The first step here is registering a company in a suitable offshore jurisdiction where no tax will apply, such as the British Virgin Islands. Let us assume that a suitable investment property has been identified, which can be purchased for $200,000. Depending on where the property is located, it may be possible for a local bank to provide mortgage finance to assist with the purchase. In London, for example, it is quite normal for investment properties to be bought through BVI companies borrowing up to 70% or more of the purchase price from local banks.
Once the company has secured a loan for 70% of the purchase price, the bank will lend $140,000 to buy the property, while the company’s shareholder will need to contribute the remaining $60,000 as a loan to the company. The company will then buy the property and rent it out to generate rental income. The rent received will be used to repay the bank loan.
In the first few years, the interest on the loan will be quite high in relation to the rental income. This means that the company’s profits will be low, even though the value of the property will typically be appreciating. If the company’s income is taxable in the jurisdiction where the property is located, which is usually the case, this means that the company will not be paying much tax. Note that in any event, no tax will be payable in the jurisdiction where the company is registered.
In later years, as the rental income increases and the interest on the loan is reduced, the company’s profits will rise. If the rental income is taxable, then the tax will also rise. The usual strategy at this point is to add a second property to the portfolio. The bank will now consider the combined value of both properties in calculating its 70% lending ratio, which means that the shareholder’s contribution for the second property will be substantially less than 30%.
To illustrate this, let’s assume that 4 years after the first property is purchased, it is worth $280,000 and that the balance of the loan has been reduced to $110,000. The purchase price of the second property is $300,000. The combined value of the properties is therefore $580,000. If the bank is prepared to lend 70% of this, the total lending will amount to $406,000. But as there is still a balance of $110,000 owing on the first loan, the amount of the additional loan will be $296,000. This means that the shareholder will only need to contribute $4,000 for the purchase of the second property.
The interest on the two loans will once again be quite high compared to the combined rental income, so the tax exposure is now back to low levels. This cycle can be repeated in the following years, acquiring more properties whenever the effective loan to value ratio of the portfolio drops too low. Many investors have successfully used this strategy to build up substantial property portfolios over the years.
In the illustration above, we have assumed that tax will apply on the rental income in the jurisdiction where the properties are located. Provided the rental income is taxed at a lower rate in that jurisdiction than in the shareholder’s country of residence, then registering a company to hold the properties will obviously lead to tax savings, as the rental income will not form part of the shareholder’s personal income and will therefore not be taxed at the higher rate.
The tax exposure can be further reduced by utilising a second offshore company, as follows: