Setting Up a Trust When You Have No Family

What is the point, you might ask, in setting up a discretionary trust to hold investment assets when you have no family?

A discretionary trust needs at least one beneficiary with the trustee having the option to retain income, or at least 2 beneficiaries where it doesn’t. However, most discretionary trusts will have hundreds of potential beneficiaries as they will be set up with one or two named persons as the primary beneficiary and then there will be secondary and, possibly, tertiary beneficiaries who are relations of the primary beneficiary.

So even though you are on your own now, you might have cousins or distant relatives who could be beneficiaries – this doesn’t mean they need to be recipients of trust income, but just that they could be. You never know when one of your cousins might invest in shares and lose the money and have carried forward income or capital losses.

There is also the issue that even though you may not have any family now, you may get a spouse at a future date. There may even be children and then grandchildren. All these people could and probably would be beneficiaries of the trust. This is generally the case even if they do not ‘exist’ at the time the trust was created.

Perhaps most importantly, a company could also be a beneficiary of the trust. This may allow for use of the bucket company strategy of diverting income to the company to cap the tax rate at 30%. Later on, the retained earnings in the company could be distributed to future family members (providing the shares of the bucket company are held by a different trust).

There are also the asset protection aspects to consider. Not having a spouse may mean holding all assets yourself and taking a risk of not ending up bankrupt. Where the assets are held on trust, the assets are generally much safer from attack should the controller of the trust become bankrupt at some point.

See the discussion at: https://www.propertychat.com.au/community/threads/legal-tip-190-setting-up-a-trust-when-you-have-no-family.36832/

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.

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

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

Loan Tip: Using Cash as Security for a loan

It is best not to use cash as deposit for an investment property, especially if you will have a main residence loan. Using cash on an investment reduces your deductions and increases your non-deductible interest.

But what do you do if you don’t have a main residence at the moment, but at looking to acquire one soon?

It is possible to use cash as security for a loan. Normally you may not want to or need to do this, but it is possible, and it can assist with maintaining high interest deductions in some situations.

Generally, the security used for a loan does not affect the deductibility of interest. This means anything can be used as security for a loan without effecting the deductibility of interest. The security could be shares, cash or even a car.

The beauty of cash is that it doesn’t need to be valued or sold for the lender to recover its money so the potential LVR on a loan secured by cash is 100%.

Example 1

Tom has $100,000 cash and wants to buy an investment property for $500,000 before he buys his Main Residence. He might be doing this because he has found a ‘bargain’.

Normally Tom would pay a $100,000 deposit and then borrow $400,000 for the $500,000 property. But doing this would mean that going forward Tom would have $100,000 less for the future main residence. He may be able to access it and borrow against the investment property, but this will have some bad tax consequences:

$100,000 x 5% = $5,000 less per year in tax deductions for the next x years (life of the loan).

So instead using the cash as a deposit Tom could use the $100,000 cash as security and borrow $500,000. Ideally this would be done in the form of 2 loans

Loan A $400,000 secured by a $500,000 property. LVR 80%

Loan B $100,000 secured by a $100,000 term deposit. LVR 100%.

Tom could wait for capital growth (from natural market increase and/or a quick reno) and then release the cash, or if Tom quickly buys the new main residence the cash could be released, and the main residence used as security for the investment loan.

This could happen like this:

Loan A $400,000 secured by the IP. interest deductible against the IP

Loan B $100,000 now secured by the main residence. Interest is deductible against theIP

Loan C $400,000 secured by the main residence. Interest not deductible. The $100,000 term deposit is released and used at settlement to pay for $100,000 of the purchase price of the main residence.

Overall 90% LVR.

Example 2

As above. $500,000 property with a $500,000 loan secured by both the property and the cash.

After 2 years the property is now worth $625,000. Tom applies to remove the cash as security and the bank agrees as the LVR is now 80% based on the property value alone.

$100,000 cash is then used as deposit for the main residence. Tom has an extra $5,000 per year in tax deductions for the next 30 years plus.

Example 3

Tom has 2 properties securing 2 loans at ABC Bank.

Tom sells his main residence and will buy a replacement main residence in a few months. The trouble is Tom didn’t realise that his investment property was also secured by the main residence. The investment property is relatively new and hasn’t grown in value so the bank is insisting that $100,000 of the proceeds of the sale of the main residence be used to reduce the loan on the investment property.

Tom refuses and the bank refuses to discharge the mortgage on his main residence so his sale cannot settle.

Luckily there is a solution. Tom lets the bank keep $100,000 from the sale in a term deposit and to use this as security for the investment property (as well as the investment property mortgage itself).

Then when Tom finds his new main residence he will offer this as security for the investment property and the $100,000 will be released.

The 3rd example is probably the more common situation in which the cash as security is used.

There is a cost to doing this – When cash is used as security it will be in the form of a term deposit with an interest rate much lower than what the bank is charging. So, Tom may lose 3% in rate – get charged 5% for the loan, but receive 2% interest for the term deposit. There are tax consequences of this too as this would not be deductible.

But hopefully the use of a term deposit will be brief, and the benefits can last many years to come.

Only authorised deposit taking institutions will allow for cash to be used as security.

Written by Terryw broker at www.loanstructuring.com.au

Discussion at https://www.propertychat.com.au/community/threads/loan-tip-using-cash-as-security-for-a-loan.36038/

keep All Receipts forever

By law you are only required to keep receipts for about 5 to 7 years. But for tax this is 7 years after you claim an expense.

You should always keep your receipts just in case. If you move out of the main residence and rent it at some stage then the expenses incurred when you were living there can be used to reduce the CGT payable. However you may not sell the property for another 50 years so you will need to keep receipts this long if you want to save tax.

When someone dies and their property is inherited by someone else the cost base of the deceased will often be the cost base of the property for the person that inherited the property. So expenses incurred when the deceased was alive and living there or renting the property out can be relevant to the tax of the person that inherited the property.

If there is a capital loss that is carried forward receipts relating to the loss should be kept from at least 5 years after it has been used up in full.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

Reimbursing yourself – Impossible

It is impossible to reimburse yourself with borrowed money after an asset has been paid for and claim the interest

Interest will only be deductible if borrowed funds are used to produce income.

Where people get into trouble with this sort of thing is when they don’t plan ahead, but may pay a 10% deposit using cash before they have the loans sorted out. Once a deposit is paid in cash it is paid. If you later borrow an equivalent amount from a loan increase and ‘pay yourself back’ the interest on this loan cannot be deductible because the interest does not relate to a loan used for the property.

So, before you pay any money for a property make sure you get the loans set up so that you can borrow to pay for that property.

On a $500,000 purchase a 10% deposit is $50,000.

A $50,000 cash payment, while you have non-deductible debt on the main residence, will result in about $2,500 per year in lost deductions ($50k x 5%). That is per year for the life of the loan. That could cost the average person $1000 per year out of their pocket – enough for a trip overseas each year.

Written by Terry Waugh, CTA & lawyer at Structuring Lawyers, www.structuringlawyers.com.au

The Pleasures of CGT: 5 Reasons Why CGT is better than Income Tax

It is not often that you use the words ‘pleasure’ and ‘tax’ in the same sentence, but if you had a choice of income tax or Capital Gains Tax (CGT) it would be more pleasurable to pay CGT.

Here’s why:

1. CGT Tax is only payable at the end so greater compounding during the life of the investment

Example

2 investments of $100,000:

A. one returning 0% income with 10% capital gains, or

B. One returning 10% income with 0% capital gains.

Same overall return but different tax consequences.

 

In year 1

A will be worth $110,000 but no tax payable yet,

B will be worth $100,000 with income of $10,000 so up to nearly $5,000 lost in tax.

 

In year 2

A will be worth $121,000

B will be worth $105,00

Each returning the same 10% again.

If this continues the gap between A and B will widen each year.

 

2. Can be avoided completely on at least one and possibly 2 properties

The main residence exemption means one asset can be completely tax free. Careful planning can allow for 2 properties to be totally exempt for the whole ownership period.

3. The 50% CGT discount

Once the tax is payable most taxpayers will actually get a 50% reduction in the tax payable because of the 50% CGT discount. This applies for assets held longer than 12 months. It doesn’t apply to income received more than 12 months!

 

4. Personal expenses can reduce it

Move into an investment property and costs incurred while living in the property can be used to reduce the eventual CGT – potentially to nil. These are the 3rd element cost base expenses and include interest, rates, repairs, insurances etc. You can’t do this with income.

 

5. Time to Plan

CGT can be minimised by careful planning. This can involve timing strategies, bringing forward other expenses and other strategies some of which I have outlined at: Tax Tip 119: How to Reduce CGT on Investment Property (Part I)            https://propertychat.com.au/community/threads/tax-tip-119-how-to-reduce-cgt-on-investment-property-part-i.10681/

 

Written by Terry Waugh, solicitor at www.structuringlawyers.com.au