Unit Trust Refinancing Principle
- Thread starter D.T.
- Start date
Refinancing
Im a practitioner familiar with this issue.
There are really two types of unit trusts which are affected by refinancing. I generally classify two types but there is a third. I dont like to give guidance on the third type - Not here anyway...A "pre-99 unit trust". So I will give some guidance on just the two major types.
1. A UT with a SMSF unitholder
2. A UT without a SMSF unitholder.
1. The key issue is that SIS Reg 13.22 is not satisfied is a SMSF has an interest in a UT which uses its real property as loan security (ie a charge, mortgage etc). Thus where a SMSF is a unitholder there is a concern that refinancing may trigger the need to calculate the "in house asset" thershold. Where this exceeds 5% the fund may be non-complying. (Highly likely)
The major message here is avoid or dont "finance" a UT where any SMSF is a unitholder - At the minimum seek advice. There can be exceptions.
2. This is the question you referred to.
Given the issues in 1, I will assume no unitholder is a SMSF. I will use examples to illustrate.
Assumption : Trust acquires a property for $100,000 in 2005. Unitholders are Mum and Dad each 50,000 x $1 initial units. Mum and dad reside in NSW. The property is in NSW. The trust was settled in NSW.
Scenario : Originally negative geared, the IP is now positive geared. Dad is a high income earner. Dad and Mum have each repaid their loan and the original debt of $70,000 is now $20K in total ($10k each).
Property has a present value of $350K. After the net debt net equity is $330k
Bank confirm valuation and happy to approve a loan of 70% x $350K = $245K
Dad and Mum consider strategy and want to redeem some of Dad's interest. They want to shift ownership to 20% (from 50%). Therefore Dad should redeem 30,000 of his 50,000 units to have a UH of 20,000 units.
Dad's applies to redeem 30,000 units. Redemption MUST occur at market value [CGT market value substitution rule!!]. Mkt value of units is $3.50 v's cost of units of $1. Dad applies to redeem...He does not transfer any units without a probable stamp duty concern. Dad applies to redeem 30,000 units and expects to receive proceeds of $105,000.
The trustee Co proceeds with bank loan of $105,000 (plus costs). Thus the borrowing will shift from a personal borrowing and become a trustee borrowing. On settlement the trustee requests the $105K is disbursed to dad. At settlement Dad uses the proceeds as follows:
- $20K to repay the existing personal borrowings ($10K each Mum & Dad)
- $85K to Dad
Dad triggers a CGT event by disposal of his trust interest. $105K less original costs base = $55K gain. The gain is reduced first by any C/Fwd cap losses then the 50% CGT discount. So lets assume no cfwd losses and $27.5K is taxable at say 45%...Likely tax will be $12.3K tax. Not due for around a year.
So dad has $72.7K surplus cash. ($105- $20k - $12.3k). He can use this to repay own home loan or buy a boat car etc.
1. Loan is refreshed...Prev deductible loan was $20K and is now $105K
2. Dad has reduced trust interest. Shifts more income from trust to Mum
3. Dad's 25% trust interest is after loan interest now.
4. In future years dad could refinance again and repeat this exercise.
5. In some states no stamp duty arises from thsi shift of underlying owner. In NSW a $2m property threshold applies. So this arrangement can incur duty ofn properties valued at $2m+ For all other states seek advice. QLD is a concern in many instances.
In refinancing cases I generally "model" the before and after tax impacts on spreadsheet to ensure no unwanted impacts arise. The major difference is that prior to refinance the interest is deductible personally against a fixed share of trust income. In the refinance situation the trust will now calculate trust income less its own interest costs so that "net" income is disributed. Its not sensible to result in a tax loss as this is quarantined to the trust. So planning is important -Again, a good reason to model the change.
Please note this is general information and no reader should act without seeking advice which may apply to their specific circumstances.
Common Questions :
Q: Can redemption occur other than at market value ?
A : Generally, no. The ATO might also consider Part IVA applies.
Q : Can all trusts do this ?
A : No. The deed needs to be reviewed and legal advice given.
Q : Can I defer or avoid CGT?
A : Generally no. A CGT event is triggered on ending a trust interest. These can be instances where CGT does not apply but these are very limited circumstances.
Q : What legal liability issues arise?
A : Thats a great question. Note that the bank is likely going to require each trustee gives a guarantee that is joint & several. So Dad may still be exposed to FULL liability for the $105K debt v's his interest in this case. I always suggest legal advice on this issue. This issue may also impact unrelated borrowers in a different way v's spouses.
Q : Will all lenders do a trust refinance ?
A : No. The loan interest is also likely to be at a higher % v's home equity loans etc. A good broker can assist.
Im a practitioner familiar with this issue.
There are really two types of unit trusts which are affected by refinancing. I generally classify two types but there is a third. I dont like to give guidance on the third type - Not here anyway...A "pre-99 unit trust". So I will give some guidance on just the two major types.
1. A UT with a SMSF unitholder
2. A UT without a SMSF unitholder.
1. The key issue is that SIS Reg 13.22 is not satisfied is a SMSF has an interest in a UT which uses its real property as loan security (ie a charge, mortgage etc). Thus where a SMSF is a unitholder there is a concern that refinancing may trigger the need to calculate the "in house asset" thershold. Where this exceeds 5% the fund may be non-complying. (Highly likely)
The major message here is avoid or dont "finance" a UT where any SMSF is a unitholder - At the minimum seek advice. There can be exceptions.
2. This is the question you referred to.
Given the issues in 1, I will assume no unitholder is a SMSF. I will use examples to illustrate.
Assumption : Trust acquires a property for $100,000 in 2005. Unitholders are Mum and Dad each 50,000 x $1 initial units. Mum and dad reside in NSW. The property is in NSW. The trust was settled in NSW.
Scenario : Originally negative geared, the IP is now positive geared. Dad is a high income earner. Dad and Mum have each repaid their loan and the original debt of $70,000 is now $20K in total ($10k each).
Property has a present value of $350K. After the net debt net equity is $330k
Bank confirm valuation and happy to approve a loan of 70% x $350K = $245K
Dad and Mum consider strategy and want to redeem some of Dad's interest. They want to shift ownership to 20% (from 50%). Therefore Dad should redeem 30,000 of his 50,000 units to have a UH of 20,000 units.
Dad's applies to redeem 30,000 units. Redemption MUST occur at market value [CGT market value substitution rule!!]. Mkt value of units is $3.50 v's cost of units of $1. Dad applies to redeem...He does not transfer any units without a probable stamp duty concern. Dad applies to redeem 30,000 units and expects to receive proceeds of $105,000.
The trustee Co proceeds with bank loan of $105,000 (plus costs). Thus the borrowing will shift from a personal borrowing and become a trustee borrowing. On settlement the trustee requests the $105K is disbursed to dad. At settlement Dad uses the proceeds as follows:
- $20K to repay the existing personal borrowings ($10K each Mum & Dad)
- $85K to Dad
Dad triggers a CGT event by disposal of his trust interest. $105K less original costs base = $55K gain. The gain is reduced first by any C/Fwd cap losses then the 50% CGT discount. So lets assume no cfwd losses and $27.5K is taxable at say 45%...Likely tax will be $12.3K tax. Not due for around a year.
So dad has $72.7K surplus cash. ($105- $20k - $12.3k). He can use this to repay own home loan or buy a boat car etc.
1. Loan is refreshed...Prev deductible loan was $20K and is now $105K
2. Dad has reduced trust interest. Shifts more income from trust to Mum
3. Dad's 25% trust interest is after loan interest now.
4. In future years dad could refinance again and repeat this exercise.
5. In some states no stamp duty arises from thsi shift of underlying owner. In NSW a $2m property threshold applies. So this arrangement can incur duty ofn properties valued at $2m+ For all other states seek advice. QLD is a concern in many instances.
In refinancing cases I generally "model" the before and after tax impacts on spreadsheet to ensure no unwanted impacts arise. The major difference is that prior to refinance the interest is deductible personally against a fixed share of trust income. In the refinance situation the trust will now calculate trust income less its own interest costs so that "net" income is disributed. Its not sensible to result in a tax loss as this is quarantined to the trust. So planning is important -Again, a good reason to model the change.
Please note this is general information and no reader should act without seeking advice which may apply to their specific circumstances.
Common Questions :
Q: Can redemption occur other than at market value ?
A : Generally, no. The ATO might also consider Part IVA applies.
Q : Can all trusts do this ?
A : No. The deed needs to be reviewed and legal advice given.
Q : Can I defer or avoid CGT?
A : Generally no. A CGT event is triggered on ending a trust interest. These can be instances where CGT does not apply but these are very limited circumstances.
Q : What legal liability issues arise?
A : Thats a great question. Note that the bank is likely going to require each trustee gives a guarantee that is joint & several. So Dad may still be exposed to FULL liability for the $105K debt v's his interest in this case. I always suggest legal advice on this issue. This issue may also impact unrelated borrowers in a different way v's spouses.
Q : Will all lenders do a trust refinance ?
A : No. The loan interest is also likely to be at a higher % v's home equity loans etc. A good broker can assist.
Good summary Paul
I can just add that I am doing some loans for a client in a UT now with the borrowings in the individual names. Lenders are more restrictive, but rates can be similar to buying in personal names - but not on the package. I don't forsee any problems with a loan being refinanced and the trustee getting the loan - normal polices would apply such as personal guarantees etc.
And, another slightly different approach is the sale of the units to a discretionary trust which would borrow to buy them. Good in the states with no stamp duty on the transfer of units.
I can just add that I am doing some loans for a client in a UT now with the borrowings in the individual names. Lenders are more restrictive, but rates can be similar to buying in personal names - but not on the package. I don't forsee any problems with a loan being refinanced and the trustee getting the loan - normal polices would apply such as personal guarantees etc.
And, another slightly different approach is the sale of the units to a discretionary trust which would borrow to buy them. Good in the states with no stamp duty on the transfer of units.
Did you get that DT?
Now... tell us the answer to your question in your own words
Yep.
1) IP is paid off or nearly paid off status
2) Trust goes to the bank to refinance it up to agreed LVR
3) Interest on above refinance is tax deductible for the Trust
4) Trust uses released funds to pay out unit holder
5) Unit holder can do with these funds as they please
6) ???
7) Profit
Excellent post Paul.
I do have one question. When the Trustee eventually decides to sell the property what is the cost base of asset to calculate the CGT?
Say property purchased in Year X.
Unit holder redeems units in Year X+5 and pays CGT.
Trustee decides to sell property in Year X + 10. Is the cost base from Year X or does it change after units are redeemed?
Cheers,
Oracle.
If I understood correctly, cost base of property is unchanged since it hasnt transferred before (unit transfer independent of real property transfer? )
So when you sell the property you could end up paying CGT twice even if the redeem price and the sell price of property is the same?
For eg. you buy property for $100 and issue 100 units. 5 years later price increases to $200. You redeem units and pay CGT on $100 and immediately sell property for $200 again triggering CG of $100 since the cost base ($100) does not change?
Is that your understanding?
Cheers,
Oracle.
I get what you're saying; I asked accountant about that the other day. I'd have to consult the notes I took when I get home today but hopefully someone chimes in
Hi,
I have no idea. These are just some thoughts.
- Trusts don't pay tax, the beneficiaries pay the tax.
- I think this must have something to do with the way the unit are redeemed.
So an example.
100,000 units (50k each Mum and Dad). Property worth $100k
Property now worth $350k.
30,000 unit redeemed to Dad, $105k for trust to buy those units.
Dad pays CGT tax on the $75k profit ($105k - $30k)
So now we have 70,000 unit remain on issue, and a property worth $350k.
Somehow the expense of $75k+$30k capital return would have to be accounted for.
So now we sell the property for $350k, and pay back the $105k loan.
If this was a company the shares would be worth $350k-105k / 70k = $3.50, which is the same price Dad redeemed the original shares for.
As this is a trust, The units would have a market value of $3.50,
but I don't know how the tax would be calculated.
Ahhh yes the potential double CGT. Thats why someone who knows about unit trusts is very important when applying the refinancing principle.
Firstly Roberts case states that you will only get an interest deduction for refinancing original capital employed. If you refinance unrealised gains then the interest on the unrealised gains wont be deductible.
So what happens. Well let's assume you acquired 500,000 x $1.00 units = $500,000. debt is paid off and market value of the property is now $1m. well if you redeem the units then market value substitution rule applies and you will have a $500k capital gain on the redemption of the units and when you sell the property another $500k capital gain to be distributed to the unit holder. Double CGT. Nasty.
Well it is if that is how you structure the transaction. However if the unit trust borrows to return capital of the original $500k then the interest is deductible and tax effect is totally different. market value substitution doesnt apply to a return of capital. So no CGT on the return of capital and interest deductibility on the funds borrowed by the unit trust to the return the capital.
Property then sold for $1m and $500k capital gain. This is then distributed to the unit holder and they pay capital gains tax on the $500k (asssuming no discount) and they are in the same position as if they held the property in their own name.
Same position. Two different results. Structuring. It's what it is all about and understanding the unique steps involved.
Firstly Roberts case states that you will only get an interest deduction for refinancing original capital employed. If you refinance unrealised gains then the interest on the unrealised gains wont be deductible.
So what happens. Well let's assume you acquired 500,000 x $1.00 units = $500,000. debt is paid off and market value of the property is now $1m. well if you redeem the units then market value substitution rule applies and you will have a $500k capital gain on the redemption of the units and when you sell the property another $500k capital gain to be distributed to the unit holder. Double CGT. Nasty.
Well it is if that is how you structure the transaction. However if the unit trust borrows to return capital of the original $500k then the interest is deductible and tax effect is totally different. market value substitution doesnt apply to a return of capital. So no CGT on the return of capital and interest deductibility on the funds borrowed by the unit trust to the return the capital.
Property then sold for $1m and $500k capital gain. This is then distributed to the unit holder and they pay capital gains tax on the $500k (asssuming no discount) and they are in the same position as if they held the property in their own name.
Same position. Two different results. Structuring. It's what it is all about and understanding the unique steps involved.
Sorry Mike, I'm not understanding whats different between the 2 above paragraphs.
NSW isnt one of them....Not for the duty issues. The DT is still subject to a land tax threshold of $0.
