Why I think aspects of the HDT will fail!

Discussion in 'Accounting and Tax' started by Ronin, 12th Aug, 2006.

  1. JIT

    JIT Member

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    Summary of my HDT thoughts...

    Hi,

    Julia, thanks for your comments and replies in relation to the HDT. That is exactly what I was after on this forum, ie, an alternative point of view/opinion/interpretation of the HDT - which will help others here make more informed choices. Though this is obviously no substitute for paid professional advice, it is a good starting point.

    Here I will try and summarise my ramblings about the HDT!

    If you believe that in the situation where the SIU holder, with 200k of SIU's used by the trust to buy a 200k IP, to create a negative gearing position for the SIU holder, should...

    (1) Be entitled to capital rights.
    (2) Have their SIU's valued at the same price as the IP in question.

    And, if the ATO agrees with this view, then I think the HDT may offer no overall advantage to purchasing in one's own name, and may perhaps be disadvantageous, as there may be a smaller pool of lenders willing to lend with a HDT involved.

    However, we are talking specifically here in regards to a special class of income - SIU's with negative gearing for IP's.

    So, I would think that the HDT could still be used beneficially like a normal DT, for other types/classes of income/investments.

    Now, the alternative point of view is that you believe that the SIU holder is rightfully only entitled to income (including capital gains, but not capital), according to the trust deed.

    So now the question becomes...

    (1) How do you justify paying 200k for these income units, with no capital rights? This is far more than what they are really worth - how do you justify 'over-paying' for the SIU's in this way?

    Now I understand there is this concept of 'net present value with a terminal value' and the 'market substitution rule' which has been mentioned on this forum before, and has relevance here. I know nothing about this, so can't really comment, but will read up on it.

    Putting this aside, using some basic financial sense, I guess you could justify this 'over-paying' by some of the following:

    (1) Over the long-term, rental income will become much more than the interest expense with inflation/greater rental demand/capital growth of the property.

    (2) The property can be value-added to significantly increase the rental income, eg, by renovation, development, change of use/zoning, multi-letting.

    (3) The principal of the loan can be repaid, thus increasing net rental income.

    (4)The investment/risk profile of the residential property asset class make it very suitable to provide an income stream for a wide range of people.

    If you follow this reasoning, I think the key things to then note are:

    (1) All income (including capital gains) while SIU's are on issue, must be distributed to the SIU holder.

    (2)
    If SIU's are redeemed, this should occur at a point when rental income is greater than interest expense, ie, when the SIU holder is positively geared.

    (3) The redemption price should be at an appropriate and justifiable market value.

    (4) After SIU's are redeemed, there should be a 'reasonable time lag' before discretionary distribution of income (ie, 'income splitting) to beneficiaries occurs.

    Now, if SIU's are redeemed at a point when rental income is still much less than interest expense, and if the redemption occurs at a market value that results in minimal CG to the SIU holder, then in this instance, it may be possible that all the interest expense incurred may be disallowed by the ATO.

    Alternatively, if the property is firstly sold, then the SIU's redeemed after this, at a market value that results in minimal capital gains to the SIU holder, at a point when rental income is still much less than interest expense, and the property itself is sold with minimal capital gains, then in this instance, it may be possible that all the interest expense incurred may be disallowed by the ATO.

    The question to ask then is why would you have to redeem SIU's at a point where rental income <<< interest expense???

    This may be if the trust/'you' is forced to sell the property much sooner than expected or when there has been minimal capital growth to the property.

    This for me would then be the real risk to the HDT.

    However, if you are confident that you will not or won't have to sell the property pre-maturely, and will hold for the long-term, then this should not really be a problem. And subsequently, the HDT may be entirely appropriate for you. So it would appear to me to be that the HDT could be very suitable for a long-term buy and hold investor in property, and even more so to people with secure jobs/incomes.

    A possible exception to note is that if there was a major renovation or development to the property, even if it was in a short-time frame, this may generate sufficient income (in the form of capital gains) to the SIU holder to justify the negative gearing losses, and make the interest expense an allowable deduction.

    Overall, despite my critical comments, I still think the HDT can work, more so if the 'conservative' interpretation of it is adopted. The only sticking point for me is the initially 'overpaid price' of the SIU's and NPV/terminal value/market subsitution rule, which I will try and resolve for myself.

    I suspect that in court, a good trust/tax lawyer could potentially argue each point of view equally well.

    Dale's comment below is very fitting:

    And I think Rolf Latham summed it up the best with this great line:

    Please note that my thoughts on the HDT are purely based on readings from this forums posts, and I have no professional qualifications to talk with any real authority on this subject! I'd encourage anyone to pick holes/flaws in my arguments! And also speak to your own advisors about the HDT, as I am about to!

    Hope this has helped!

    GSJ
     
    Last edited: 20th Dec, 2006
  2. julia

    julia Member

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    You can salary sacrifice the interest rates etc for both the owners of the property effectively giving the high income earner a deduction for all the expenses and just splitting the rent and depreciation on the basis of ownership. Usually means the property is positively geared to the low income earner. On sale capital gain is distributed on basis of ownership which can be as little as 1% to the high income earner if that is what is on the deed. The otherwise deductible rule means that the employer does not pay fbt. More into at http://www.bantacs.com.au/fbt_rental.php.

    As for the other ways they are as you say direct ownership by the low income earner or DT so not that good if negatively geared and can't direct other income to the trust that holds the property. But this would normally only be the case if the high income earner was an employee so that is when you SS instead.

    Sometimes you can get stamp duty concessions on transfers between spouses but their would be no CGT concessions unless there is a marriage breakdown. Again SS is more flexible here you just change which spouse does the SS.

    Julia
    www.bantacs.com.au
     
  3. JIT

    JIT Member

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    Salary Sacrificing

    Ah! I know understand what you were saying in a previous thread about this topic. I should have looked at your website first!

    After all that reading on HDT's, I must admit, that this strategy sounds a lot simpler, cheaper, much more flexible, and ? perhaps less risky and more proven...

    The flexibility, in terms of simply changing the person who participates in the SS depending on who has the higher income is good. Also in terms of allocating an ownership %, eg, the high-risk person could own 1%, and the low-risk person could own 99%.

    So, you could set it up so that the high-risk, high-income person, has a 1% ownership, but by participating in the SS, they get most of the tax benefits.

    This achieves flexible tax-effectiveness and asset protection, without any trust!

    If you can get this arranged, then it would seem a very good strategy.

    However, the most tricky part about this strategy is convincing both you and/or your spouse's employers to participate in this arrangement (which is to their risk, and your entire benefit, I can't imagine this would be easy, particularly if it is just for you two, and no other employees are doing this) - in order to then get the private binding ruling. Furthermore, if you change employers you may have to go through the whole process again, and if you don't actually have a spouse, it's probably not going to work. Also, if you are not an employee, but self-employed or in business, I am not sure if it will work.

    Anyway, there's now a few options here, each with their own pros and cons, for people to consider...

    GSJ
     
  4. Bandita

    Bandita Member

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    Hi GSJ,

    I've been watching this thread with interest, and think this is a really key point. We have a HDT, and when we were deciding whether to set one up or not - one of the first things that was asked of us is what are your future plans with the properties you buy in them - and ours was long term buy and hold. I don't believe the HDT would have been recommended to us at all if we were looking to sell quickly.

    You need to setup the appropriate structure for YOUR circumstances. I don't believe a HDT is appropriate at all for a short term negative gear buy and sell strategy. It's too risky to be seen by the ATO as simply a measure for avoiding tax and brings into play all the questions that have been bounced back and forth in this thread and others.

    Cheers,
    Jen
     
  5. JIT

    JIT Member

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    Although you may have no intention of selling quickly, the point to emphasise here is: what are the chances that you will be forced to sell pre-maturely...? I think this is the risk you need to weigh up.

    So, if you have a job/income that may not be that secure and run into troubles servicing the NG shortfall, or, alternatively if you simply select the wrong property that doesn't achieve much CG at all - then you could find yourself in trouble.

    This, however, is nothing unique to any structure, it is just how investing with a negative gearing strategy is. And, this is a strategy that is more suited to high-income earners.

    Again, just my thoughts, happy to be questioned/corrected on any of the points I have made.

    GSJ
     
  6. julia

    julia Member

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    You are abosolutely right it is difficult to get an employer to co operate but this was once the case for novated leases. We just need enough people out there pushing. That is why I created the kit so that it was easy for the employer to get an ATO ruling. There is also no point if you do not have a spouse but then a HDT would only be useful in that case if you were anticipating getting a spouse in the future anyway. As for self employed they are usually in a position to set up a normal DT and divert income from the business into it to offset the losses and they are not normally looking to shift income anyway as they are normally doing that through their business. Further if they operate as a Co or Trust they are employees of them selves so can use the kit without having to persuade their employer but again they probably don't need it.
    As I said in most cases there is normally another way than a HDT but it varies depending on all these factors.

    Julia
    www.bantacs.com.au
     
  7. Bandita

    Bandita Member

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    Hi GSJ,

    Of course things go wrong, but if there's any chance you would be forced to sell quickly - I don't know why you would setup a trust to begin with? The costs of setting up a trust aren't cheap, and the asset protection they give are pretty much irrelevent if you'll be selling quickly anyways. If your plans were for a long term buy and hold and you are forced to sell quickly, I do think that you would be OK by the ATO - because tax avoidance wouldn't have been your plan at all and you would be able to prove that by why things went wrong.

    Meaning - if you buy for a long term buy and hold - the problems you might face with the ATO with negative gearing are irrelevant because you will be getting increased rental income over that time - and if things go wrong and you're forced to sell, you would be able to prove it. If you buy in a HDT for short term buy and sell, you're probably only doing it for tax minimisation and you might face problems. And I don't know why you'd pay the costs to set up the trust and take that risk for such a short period of time??

    So plan your structure with the end in mind! Obviously things go wrong - but if you're able to prove that, you'll be in a much better situation.

    Cheers,
    Jen
     
  8. JIT

    JIT Member

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    Yes that makes sense.

    Yes that makes sense, but I don't know how the ATO views these things.

    I may have already said this in a different way before...But I guess you would basically justify the negative gearing with income units, not primarily by any anticipated capital growth/gains, but due to the future rising rental income stream, well above the interest expense incurred, which would generally mean the trust holding the property long-enough for this to occur.

    GSJ