anyway, may not allow you to wrap the property anyway if there is an existing mortgage on it already.

Besides that, remember this is still a VERY early draft and it will change before it is finalised. Furthermore, even when it is finalised, it will remain the Tax Office opinions and will not carry the force of law.

Sorry for all the disclaimers, but, I don't want anyone to get carried away with this.

Have fun

Dale
 
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Reply: 1.1.1.2.1.2
From: Mike .


Hi Dale,

You really deserve a pat on the back for all the wonderful help you have provided on the forum over the last 12 months. Tax issues regarding creative RE investing are even more complicated than normal investments and I believe your efforts are giving people the confidence to try real cashflow strategies instead of just playing out that fantasy with Cashflow 101.

The Wrap doc you put together is a beauty. Can you clarify a couple of things for me, please?

Could you explain “the emerging profits” rule? with an example?

For those wrappers who use investors to fund the deposits, what ramifications does the proposal have for those investors? Investors don't want to pay CGT on their deposits. It reduces their return.

Regards, Mike
 
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Reply: 1.1.1.2.1.2.1
From: Jas


On 6/27/02 10:43:00 AM, Mike . wrote:
>Could you explain “the
>emerging profits” rule? with
>an example?

Hey Dale,
I'm with Mike on this.

Also, can you explain this one too?
7. Although it is acknowledged that CGT will apply, it is also acknowledged that the CGT is reduced by the income otherwise declared from the same transactions. In most cases, because income was declared greater than, or equal to, the Capital Gain, there should be no need CGT payable on the sale of the property.


Jas

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When facing a difficult task, act as though it's impossible to fail. If you're going after moby dick, take the tartar sauce
 
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Reply: 1.1.1.2.1.2.1.1
From: Mike .


Hi Jacinta,

My interpretation is that the Position Paper is allowing the capital gain to be streamed as income via “the emerging profits” rule. (accounting method allowed by ATO) When the sale is eventually completed if the vendor has already received the entire capital gain via instalments and paid the required tax then there should be no further CGT to pay upon the sale.

How this method is accounted and documented when filing a tax return I'm not sure.

Question is: would this Pay As You Go method be acceptable to deposit investors? I guess it must be better than paying all the CGT up front.

Regards, Mike
 
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Reply: 1.1.1.2.1.2.1.1.1
From: Jas


> From: "Mike ." <mdengler@onetel.net.uk>

Ah yes, now I remember. Paying CGT tax as you go :)

> How this method is accounted and documented when filing a tax return
I'm
> not sure.

As CGT forms a portion of your annual income, and then is taxed at your
rate, all you have to do is deduct for each year the amount of capital
gains you put in.

In order to do this, I believe you'd have to put in an IIS each quarter.

> Question is: would this Pay As You Go method be acceptable to deposit
> investors? I guess it must be better than paying all the CGT up front.

Not sure what you mean by deposit investors

Jas
 
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Reply: 1.1.1.2.1.2.2
From: Dale Gatherum-Goss


Hi Mike

Thank you for your kindness. I have done very little other than share information and thoughts just as everyone else does.

I have attached a spreadsheet that I have prepared which hopefully will explain how the tax office see the income being declared. I hope that this helps and I apologise for the 'roughness' of it.

"Emerging profits" is a way of showing a little bit of profit each and every year over the life of the contract instead of all at the beginning.

As for Investors . . . in a nutsehll, that is a separate situation completely from the wrap. For example, I borrow $100k from you to buy a house for wrapping. I pay you as we agreed and you declare the interest as your income. When I return he principle, that is of course, tax free.

Does this help?

Dale
 
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Reply: 1.1.1.2.1.2.1.2
From: Dale Gatherum-Goss


Hi Jas

The tax act, as a general rule, does not allow you to be taxed on the same income twice. Therefore, although a wrap transaction might show a Capital Gain this is not taxed if you show the same amount or more as ordinary income over the term of the contract.

Does this help?

Dale
 
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Reply: 1.1.1.2.1.2.2.1
From: Tibor Bode


Thanks Dale,

You are (your knowledge and willingness to contribute) an extremely helpful gold mine

Tibor
 
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Reply: 1.1.1.2.1.2.2.1.1
From: Mike .


Hi Jacinta,

What I mean by "deposit investor" is a third party investor also known as a money partner. You see a wrap buyer (wrapee) usually doesn't have the entire deposit to qualify for a loan at 80% LVR.

The wrapper (you or I) can secure a normal investment loan because we have a good credit rating, good serviceability, and enough free equity to fund the 20% deposit. The wrap buyer, however, may have enough savings only to cover the purchasing costs.

Wrappers in Australia have been able to do many wraps because they are able to get their deposit money back almost immediately from the First Home Owners Grant which enables them to repeat the process over and over again. However, the time will come when the FHOG is no longer available. Wrappers will then have to find third party investors called money partners to fund the deposits because most wrappers don't have loads of equity available to fund dozens of wraps. This is how it is done in the U.S. Problem there is that the profits will have to be split with them 50/50.

Hi Dale,

Thanks for the spreadsheet. Hopefully, commonsense prevails and the ATO accepts the Pay As You Go scenario. Your Scenario 3 raises a point that has always been unclear to me. In scenario 3 you suggest that the total profits received by the Wrapper is the $20,000 premium (capital gain) plus the "interest payments" of $2,856 each of two years giving a total of $25,712. I always assumed that the "interest payments" were actually part of the initial premium. In other words, when the property is refinanced to release the $10,000 at the end of year two, the wrapper only receives the balance of $4,288. This is because he has already received $10,000 deposit, plus $2,856 per year for two years ($5,712).

I thought the profit on the deal was only the premium, not the premium plus "interest payments". If it was premium plus payments I would suggest the wrap buyer would find it difficult to ever own the property because $10,000 of the refinanced amount would go to the wrapper first. Let's assume my scenario is correct, then the Wrapper's total profit in the deal is taken out by the end of year four. $10,000 up front plus 4 X $2,856. If the valuation at the end of year four was greater than $120,000, then the property could be refinanced to take out the $20,000 equity which all goes to the wrap buyer to use as the deposit to take ownership of the property. Of course, the wrap buyer wouldn't actually receive cash. The bank would simply refinance to 80% LVR which is $100,000.

Dale, if third party investors were used to fund the deposit how would the Wrapper declare his own 50% of the income? Presumably, if he holds the first mortgage he receives the entire instalment amount from the wrap buyer (wrapee). He then must pay the third party deposit investor 50% of the instalment. In this scenario would the Wrapper tax the deposit investor's share before forwarding him his payment?

In the States, some Wrappers structure the deal so that the deposit investor buys the property in their name and holds the first mortgage, effectively making the deposit investor the Wrapper and the Wrapper becomes a Flipper who receives his finders fee in monthly instalments instead of a lump sum on the sale of the property to the deposit investor.

Regards, Mike
 
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Reply: 1.1.1.2.1.2.2.1.1.1
From: Dale Gatherum-Goss


Hi Mike

>Thanks for the spreadsheet.
>Hopefully, commonsense
>prevails and the ATO accepts
>the Pay As You Go scenario.


No worries, I thought it might help a little to show how I interpret the tax office position.


>Your Scenario 3 raises a point
>that has always been unclear
>to me. In scenario 3 you
>suggest that the total profits
>received by the Wrapper is the
>$20,000 premium (capital gain)
>plus the "interest payments"
>of $2,856 each of two years
>giving a total of $25,712. I
>always assumed that the
>"interest payments" were
>actually part of the initial
>premium. In other words, when
>the property is refinanced to
>release the $10,000 at the end
>of year two, the wrapper only
>receives the balance of
>$4,288. This is because he has
>already received $10,000
>deposit, plus $2,856 per year
>for two years ($5,712).


OK, I may be wrong and I prepared this in a rush yesterday afternoon . . . also, as I do not wrap myself, I may have misunderstood the concept, and lastly, it is well known that I cannot count very well!

Having said that, In scenario 3 I was trying to show a guide of how I interpret the tax office position might work with a short term payout.

In my simple way, the wrapper has a $20k gain from the difference between the sale and the purchase price. He will also receive the spread between the repayments as income and at this stage I would focus more on the concept of the income rather than the exact numbers.

My calculations will not be accurate and I thank you for now embarrassing me into admitting it.

Only joking! ;-))))


>I thought the profit on the
>deal was only the premium, not
>the premium plus "interest
>payments". If it was premium
>plus payments I would suggest
>the wrap buyer would find it
>difficult to ever own the
>property because $10,000 of
>the refinanced amount would go
>to the wrapper first.


I guess this is more a matter of identifying the wrap by the contract used and people such as Rick, Steve, Michael, Yuch, Darren and co might be best to answer this one.


>Let's assume my scenario is correct,
>then the Wrapper's total
>profit in the deal is taken
>out by the end of year four.
>$10,000 up front plus 4 X
>$2,856.


NO, the reason why wrappers are excited by this is that the remaining years will also show profit. It's like the bank . . . when you borrow $100,000 from the NAB or CBA you end up paying them $250K or whatever in mortgage repayments. They get their $100k back PLUS another $150K.


>If the valuation at
>the end of year four was
>greater than $120,000, then
>the property could be
>refinanced to take out the
>$20,000 equity which all goes
>to the wrap buyer to use as
>the deposit to take ownership
>of the property. Of course,
>the wrap buyer wouldn't
>actually receive cash. The
>bank would simply refinance to
>80% LVR which is $100,000.


See comments above.


>Dale, if third party investors
>were used to fund the deposit
>how would the Wrapper declare
>his own 50% of the income?


Whoa nelly!!! I'm in unchartered territory here (anyone see evidence of Indians??) Again as I understand it, the investor is simply providing funds for the wrapper to do what he does. Therefore, his contribution will be a deposit into the wrappers bank account and the wrapper will then use those funds for a deposit. In doing so, the wrapper will pay interest (a normal business expense in this scenario) to the investor for the use of his/her funds.

Alternatively, if the wrapper and investor jointly own the property then they would each show 1/2 of the income.


>Presumably, if he holds the
>first mortgage he receives the
>entire instalment amount from
>the wrap buyer (wrapee). He
>then must pay the third party
>deposit investor 50% of the
>instalment. In this scenario
>would the Wrapper tax the
>deposit investor's share
>before forwarding him his
>payment?


Did I answer this above?


>In the States, some Wrappers
>structure the deal so that the
>deposit investor buys the
>property in their name and
>holds the first mortgage,
>effectively making the deposit
>investor the Wrapper and the
>Wrapper becomes a Flipper who
>receives his finders fee in
>monthly instalments instead of
>a lump sum on the sale of the
>property to the deposit
>investor.


Makes good sense too.

Just remember, there is no one correct way to do wraps and at this very early stage in tax law the tax office have no real idea what they are or how they should be taxed. BUT, they are in the process of formulating a plan of attack.


>Regards, Mike
Cheers Dale

Tonto, tonto, anyone seen that damned Indian?
 
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Reply: 1.1.1.2.1.2.2.1.1.1.1
From: Michael G


Hi all,

This is my effort to help with Mike's questions.

If we look at Steve McKnight's and Rick Otton's style of wrapping, there is two distinct tactics.

Steve promotes the idea of long term positive cashflow. The goal being to have the property wrapped to the wrappee for the full term and enjoying the benefits of that cashflow.

If we use Dale's example of a property purchased for $100k @ 7.5% and wrapped for $120k @9.5% we see the wrapper enjoying a cashflow of $325/mo for the term of the installment contract.

$325 represents the difference between installment payments on a $120k loan and a $100k loan. There is no distinction made between "capital gain" on the principal payments or "income gain" on the interest payments. It is all now treated as "taxable income"

Now Rick promotes refinancing, the idea being to "turn-over" your capital as quickly as possible. The objective of this strategy is getting the capital gain back as quickly as possible so that can be utilised over and over again.

In Dale's example, this is the difference between the $100k purchase price and $120k sale price.

So in scenario 3, the $120k sale price was reduced initially by a $10k deposit by the wrappee. So in year 1 the wrapper now has $10k to declare as income. Now remember the property was marked up by $20k ($120k sale price). So this $10k represents 50% of the marked-up price.

So what remains is a outstanding balance of $110k still @ 9.5%. The repayments of which are $961/mo.

Remembering that our 1st mortgage repayments are $723 ($100k @ 7.25%), this means the wrapper is still collecting $238/mo

So as Dale points out in year 1 the wrapper has to declare a $10k lump sump profit + 12 x $238 payments (total $12,856).

Throughout the next year the wrappee continues to make regular repayments of $238/mo, but at the end of the 2nd year decides to refinance. This could be due to the value of the property going up.

Now the nature of mortgages is that for the 1st couple of years, the borrower is mostly paying interest, and very little principal. To keep things simple, Dale's example has rounded of the very small principal paid down to zero.

So in scenario 3, at the end of year 2, the wrapper's original loan of $100k (remember property was 100% financed), and the wrappee's $110k installment contract price (remember they bought it for $120k less $10k deposit), hasn't changed at all in two years.

So, when the wrappee decides to "cash-out" the wrapper, they go get a loan for $110k and pay this to the wrapper (thus paying the full balance owning on their contract).

The wrapper in turn pockets $10k and pays out their own $100k loan they used to initially secure the property.

So at the end of year two the wrapper has to declare 12 x $238 monthly payments (the difference between 1st mortgage and installment payments) PLUS the lump sump difference gained when they were cashed out.

This would be a total of $12856 for year 2.

You see $12865 x 2(years) = $25,712, now remember the markup was only $20k, so the extra $5k was the interest charge on the contract.

I hope that didnt make matters worse.

But now I have a question. In scenario #3, I wonder if the ATO will treat the deposit and payout lump sum payouts as capital gains or as income?

I wonder this because they make the distinction that only capital losses can be offset by capital gains.

So for a wrapper could all their operational expenses like advertising, phone calls, etc be written against these lump sums profits, all will they be restrained to only reducing this liability against a loss like a potential fire sale?

One model I can think of is if they "wraps" were held in trusts and let's say these trust held negatively geared property. Then ideally you would want to be able to offset these "lump sum payments" (possible capital in nature) against the negative cashflow of say an appreciating property.

But it would be no good if one were to get CGT on the lump sums and still have a negative loss on the other property.

I hope that last bit makes sense. You thoughts would be greatly appreciated on this one Dale :)

Michael G
 
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Reply: 1.1.1.2.1.2.2.1.1.1.1.1
From: Dale Gatherum-Goss


Hi Michael!

Thanks for explaining my thoughts, wasn't doing a very good job.

You wrote:

But now I have a question. In scenario #3, I wonder if the ATO will treat the deposit and payout lump sum payouts as capital gains or as income?


The current position (which may well change) is that they will treat it all as income.


I wonder this because they make the distinction that only capital losses can be offset by capital gains.


I don't see this as an issue.


So for a wrapper could all their operational expenses like advertising, phone calls, etc be written against these lump sums profits, all will they be restrained to only reducing this liability against a loss like a potential fire sale?


Absolutely. When you think abt it, the costs that you mention are just operating costs of running your business.


One model I can think of is if they "wraps" were held in trusts and let's say these trust held negatively geared property. Then ideally you would want to be able to offset these "lump sum payments" (possible capital in nature) against the negative cashflow of say an appreciating property.


As I mentioned, the income is exactly that and so yes, you should be able to offset the losses from negative gearing against your income.

Mind you, perhaps you should hold your wraps in one entity and your buy and holds in another for a number of reasons. Something to consider?


Have fun

Dale
 
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Reply: 1.1.1.2.1.2.2.1.1.1.1.1.1
From: Michael G


Dale,

Yeah, I think of trust as buckets and the cash the liquid within.

So as my wrap bucket fills I'd pour that into my neg gear bucket which is full of holes (grin).

Michael G
 
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