Don’t listen to the Armchair experts on Family Law

On various internet forums where family law issues are discussed, it is interesting to see how the non-law trained persons become the instant experts in Family Law. They will know more than lawyers instantly, often citing the experience of friends or friend’s friends or media reports.

The non-expert opinions that I have heard recently are:

  • Binding Financial Agreements (BFA) are a waste of time and money because the courts just overturn them. This is not true.
  • Women get more than men in property settlements – “they come with a handbag and leave with a property” is one quote that I have heard. There is no legal basis for this.
  • The courts favour women over men.
  • A short relationship can see you (if you’re a man) lose 50% of your assets.
  • You can just transfer your property to your sister to avoid your spouse ‘taking’ it.
  • Trusts provide asset protection on divorce or relationship breakdowns.
  • You should charge your girlfriend $1 per week rent so that she cannot make a claim on your property (seen a guy who actually issued receipts to his girlfriend – not sure if she actually paid him).
  • You can only sign BFA before getting married. You can actually enter into a BFA before, during or after a relationship.
  • You are not de-facto if you maintain a separate residence – knew a guy who lived with a girl but kept his own house unrented. He told me this was to prove he lived separately from her.
  • There is a do it yourself BFA option – I have heard of persons who have written out their own agreements. These are probably worded poorly, but they will also not comply with the Family Law Act if they are not explained by a lawyer.

It seems to me that the area of family law brings out more armchair experts than any other area of law and I am not sure what, but it could be because it is an emotional area of law.

My suggestion is if you want to know about family law issues disregard absolutely everything anyone says unless they are a practicing lawyer with a family law focus.

Moving out of the Main Residence – When can you claim Interest on loans?

There are 2 major issues when taxpayers want to claim the interest on a loan relating to a former main residence:

  1. Redrawn amounts
  2. Timing

Redrawn amounts and Mixed Loans

Interest is only deductible if the loan it is incurred on was used to purchase the property, or for improvements etc. Where any amounts have ever been redrawn from a loan the interest would need to be apportioned.

Example 1

Tyrell borrowed $500,000 to buy a main residence. Along the way she paid it down to $450,000 and then redrew $50,000 to buy a yacht (which is actually a small boat, but sounds better if he calls it a yatch).

This loan no longer relates solely to the property but is a mixed purpose loan so only 450/500 or 90% of any interest on the loan could be deductible once the property is available for rent.

Example 2

David used a LOC for his loan to purchase his main residence and borrowed $500,000 initially. Every week he deposited his salary and then redrew amounts to live on. The amount of the loan relating to the property will decrease each week and at the end of 5 years the loan would be extremely mixed.

He would have to spend hours to work out the portion of the loan relating to the property and might find that this might only be 10% of the loan amount.

(this is why you should never use a LOC as the main loan, but only to ‘access’ equity)

Timing

The other issue is timing. A person cannot start claiming interest until the property is available for rent. This is generally only after you have moved out and have advertised the property for rent at market rates. While you are living in the property and advertising it the property wouldn’t be available for rent, so you could not claim interest during this period.

There are also timing issues on when interest is incurred and debited to an account because interest is generally incurred daily but added monthly to the loan.

Example 3Let’s say someone moves out on the 30th and immediately advertises the property for rent and on 1st of the following month they are charged $1,000 in interest. Can they claim that interest? No, well not in full because interest is charged in arrears and added to the account monthly. So, 29 days of that interest related to the period you would living in the property. So, in the first month only 1/30th of that $1,000 should be claimed.

The 2 broad methods of Debt Recycling

Broadly speaking there 2 ways to ‘debt recycle’.

Debt recycling is the conversion of ‘bad debt’ into ‘good debt’. See http://www.structuring.com.au/terry/recycling-debt/what-is-debt-recycling/

  1. Use the income from investments to pay down non-deductible debt, then borrow to invest further, or
  2. Selling investment assets and using the funds released to pay down the non-deductible debt and reborrowing

The best approach might be a combination of the 2 methods.

Example

Bart has owned a few investment properties for a few years. They are positive geared by $100 per week so that is about $5,200 per year in extra funds he can use to pay off his non-deductible home loan.

But the properties have about $500,000 in equity in them.

Bart only owes $400,000 on the main residence so what he could do is to sell the properties, pay the tax and used what is left to pay off the main residence debt, and to reborrow to buy more properties.

This way he uses a combination of the 2 debt recycling methods.

Of course, there is a lot else for Bart to consider such as, most importantly, his ability to qualify for finance to buy more properties.

Tax Strategy: Use Capital Losses Quickly – Recycle debt + death

Some people have carried forward capital losses. These losses can usually be carried forward until the taxpayer has a capital gain which can ‘soak up’ the capital loss.

I think it is a good idea to use up these losses as soon as possible.

The main reason being that losses are ‘lost’ at death. If the taxpayer dies their loss cannot be passed on to any other person who could utilise it. Don’t lose a loss!

Example

Bart bought a property in a mining town for $1,200,000. He ended up selling it for $700,000 and has a carried forward capital loss of $500,000.

Bart dies and leaves a rental property that he owns to his sister Lisa. The property has a $500,000 capital gain.

Unfortunately, Bart’s loss will not benefit anyone. Lisa will inherit the investment property pregnant with a $500,000 gain, yet she cannot benefit from the loss.

Had Bart sold the investment property before his death he might have made $500,000 tax free and this money could have been passed onto Lisa. He might have even sold the property to Lisa – perhaps with vendor finance if she couldn’t have afforded a loan. Also, if Bart had a flexible will his estate could have sold the property and possibly used up the gain.

Another reason to use up capital losses is their benefits with debt recycling. Making capital gains without needing to pay tax will mean there is more money with which the non-deductible debt can be reduced.


Example of Debt Recycling

Lisa has a $100,000 capital loss from some bad share investments many years ago. Because of this she has a large amount of debt still outstanding on her main residence. But this has not stopped her investing in shares again. She has learnt from her mistakes and is now making some good capital gains.

If Lisa’s shares increased in value by, say $20,000 in the first year, she could sell these shares, pay no tax, and use the proceeds to pay down the non-deductible debt, and then invest in more shares and repeat.

Doing this has 2 advantages

  1. It uses up the loss, and
  2. It produces tax free capital gains which can then be used to pay off the non-deductible debt quicker.

Speak to your tax lawyer or tax agent.

How to Fund a New Discretionary Trust

Discretionary trusts are generally started with just $10 or $20. Mostly trusts are established for a trustee to hold shares or property for the benefit of a beneficiary, so how does the trustee get the deposit or money to do this?

There are basically just 3 options to consider:

  1. Gift

A gift is an irreversible transfer from one person to another.

It is better than a loan for asset protection against bankruptcy because if the gift giver goes bankrupt generally the gift will not be available to creditors (but the claw back laws need to be considered).

Gifts to discretionary trusts may not be ideal though because when you die the gift will not form part of your assets and cannot be passed via your will.

If the gift giver is borrowing money to gift to a trust the interest will not be deductible.

Gifts should be documented with a deed.

2. Loans with interest

A loan can be made with interest accruing. However, interest is income to the receiver. Interest may be deductible to the trust if it is using the borrowed money invest, s 8-1 ITAA97.

The interest rate could at market, under market rates or higher than market rates. Each has different consequences.

But a person cannot contract with themselves, so you could not lend to yourself if you are the trustee.

Generally, someone borrowing money to lend to the trustee should consider charging interest to the trust. This interest would need to be at least the same interest that the bank is charging you. But the question you should be asking is if the bank has a first mortgage security over real property and charges say 4% to you, if you lend to the trust at 4% without security would this be a market interest rate? Are there any Part IVA consequences?

A loan should be documented with a written loan agreement which would be either a contract or a deed.

3. Interest free loans

Many like to make interest free loans to trusts because there are no direct tax consequences and the loaned money would generally come back to the lender at death and therefore form part of their estate and can then pass into a testamentary discretionary trust.

But a major issue with loans is the various state limitations acts. This could cause a loan to become unenforceable if there has been no activity with a loan for 6 years (NSW law). So, a loan made say 7 years ago which is interest free and no transactions have happened will not be recoverable if the borrower refuses to pay back. You might think that you are not going to sue a related trust, but you must remember that if you set up a trust you are just in control temporarily. If you lose capacity, go bankrupt or die the control of the trust will pass to someone else.

Interest fee loans should be documented in the same way as loans with interest.

Which method should you use?

You should all get specific legal advice from a lawyer, but as a guide:

  1. If you have cash and are concerned about bankruptcy a gift might be worth considering
  2. If you are not concerned about bankruptcy and have cash, then an interest free loan may be worth considering
  3. If you are borrowing and on-lending the money to the trust a loan with interest may be worth considering.

If you do make a loan you must adhere to the terms of the loan for it to be effective.

Being Both Executor of a Deceased Estate and Applying for Super Death Benefits

The executor of an estate has fiduciary duties to maximise the estate of the decreased. There can be conflicts of interest where someone is both executor and they apply, in their personal capacity, for the superannuation death benefits of the deceased, and this is because they are trying to avoid having the super death benefits paid into the estate, to benefit themselves.

Example

Mum and Dad divorce many years ago, son dies without a will. Son has about $40k in assets plus about $400,000 in super death benefits. Under the intestacy laws where a person dies without a spouse and children then both parents will benefit equally from the estate.

The issue here is that $40k is in the estate and will go to each parent in the share of $20k each.

If the superfund pays the death benefits to the estate the parents will get another $200,000 each.

If the superfund pays the mum, dad will miss out on $200k and similar if the superfund pays dad.

But, by mum applying for the benefit herself she is depriving the estate the money which means she is potentially breaching her duties as executor. As executor she should be asking the superfund to pay the money into the estate – it is her legal duty to do so.

 Moral of the story – seek legal advice before accepting the position of executor, especially if the deceased

An Example of How poor Ownership Structuring Can be Painful.

Homer and Marge own 5 investment properties all jointly as Joint Tenants. All in NSW and with a combined land value of $1,200,000.

Homer is on the top marginal tax rate and Marge doesn’t work.

They have reached their borrowing capacity.

They have just paid off their main residence and are saving about $10,000 per month.

Issues

  1. Land tax

Combined land tax is $9,236 (2018 year)

If they have owned $600,000 worth of land each then there would be no land tax

  • CGT

If they sell any investment property 50% of the gain will go to Homer. They can’t divert the income to Marge.

  • Paying Down Debt

They have excess cash, ideally this would applied to Marge’s debt as she would pay less tax. But as all the loans are joint they are stuck with reducing the debt relating to both Homer and Marge

  • Offset Accounts

Similar with the cash savings/buffer. It must go into an offset account liked to a joint loan so Homer’s income will increase.

Death Planning

Because they own everything as joint tenants if one dies there is no opportunity to get half of the assets into a testamentary discretionary trust. This will result in extra tax being payable after the death of one of them.

Possible Solutions?

As they have reached their borrowing cap there may not be much they can do if they cannot qualify for a loan. But they could consider

  1. Spouse A selling 50% of the property to Spouse B.
  2. Selling on property and buying a replacement in Marge’s name only
  3. Save up and lend cash to a trustee of a discretionary trust which will buy property and then divert the rental income to Marge
  4. Sever the Joint Tenancy so they hold the existing properties as Tenants in Common in equal shares – no duty, no CGT and easy to do without triggering a loan reassessment. They could then each leave their shares of the properties to the trustee of a testamentary discretionary trust controlled by the other spouse. Half the rents could then be streamed to the children potentially tax free.
  5. Etc

Loan Tip: Overcoming Cash out Restrictions When Buying Main Residence

This strategy is simple yet often overlooked.

Strategy: When buying a new main residence borrow 80% to acquire it, whether you need to or not.

Example

Bart has $400,000 cash and wants to buy a new main residence for $500,000. He plans to borrow $100,000 and then later set up a LOC to invest.

He borrows $100,000 and settles on the purchase. Then he asks for a $100,000 LOC and the bank starts asking questions. Eventually, after giving a DNA sample Bart is approved, but they want a statement of advice from a financial planner saying that Bart will invest in shares.

Lisa is in the exact same situation. Lisa gets some credit and tax advice and borrows $400,000 to buy her main residence. At application stage she splits the loan appropriately so that at settlement she can pay down 2 loan splits and is left with one split with $100,000 outstanding.

  • Lisa had no questions asked about future investment plans,
  • Lisa got the lower main residence rates for all of her splits (prob paying 1% less than Bart),
  • Lisa isn’t incurring any extra interest or costs, and won’t until she draws on the splits, and
  • Lisa has split the loans for tax purposes already.
  • Lisa has saved by not needing to pay a financial planner tosatisfy the lender.

In summary, Lisa has overcome the cash out restrictions and gotten a lower interest rate.

Tax Tip: The effect of Taking a Year off Work to Save CGT

If someone sells a property and has a large capital gain is it worthwhile taking a whole year off work to save tax? In my view it is always great to take a year off work, but it might not actually save you that much tax.

Example

Richie Rich is about to sell an investment property with a $200,000 capital gain. He is sick of it under performing and draining him with land taxand has a low yield. Richie is toying with the idea of taking a whole year off work to save CGT. Is it worth it?

Let’s assume Richie earns $100,000 in his job, and the sale will happen in the 2018-2019 financial year.

If he sells the $200,000 gain will be reduced to $100,000(due to holding it longer than 12 months) and added to his other income for the tax year. The result is an annual income of $200,000

Tax on $100,000                   $26,117          Net income   $73,883

Tax on $200,000                   $67,097          Net income   $132,903

Difference                              $40,980          Difference      $59,020

The Capital Gain will mean $40,980 in extra tax payable for the year.

This means by giving up a year’s income from work Richie would only earn $100,000 from the capital gain. Therefore, he will save $40,980 in tax by not working.

But not working means he has less income, working the full year in which the sale occurs will net him only $59,020 as opposed to his normal $73,883 (a difference of $14,863).

He would need to determine if the effort of working is worth the pay cut of $14,863 which is about $286 per week.

He should also factor in transport costs to work and other work-related costs – clothing, lunches etc.  and there are also heaps of non-financial things to consider. There would be time to do other things such as:

  • Start a business
  • Travel
  • Study
  • relax

Written by Terry Waugh of www.structuringlawyers.com.au