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Thursday, October 31 2013

Understanding trusts…if that’s possible

At their heart trusts are relatively simple but at first glance their function and purpose can be utterly confusing. I am going to give my best shot at explaining trusts but if you find yourself confused you are not alone.

 

I think the best way to understand a trust is to actually have one and see it in operation, but not everyone has that luxury. The important point to make at the outset is that trusts will not be for everyone.

 

So what is a trust?
A trust is an agreement (the trust deed) that certain individuals (beneficiaries) may be entitled to certain property as determined by a nominated party (the trustee) who is responsible for holding and managing property on behalf of the trust.

The trust deed spells out the powers, responsibilities, and limitations of the trustee. The trustee can be either a person or a company. In short the trustee is generally expected to manage the assets of the trust for the benefit of the trustees.

Perhaps the most common form of trust is the discretionary trust. A discretionary trust means that the trustee has complete discretion how any income or assets of the trust may be distributed to the beneficiaries. The set up of this structure is best explained by way of an example.

Bill and Jane Smith wish to purchase an investment property using a discretionary trust. They establish a trust called “The Smith Family Trust” with a company (Smith Investments Pty Ltd) as trustee. Both Bill and Jane are shareholders and directors of Smith Investments Pty Ltd and are also beneficiaries of the trust. The trust has all the powers of a natural person.

So in essence Bill and Jane have complete control over the investment property and complete say over how any benefits coming from that investment can be distributed.

But why would Bill and Jane choose a trust structure? 

  • Asset protection
  • Estate planning
  • Flexibility for tax planning

Asset protection
Trusts can provide a means of protecting you from litigation.

For example let’s say you owned your home in your personal names but your investment property was owned through a trust with a company as trustee. Your tenant in the property slips on the stairs and decides to sue you for personal injury.

In general terms the tenant would only be able to sue the trust and the company as trustee and would not be able to pursue your personal assets. If the property was worth $250,000 and the loan against the property was $260,000 then this would not make the trust an attractive target and may kill off any action. If however the investment property was owned in your name then this would open the door to your personal assets. 

This remains an area of contention and the laws on this are being reviewed all the time. So whether trusts remain a safe haven remains to be seen. In any case it would be wise to have landlords insurance with adequate public liability to protect you from such an event.

 

Estate planning
Assets held in a trust do not form part of your estate and therefore do not pass in accordance with the terms of your will. This may be of benefit where you wish to keep your assets out of reach of certain parties in a situation where a will may be contested.

A trust may also allow for a more tax effective distribution of assets to your family or other beneficiaries upon your death.

 

Tax planning
A trust does not pay tax. Any income earned by the trust must be distributed to the beneficiaries. The beneficiaries will then be taxed at the appropriate marginal rate. Depending on the type of trust you have established a trust allows you to distribute income in a manner that is most tax effective.

 

Referring to our example again. If Bill was a high income earner and Jane was not working then all income from the trust could be directed towards Jane so that any income is taxed at a lower marginal rate. Again if the trust sold the property and made a capital gain, that gain could be directed towards Jane.

It can also provide an opportunity to defer payment of tax which can be of benefit to your cashflow.

 

 

Types of trusts
There are numerous types of trusts but the most common are:

 

  • The discretionary or family trust
  • The unit trust
  • The hybrid trust

 

The discretionary or family trust
I have already touched on some of the features of this type of trust above. The key element of this trust is that the trustee can distribute income to beneficiaries however they see fit.

This means that income can be distributed in one way in one year and in a different manner the next. Providing complete flexibility in managing tax.

 

The unit trust
Unit trusts are generally used where several separate parties enter into a joint venture. Each party purchases units in the trust equating to their percentage share of the assets held in the trust.

This structure may be appropriate where a number of friends or family wish to buy or develop a property but will be contributing differing amounts. Those who provide a higher level of equity would receive a larger number of units.

The difference here however is that there is no discretion as to how income can be distributed. Any income earned by the trust must be distributed to beneficiaries according to the number of units they hold.

 

The hybrid trust
This is essentially a cross between a discretionary trust and a unit trust. Hybrid trusts are generally used where a property is negatively geared and the beneficiaries want to use those losses to reduce their taxable income.  

Income can be distributed to beneficiaries according to their unit holding or at a later date income can be distributed at the trustee’s discretion. For example in the case of a capital gain. 

 

Asset protection, greater flexibility with tax planning…all sounds good. But before you get too excited there are some potential downsides.

 

Negative gearing
A trust can only distribute income not losses. So in the case of negatively geared property the losses are trapped in the trust and can not be passed on to the beneficiaries to reduce their taxable income.

There can be a number of ways around this depending on your personal situation.

 

Using your business

For example if you have a profitable business which is operating through a trust you can establish a separate trust for property investment.

It is then possible to divert profits from the business trust to soak up losses in the investment trust. For example if your business trust made a profit of $100,000 and the investment trust made of loss of $10,000, then the business trust could distribute $10,000 to the investment trust to absorb the loss.

The business trust would then only need to distribute $90,000 to the beneficiaries.

 

A hybrid trust

A hybrid trust can also be effective. Under this scenario you borrow funds in your name which you use to buy units in the trust. The trust then pays cash to purchase the investment property. As long as the property is rented the trust should then be cash flow positive as it is not carrying the major expense of interest.

Surplus income from the trust is then distributed to you, which can be offset against the interest on your loan.

 

Costs
Setting up trusts, in particular trusts with a company as trustee can be expensive. You could expect to pay close to $2,000 or more. Because you have a separate entity there will also be additional accounting fees at tax time to prepare your returns.

If you have a company as trustee then there will also be ongoing ASIC fees, and fees if you make any changes to directors or shareholders.

 

Land tax
In general the tax free threshold for trusts is lower than with individuals plus the rates are higher.

Lenders
Not all lenders will lend to trusts or will only make certain loan types available. Also additional fees will generally be payable at application for perusal of the trust deed.

 

In summary
Certainly there are some significant advantages to be had by using a trust, but these need to be weighed up against the potential costs. And as mentioned trusts are not for everyone. The key here is to do your homework in advance and get advice 

 

What opportunities are you missing?
Are there ways to improve your current cashflow that you are not currently doing? Are your finances correctly structured to build a property portfolio or are they holding you back? Do you have a plan of attack of how to build a portfolio? Are your finances set up to ensure you can acquire property without negatively impacting your lifestyle? Are there things you are missing that you should or could be doing that could have a significant impact on your wealth creation plans?

Contact us for an initial discussion.

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All the best

Greg Carroll
MTA

Posted by: Greg Carroll AT 09:01 am   |  Permalink   |  Email