Declaration of Trust

A declaration of trust happens when the legal owner of an asset declares that they now hold that asset on trust for another person or persons.

A more technical definition is found in legislation, for example in section 8(3) of the Duties Act 1997 NSW which has:

“declaration of trust” means any declaration (other than by a will or testamentary instrument) that any identified property vested or to be vested in the person making the declaration is or is to be held in trust for the person or persons, or the purpose or purposes, mentioned in the declaration although the beneficial owner of the property, or the person entitled to appoint the property, may not have joined in or assented to the declaration.

Example

Homer owns 123 Smith Street. He is the legal and beneficial owner. One day he decides he wants to begin holding that property but for the benefit of his son Bart. Homer makes a declaration of trust that from this day forward he holds the property as trustee for Bart.

Homer is still the legal owner, but now Bart is the beneficial owner of the property. If Homer goes bankrupt the property is, at face value, not his property and not available to creditors (but…). If Homer dies this property is not one that can pass via his will. If the property is rented out the income will be taxed in the hands of Bart etc.

There are also various tax and duty consequences to making a declaration of trust and I will cover these in a future post.

Tax on Trust Income not Distributed

Where a trust has income and no one is presently entitled to it, the trustee of the trust will be taxed on this income at the top marginal tax rate because of s99A(4) ITAA36

http://classic.austlii.edu.au/au/legis/cth/consol_act/itaa1936240/s99a.html

Note that the income doesn’t necessarily need to be distributed, it could be retained by the trust yet still be taxed in the hands of the beneficiary if they have been made presently entitled to it.

On present entitlements and trusts see this post I wrote a few years ago:

Legal Tip 87: Trusts and Unpaid Present Entitlements

https://propertychat.com.au/community/threads/legal-tip-87-trusts-and-unpaid-present-entitlements.4718/  

Example

Simpson family trust has $10,000 in income in year 1. The trustee makes Bart presently entitled to the income so Bart is the one that is taxed on this income. The trustee may not physical transfer the money, but if the is the case Bart will still be taxed (and he will have an unpaid present entitlement with the trust, which is similar to a loan). Bart has no other income and pays no tax.

In year 2 the trust has $10,000 in income, but the trustee doesn’t make anyone presently entitled – perhaps they forgot, or perhaps their resolutions were defective.

The trustee will pay the tax at the top tax 47%

Can Children be Executors under a will?

Children are considered legally ‘disabled’ until they reach 18. They can be appointed as executors under a will, but if the testator dies while the child is under 18 the child cannot act as executor.

So what happens?

Usually their legal guardian will be executor in their place, or the courts can appoint someone else.

Under NSW law this would be s 70 of the Probate and Administration Act 1898

http://www8.austlii.edu.au/cgi-bin/viewdoc/au/legis/nsw/consol_act/paaa1898259/s70.html

Example

Bart has divorced the mother of his sole child – Junior.

Bart makes a will while Junior is 11 and appoints Junior as the executor of his estate with no backup. Bart has no plans on dying but carks it in a skateboard accident when Junior is 16.

Junior’s guardian at this point is her mother. The mother applies for probate as guardian of the executor and this is granted by the courts.

Bart roles over in his grave when his ex-wife, whom he still hates, takes control of his estate.

Strategy: Take a Wage Haircut and Move to a cheaper area

If you moved to a cheaper area to live and took a haircut on your wage, it might not be as bad as you think. This is can speed up financial independence and reduce stress and give you a better quality life.

Example of a $20,000 wage reduction

After tax income on $100,000 would be $73,883 (2018-19 tax year)

After tax income on $80,000 would be $61,383

So, a $20,000 reduction in gross income means only a $12,500 reduction in real terms

Try working it out yourself at https://www.taxcalc.com.au/

But the real benefit may be the savings with home ownership.

An equivalent house costing say $1mil in Sydney v $600,000 in Adelaide (for example)

Repayments on $1mil at 4% pa are          

  • $4,774 per month for 30 years with Total interest payable $718,695

Repayments on $600k at 4% pa are         

  • $2,864 per month for 30 years with Total interest payable $431,217

The repayments on the smaller loan mean a cash flow saving of $22,920 per year – which more than makes up for the lower wage income.

Furthermore, if you consider commuting times – you might be saving 1 or 2 hours per day living outside of Sydney.

Living costs may also be generally cheaper. Consumer prices are supposedly about 12.75% higher in Sydney than Adelaide:

https://www.numbeo.com/cost-of-living/compare_cities.jsp?country1=Australia&country2=Australia&city1=Adelaide&city2=Sydney
https://www.numbeo.com/cost-of-living/compare_cities.jsp?country1=Australia&country2=Australia&city1=Adelaide&city2=Sydney

Consider also the quality of life.

Conclusion

It can be worth moving out of Sydney and living elsewhere and this can be the case even if you were to take a substantial haircut on your income.

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/

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.