is a regular contributor to Australian Property Investor Magazine, Australia's top selling property magazine. Pick it up at your newsagency or order online at www.apimagazine.com.au/metropole While many investors buy their investment properties in the name of a trust, trusts certainly aren't for everyone.
And trusts aren't one-size-fits-all. The tax benefits don't work for everyone, and the asset protection mightn't be necessary - or effective - for everyone.
In this artcicle Michaela Ryan explores a few of the pros and cons of the most common trust structure used by property investors - the discretionary family trust
This article was first published in Australian Property Investor Magazine and is copyright and reproduced with their permission.
While effective for some property investors, trusts certainly aren't for everyone.
A lot of investors buy property in the name of a trust. They commonly do so for "tax reasons" and "asset protection". But trusts aren't one-size-fits-all. The tax benefits don't work for everyone, and the asset protection mightn't be necessary - or effective - for everyone.
Here we'll explore just a few of the pros and cons of the most common trust structure used by property investors - the discretionary family trust.
This article is merely a starting point. It's crucial to get professional advice about the best structure for you. Above all, be wary of setting up a trust without understanding why you're doing so. It's dangerous to blindly follow the advice of someone who's motivated by the fees they'll generate by setting one up for you.
On the other hand, if a trust is going to suit your circumstances, it's better to set one up sooner rather than later.
If, in the future, you decide to hold your properties in the name of a trust, you'll need to transfer them from your name into the trust's name. This can attract stamp duty, capital gains tax (CGT), and legal fees.
The longer you wait to do the transfer, the higher the growth you'll have had in the value of your properties, and the more CGT and stamp duty you might have to pay.
Tax reasons
Possible disadvantages
1. The negative gearing dilemma
Before looking at the tax benefits trusts can provide, consider this: you don't get negative gearing tax benefits in your personal tax return when you own properties in a discretionary family trust. Any tax benefits you'll get by setting up a trust will need to outweigh the loss of these benefits. So what does that mean?
If you're negatively geared, the interest payments on your loans, plus all other property-related expenses (property management fees, insurance etc.) outweigh the rental income you're earning from your properties. Basically you're making a loss on your property portfolio each year. This is desirable for some investors, because the loss can be offset against personal income - allowing them to pay less tax.
However, this only applies if you own properties in your name, and not in the name of a trust.
Similarly, if you own properties in your name, you might be able to claim depreciation benefits. But you can't claim these depreciation tax deductions if the properties are owned by a trust.
Basically the negative gearing losses and depreciation tax benefits get stuck in the trust. They can't be offset against your income because you don't own the properties - the trust does. And the trust may have insufficient income against which it can offset these deductions.
At some point in the future, your rents will increase and your interest payments might decrease (assuming you're paying off the principal). For these reasons, your property portfolio could become positively geared.
If you own those properties in a trust, you'll then be able to claim the losses and depreciation incurred in past years (when the properties were negatively geared). However, until that point, you might be substantially worse off from a cash flow perspective. And with less cash flow, your ability to acquire more investments might be restricted.
So it's vital to consider your long-term strategy. Are you likely to be negatively geared for a long time (for example, because you plan to use any excess income from your properties to service loans on more properties)? In this case, a trust mightn't be the best solution for you.
You might think, "I'll just transfer my properties to a trust once my portfolio becomes positively geared."
But hold your horses - the CGT, stamp duty, and legal costs for that transfer might outweigh the potential benefits.
Because of the negative gearing dilemma associated with discretionary family trusts, "unit trusts" are often put forward as an alternative.
You borrow from the bank in your own name, and you use the funds to buy units in the trust (a bit like buying shares in a company).
The trust uses these funds to buy property.
A 50% discount applies to any capital gains (as is the case with family trusts and individuals, but not companies).
Since the loan is in your name, you can offset your personal income with a tax deduction for the interest payments.
Hybrid trusts are sometimes an option. These are effectively unit trusts with a discretion as to the distribution of income and capital (we'll discuss the advantages of discretionary income and capital distribution in a moment).
However, have caution if you're considering setting up a hybrid trust. Allan Swan, estate planning and structure partner at Moores Legal, argues that the greater the trust's discretion, the less likely an income tax deduction can be claimed by a unit holder.
2. Ongoing costs
The potential tax benefits of a trust will also need to outweigh the ongoing operation costs.
"There's a nominal stamp duty to set up the trust," says Nick Renton, author of Learn More About Family Trusts. "You would need to pay a solicitor to draw it up for you...but that's a one-off cost."
Chartered accountant Adrian Raferty, CEO of Accountants R Us, says, "If you've got an individual as trustee, it will probably be $450 or thereabouts to get a trust deed done up. If you have a corporate trustee, which is probably a preferable option in terms of limited liability, the cost of establishing it is closer to $2000."
Raferty points out that even a basic trust will incur approximately $500 a year in accounting fees to compile trust accounts and prepare a trust tax return. (That $500 is tax deductible). "Also with a corporate trustee there'll be an annual ASIC return fee and that's $212 per year," Raferty says.
You may also have costs for separate bank accounts, fees paid to a trustee, legal costs if a dispute arises, and any costs for winding up the trust down the track.
3. Land tax
Land tax is charged by the State or Territory Government in the state where you own property.
Swan points out that in
However, in some states you may actually be able to reduce your land tax by spreading your properties across different entities (i.e. some might be held in your name, and some in the name of a trust).
Land tax is levied on each individual or entity which owns property. So the more entities which own the properties, the more times you can claim the tax-free threshold, or fall into lower tax brackets. Hence land tax can only be reduced if such thresholds and brackets exist.
See the website of the relevant Office of State Revenue to find out how it works in your jurisdiction.
Possible advantages
1. Income distribution
Now we'll look at the major tax advantage offered by discretionary family trusts - income distribution. Remember this is only beneficial once the trust's properties are positively geared (i.e. income exceeds costs).
If you own properties in your name, you're taxed on the properties' income on top of your earnings. So if your salary is $60,000, and you earn $40,000 from your properties, you're taxed on a personal income of $100,000.
The main way a trust can reduce your tax bill is by allowing you to distribute this income (the extra $40,000) in a more tax-efficient way. In other words, that $40,000 can be taxed in someone else's hands - typically a family member in a lower income tax bracket than yourself.
The trust's income could be distributed to a spouse who isn't working, for example. That spouse would be taxed at a lower rate than his/her partner - by taking advantage of the tax-free threshold and lower income tax brackets. This is useful for couples if one partner is on the highest tax rate, while the other partner has little or no income. However, if both partners earn a similar amount, there mightn't be a benefit.
And if you're earning a sizeable income from your properties, the benefit of the lower tax brackets mightn't be that significant in the overall scheme of things.
To explain, property author Margaret Lomas, director of Destiny Financial Solutions, gives this hypothetical: "By the time I've been investing in property for 20 years, I'm going to be making $300,000 a year from my properties. So a trust has limited ability to avoid tax on that $300,000. Whether I've got a spouse who's working or not, most of what we both earn from that trust is going to be in the top marginal rate of tax anyway."
Lomas points out that the small amount of tax you save at that stage mightn't exceed the depreciation and other tax deductions you perhaps lost over the years by investing in a trust.
Trust income could be distributed to children under 18. But don't get too excited about this option. Children are usually only able to receive $1325 of investment income tax free. After that, income is taxed at the highest marginal rate. (NB. Children don't need to lodge a tax return unless they earn more than $1325 from investment income in a year).
Although the tax-free sum is small, Raferty says it's often still worth distributing to each child every year. The more children you have, the more beneficial this would be.
Distributions could also be made to "children" who are over 18. But if they're earning an income, the benefits mightn't be huge. There may only be a period of a few years, when they're at university for example, when they're earning little or no income.
If you have a low income-earning sibling, parent, or other family member, they might also be a beneficiary. However, check that any distributions of income won't affect their Centrelink entitlements.
The benefit of a discretionary trust is that the distributions can go to different beneficiaries each year (provided they're named in the trust). So income could be distributed to a spouse, children and other relatives at different times, and in differing amounts, depending on your changing incomes and circumstances.
Keep in mind the trustee must distribute income each year (otherwise the undistributed income is taxed at the highest rate). But in a particular year there mightn't be any beneficiaries on a low tax rate. This is one reason you might set up a corporate beneficiary. This is a company which receives income from the trust. It's taxed at the company tax rate (30 per cent).
A corporate beneficiary might benefit someone who plans to let money accumulate in the company while they're on a high income (and therefore being taxed at a high rate). At a later stage, when that person is on a lower income, or is retired, they might receive a salary or dividend from the company.
Before being paid a salary or dividend, you might actually re-invest the income which is earned by the corporate beneficiary, says Raferty.
Remember that with a corporate beneficiary you'll need to pay a number of set-up costs and ongoing fees - so these need to be weighed against the potential benefits.
2. CGT
When you sell a property which is held in the trust's name, the trustee can choose which beneficiaries will receive the net capital gain. That might be the beneficiary who would be liable for the lowest amount of CGT. (CGT is based on your marginal tax rate, so a low income earner would pay less CGT than a high income earner).
3. Tax deductions for trusts
Your trust might effectively be a property investment business. There are potentially several tax deductions available to that business that would be deemed as "private" expenses if incurred by an individual. An extensive list of potential deductions is outlined in Trust Magic, by Dale Gatherum-Goss (available through the Business Mall catalogue in the back of this magazine).
One example is internet fees. If you pay these through a trust, the trust might be able to claim 100 per cent of the fees, whereas an individual would need to reduce the tax deduction to the extent that the internet usage was "private", rather than related to property investing.
Seek professional advice in relation to the deductions you can legitimately claim. Also seek advice about the potential disadvantages of treating your trust as a property investment business.
Asset protection
Why do I need protection?
If you buy properties through a trust, in theory they'd be protected if you were sued. For some individuals this is an important consideration.
Lomas says, "I can understand that (an investor in) a high risk profession may have a legitimate reason for setting up a trust."
However, she points out that many would be covered by professional indemnity insurance anyway. (Although if there are too many exclusions in your policy, you might be prompted to consider additional asset protection).
So what if you're sued in relation to something which happens on one of your properties? Lomas suggests your public liability insurance (typically found in a landlord's insurance policy) would probably cover you. So when might you need a trust for an event that isn't covered by insurance?
He gives the example of someone making a commercial loss, such as a business operator who owes a creditor money for stock he can't sell. In situations like this, a trust might protect your assets if you were sued.
(However, you won't always be protected, as we'll discuss in a moment).
"Your own folly" might also include those freak accidents you hear about. In her book The Truth About Positive Cash Flow Property, Lomas retells a story she once heard at a property show.
Apparently one golfer smacked a ball into the head of another golfer, allegedly killing him.
His estate sued the first golfer, and he lost everything he owned. Apparently he would have avoided this by putting his assets in a trust.
Lomas says, "In real life, look about you, see how many people you know who have been frivolously sued and ask yourself the question, 'What are my real chances here? And are the drawbacks of setting up a trust greater than any benefits that I'll gain in the slim chance that I'm going to kill someone with a golf ball and they'll sue me?" LET AUSTRALIA'S TOP PROPERTY EXPERTS TEACH YOU HOW TO MAKE SUBSTANTIAL PROFITS IN THE PROPERTY MARKETS IN 2008
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How well are assets protected?
In some situations a trust won't adequately protect your assets.
1. "Claw back"
Allan Swan explains that if you become bankrupt, and you've purchased property through a trust in the past four years, then those properties can be "clawed back" into your own name (giving your creditors access).
This four-year period applies if there was no identifiable threat of bankruptcy at the time you bought the assets. If there was such a threat, then the claw back provisions apply to assets acquired in the past five years.
"That means it takes time for family trusts to achieve asset protection," he says.
2. Lending money to a trust
To buy property through a family trust you tend to get a bank loan in the trust's name. However, often there's a deposit amount (cash) which comes from you as an individual.
To gain a tax advantage, some people choose to set this up as a loan to the trust. However, it's preferable to make a gift of that money to the trust from an asset protection point of view, says Swan. Otherwise, in the event of bankruptcy, the trustee in your bankruptcy can call in the loan (again giving your creditors access to those funds).
3. Relationship breakdown
A trust won't protect your assets very well if you get divorced.
Swan says, "From a family law viewpoint, the (Family) Court has the power to undo trusts. Particularly since the (law's) amendment in 2004, it has had very strong powers.
"And the Family Court looks like taking over de facto relationships next year which would mean that the same thing would apply to de facto relationships."
Therefore Swan says a binding financial agreement (such as a pre-nuptial or even a mid-nuptial agreement) is the best way to protect your assets prior to a relationship breakdown. But both parties have to agree to it.
4. Estate challenges
"The other area where people use trusts is to stop their estates being challenged," Swan says. "In
That's because under the laws in NSW and the ACT: "If someone dies, and the assets appear to be out of reach because they're in the family trust, the court can override that."
5. Hostile beneficiaries
"If you're looking at a family trust and trying to work out if you've got asset protection, the first port of call is the balance sheet," says Swan.
That's the document which sets out who is owed money by the trust. Potentially you're quite exposed if you've been allocating income - on paper - to a family member who is now hostile.
Swan gives the real life example of a lady who split up with her husband.
For some years she'd been a beneficiary of the family trust of her parents-in-law. But she'd never actually received any income. So after the marriage breakdown, she sued the former parents in law for the monies owing to her - and walked away about $500,000 richer.
6. Recent developments
The legal proceedings involving the former directors of the Westpoint Property Group should sound warning bells for people who are trying to use trusts to hide their assets from creditors or corporate investigators.
In June 2006, a decision of Justice French in the Federal Court showed that trusts won't always be free from scrutiny.
Receivers were appointed to the property of the former Westpoint directors earlier this year.
A couple of months later, ASIC asked the Federal Court to open up the scope of this property to include trust assets. In particular, trusts in which the former Westpoint directors were beneficiaries were brought into question.
This is unusual, because normally a beneficiary isn't seen to own trust assets until a distribution is made to him or her. However, Justice French suggested he'd be willing to extend the receivers' orders to include trust property if the beneficiary effectively controlled, or effectively had ownership of, that trust property.
Beware
Two final warnings. First, be wary of buying a principal place of residence in the name of a trust, as you may miss out on CGT exemptions, land tax exemptions and social security benefits. And second, remember that there's a political risk associated with trusts. State and federal legislation could change at any point, and negate some of the benefits for which you set up your trust.
Here are some questions to ask your accountant or lawyer about trusts...
1. What are the potential dollar savings if I own my properties through a trust?
2. How much will it cost me to maintain this trust each year?
3. How will it affect the amount of land tax I pay?
3. How much paperwork will be involved each year?
4. What's the most efficient way for me to pass my wealth on to my children?
5. What are the pros and cons of buying property through a self-managed superannuation fund rather than a family trust?
6. Could any benefits of setting up a family trust be achieved through other means (such as insurance, ownership of assets in spouse's name, or setting up a testamentary trust)?
7 .Does this trust structure take advantage of legal loopholes that could be closed in the future?
8. How many properties should I acquire in the name of this trust before setting up a new one? Why?
9 .Who should the beneficiaries be, and why?
10. What will I need to do if my circumstances change and I want to add or remove beneficiaries? How much will that cost me?
11. How much control will I have? And what are the pros and cons of having control?
12. How will this trust affect my entitlement (and the beneficiaries' entitlement) to Centrelink benefits, including the pension?
Some influencing factors as to whether you should use a trust or not?
1. How high is your income (and therefore your tax rate)?
2. How many family members (potential beneficiaries) do you have?
3. How many of those family members are on low (or no) income?
4. How soon is your property portfolio likely to become positively geared (i.e. income exceeds expenses)?
5. Will the tax benefits outweigh the ongoing costs of maintaining the trust?
6. Are you at high risk of being sued because of your occupation?
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