We live in Melbourne. Am embarking on getting our first IP, and we want to set up a right structure for us (whether a trust or in our own names). We are exploring the idea of a hybrid trust. This are the factors that we are considering at the moment…
1 – Set-up and running cost: Sure, around $2.5K setup fee for a hybrid trust with corporate trustee, plus easily $1K running cost each year. As we plan to add around 4-5 more IP as a minimum, has anyone ever considered how many properties one should have in a trust to make the running cost worth it?
2 – Negative Gearing and deprecation: Negative gearing is taken cared of by borrowing the loan in our own name and lending the money to the trust to purchase the IP, so we can receive the interest from the loan. What about the depreciation? As the trust will be the one holding onto the IP, would the depreciation not stay within the trust and not be accessible by us? How can that be overcome, if possible?
3 – Asset protection: Often, that is one of the main reasons for having a trust. What are the alternatives to this? Maybe via having the appropriate insurances?
In the end of the day, is it really down the the long term strategies that we have for ourselves? We look to buy an IP within the next few months (in early 2009), start a family then after, buy our next home in 2011 – 2012, then rent out our current home as an IP. Which means we probably will not be officially be buying another IP till earliest 2012.
Is it worth incurring the cost of setting up and running a trust for us? When is doing that worth it?
Would be good to hear stories from people on why they decided to go for a trust, and why they did not.
One teeny tiny problem I found with a hybrid trust recently – no banks would lend against it. Apparently the banks are very nervous about hybrid trusts because the ATO has come out with some complex rulings about such trusts recently. In the end I had to go with a non bank lender who have outrageous rates and early exit fees.
This might have changed in the last few months – my loan was in September, but worth checking out before you set up the trust.
Hybrid trusts don't really work in any meaningful way.
1. Setup costs can be much cheaper. It costs $400 to set up a company with ASIC and a trust deed can be $600+ (+ stamp duty). Running costs: If a trust has just one property then the tax return for this trust should be very cheap. Many accountants charge you a fee per property, so it shouldn't really cost you much more than owning the property in your own name. ASIC has a yearly fee of around $220 for the annual report – with some accountants charging you a fee of $200 just to post this in! So running costs need not be too much for a trust.
2. With a HDT you would borrow to purchase income producing units in the trust. The tax deductibility of these borrowings would depend on the commerial prospects of getting an income from these units. It seems the ATO will only allow the interest to be claimed if the unit holder must get all of the income and capital gain from the property. If there is any discretion, then full deductibility won't be possible. That means your HDT must act like a unit trust until the units are redeemed by the trustee.
Depreciation goes to the owner of the property which is the trust in this case. But since interest is the biggest expense your trust should be running at a profit if you can personally claim the interest. The profit can be offset by the depreciation.
3. There is little or no asset protection in a HDT as the units are property and could be taken by creditors if you were to go bankrupt. There have been deeds worded so that the units become worthless if the unit holder were to go into bankruptcy, but this may effect the deductibility of interest argument if the trustee has discretion here.
I agree with others above, you should look at avoiding HDTs or getting independent legal advice from a tax lawyer about using a HDT. Using a discretionary trust may be the way to go, as Richard mentioned. Low rates will mean less of a loss and with rising rents the property will be positive income soon.
HDTs have problems with finance because the owner of the property and the borrowers are usually different. If the trustee and the unit holder/borrower is the same it should be much easier.
So why do Accountants keep saying that HDT's are a better way to invest if you intend on building a portfolio. Would you think about setting up a Testamentary Trust instead for the future.
These days I don't think there are many accountants recommending HDTs – in fact most are saying to avoid them I think.
A testamentary trust is one which is established after you are dead. Great for future planning – just not your future. With income from a testamentary trust kids can earn income and be taxed at adult rates, not the penalty tax rates that normally apply to kids. Your assets don't actually pass to them, but remain in the trust and this can help asset protection if they go bankrupt or divorce etc
sorry another question I forgot to ask is what about Privacy – What if you want your property portfolio kept private from people is there a way to protect your privacy if people do a search on your investments?
A Unit Trust could POSSIBLY get you the interest deduction, but the problem with this is the income from the trust is paid to the unit holders in proportion to their unit holdings. If you own all the units, to get the interest deduction, you also get all the income.
I'd look at a discretionary trust. As Richard says, at the moment interest rates are low and there is more cash flow neutral property around than in prior years. Any initial losses are locked in the trust, and distributions would be made after those losses have been used up.
If you have minors you can distribute to, you can distribute the first $2666 (for 2009 year) to a minor tax free (dependent on your trust deed),
If you are planning on buying and holding, and adding to your portfolio, I would look at the Discretionary Trust option.
So, with a Hybrid Trust and a Unit Trust, the units themselves become assets and are open to creditors. With a Discretionary Trust, you are free to distribute the profits to any beneficiaries, but depreciation and deductibility of interest is held within the Trust.
What then makes a Trust worth the short to medium term pain. Eg: most properties start out negatively geared, and the tax deductible interest and depreciation makes it easier to hold onto the property. Of couse, we all know the long-term benefits of holding positive geared properties in a Trust.
That is my next question: What makes the short to medium term pain of losing the tax deductible interest / depreciation worth it? Has anyone gone ahead without a Trust?
It is possible to get other income into a trust and then offset any negative from the property – or you can let the loss roll forward to be offset by future gains.
The purpose of investing is to profit so I think you should look at the long term situation. Saving a few thousand in tax now by negative gearing in your own name could cost you tens of thousands in a few years.
eg. a mate of mine purchased a property in WA a few years ago. He was earning $100,000+ and his wife nil so he purchased in his own name. I advised him to look at a DT but he didn't. The property doubled in 2 years and he sold and had to take to full capital gain of about $200,000 after the 50% discount. He would have paid around $100,000 CGT while his wife was still on no income.
Thats interesting Richard because it seems that Chan & Naylor like to push the field of Trusts. So what structure are accountants recommending then for asset protection and interest deductiblity?
Any accountants care to give their thoughts. I am glad that their are finance brokers here saying that finance is the first field you look at before going out purchasing a property.
Thanks again Richard with your information.
I have always steered clients away from hybrid trusts, long before the ATO expressed their view on these trusts. Never actively promoted them and when clients queried their use, I had not been comfortable. There are just too many issues to worry about (eg, s51AAA), which fails the "sleep test" for me (ie, if you can't sleep at night because of a risk you have taken on, then it was not worth doing in the first place). I do like discretionary trusts though because of:
1. Asset Protection – None of the beneficiaries have any present entitlement to the income and capital of the trust at any time until the trustee makes a resolution. This is arguably one of the most powerful asset protection device in my mind.
2. Flexibility in Distributions – Coupled with a corporate beneficiary, high income family groups can cap the maximum tax rate to 30%, subject to any Division 7A issues. Again, very useful if discretionary trusts are used as an investment vehicle to build wealth.
3. Capital Gains Discount – A capital gain derived by a discretionary trust will qualify for the 50% CGT discount if the property has been held for at least 12 months and provided that the gain is distributed to individuals.
Someone also mentioned privacy. You can achieve privacy by using a corporate trustee and a nominee company as shareholder. The nominee company will merely hold the shares in the corporate trustee in trust for the "real" owner under a Declaration of Trust. Relatively simple to do.
I spoke with the accountant, and was advised to not bother about a trust.
The factors leading to that decision were:
1 – Many lenders do not understand the various types of trust available and are very wary of lending to anyone in this current climate. We would only find one lender willing to deal with a HDT, and even they limit LVR to 80%;
2 – Our strategy of using the negative gearing and depreciation to make it easier to hold onto a property, and repeating that strategy every 2-3 yrs means the overall portfolio will be at best neutral geared; hence a trust is not feasible, unless we are happy to roll over thousands in interest deductions / depreciation for years to come;
3 – The running cost of a trust at the moment for us would be the equivalent of us having bought 6 IPs over the next 10-12 yrs. Our circumstance may change by that time and we can explore that option once again;
4 – As much as everyone talks about how important it is for a property investor to start out with a trust, the majority of investors invest in their own name.
5 – Getting the adequate insurance and not running our own business significantly lowers the risk of being sued; as much as everyone talks about Australia going down the US litigation route, the reality is that not many landlords do get sued;
6 – As our incomes are almost equal, and we plan to cut down working hours as and when investment income starts to flow in, using a DT to distribute income become less relevant to us for tax purpose.
That is all I can remember. She gave me details of some mortgage brokers, spoke about the economy at large, interest rates, her own property experience. Told her that we are not looking to purchase till Feb / Mar 09, so we have time to set our house in order.
Firstly she is wrong about only 1 lender accepting applicationsfrom a HDT I can think of 4 off the top of my head who will go to 90% + if the application is full doc.
Secondly if the costs of running a DFT is equivalent to you have bought 6 IP's then i think i would be immediately looking for a new Accountant.
Totally disagree about not using a DFT as you intend to cut back your working hours and therefore the income distribution is irrelevant. I also disagree with the fact that not many landlords get sued. May she would like to check out the current cases in front of the bench and then advise again.
Funny in my Profession usually the only people who tell you not to bother about something are those who dont understand it. Hate to say this also goes for a lot of Accountants.
Richard Taylor | Australia's leading private lender
Did she mention the problems with HDT's and the ATO taxpayer alert? This is the main reason accountants are steering their clients away from Hybrid Trusts.
I'm not sure of how she worked out the amount, but the running costs of a DFT are higher, expecially if you have a corporate trustee, due to the ASIC fee, preparationof minutes, financials statements etc. Is having one property in a DFT the same costs as having six in your own name? I'm not too sure about that.
It sounds like the most important thing at the moment to you is getting the tax breaks for negative gearing. If that's the case, then buying in your own name may be the way to go for you. But this strategy could mean you pay more tax than you need to in the future, especially if you build your portfolio.