YAHTQ (Yet Another Hybrid Trust Question)

[Glebe]

Hi people,

I have a HDT scenario. Please tell me at what point/s I've got it wrong.

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Scenario:

Say Millie Smith earns $100k and Billie Smith earns $50k. Their professions share equal risk profiles.

Now, say they want to give $300k to the trust and they want the trust to borrow $300k to invest in the sharemarket. They expect the trust to initially run at a loss, but turn a profit in a year or two. So, they want to distribute the losses to the high income earner, then in due course, distribute the profits to the high income earner.

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Actions:

Millie buys 300 000 special income units at $1 each. The trust takes this $300k, borrows another $300k via the corporate trustee, takes the $600k and invests it in the sharemarket.

At the end of it's first financial year, the trust is negatively geared, and the loss is distributed to Millie.

But at the next financial year, the trust is positively geared. So to distribute the profit tax efficiently, the special income units are redeemed by the trust and distributed discretionally to the low income earner, Billie.

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Is that correct, and if so, did Millie have to pay any tax on the selling of her units back to the trust? This is confusing stuff...

Thanks,

Glebe.

 

[NigelW]

YAHTQ? I though that was a small tibetan mountain goat...

See comments below in CAPS (not meaning to SHOUT! ). You can of course do what you want...the key is just to do things in the most tax-efficient way possible under the law...

Hi people,

I have a HDT scenario. Please tell me at what point/s I've got it wrong.

----------

Scenario:

Say Millie Smith earns $100k and Billie Smith earns $50k. Their professions share equal risk profiles.

Now, say they want to give $300k to the trust and they want the trust to borrow $300k to invest in the sharemarket.

OKAY STOP HERE. WHEN YOU SAY "GIVE" PRESUMABLY YOU MEAN THEY WANT TO ACQUIRE $300K OF UNITS ISSUED BY THE TRUST...ALTERNATIVELY THEY COULD JUST GIFT THE $300K BUT THAT'S NOT TAX EFFICIENT.
They expect the trust to initially run at a loss, but turn a profit in a year or two. So, they want to distribute the losses to the high income earner, then in due course, distribute the profits to the high income earner. NO. YOU CANNOT DISTRIBUTE LOSSES. BUT IF MILLIE DOES ALL THE $300K OF BORROWING TO BUY THE INCOME UNITS THEN SHE'LL HAVE THE $21K ODD TAX DEDUCTION PER ANNUM (@ 7% INTEREST ONLY). THIS WILL REDUCE HER TAXABLE INCOME AND SAVE THEM ABOUT $10K IN TAX.
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Actions:

Millie buys 300 000 special income units at $1 each. The trust takes this $300k, borrows another $300k via the corporate trustee, takes the $600k and invests it in the sharemarket. MILLIE SHOULD BORROW THE $300K AS NOTED ABOVE. THE TRUSTEE OF THE TRUST, IN ITS CAPACITY AS TRUSTEE, WILL HAVE BORROWED THE 2ND $300K AND WILL HAVE IT'S OWN DEDUCTION OF SAY $24K (ASSUMING MARGIN LOAN @ 8%).
At the end of it's first financial year, the trust is negatively geared, and the loss is distributed to Millie. THAT IS (IGNORING OTHER EXPENSES) THE DIVIDEND INCOME OF THE TRUST IS LESS THAN $24K.But at the next financial year, the trust is positively geared. So to distribute the profit tax efficiently, the special income units are redeemed by the trust and distributed discretionally to the low income earner, Billie. MAYBE. IDEALLY YOU'D WANT THE SPECIAL INCOME UNITS TO HAVE AN ENTITLEMENT TO SUCH PROPORTION OF THE INCOME OF THE FUND AS THEY REPRESENT OF THE CAPITAL...IN THIS WAY WITH CAPITAL GROWTH (SAY BY REINVESTING DIVIDENDS, PLUS ADDITIONAL GIFTS) THE DISTRIBUTIONS TO MILLIE VS BILLIE WILL SLOWLY EQUALISE. BUT IN THE SHORT-MEDIUM TERM WHY NOT MAINTAIN THE GEARING AND GET GROWTH ON $600K OF ASSETS WHICH WHEN YOU SELL YOU CAN DISTRIBUTE EFFECTIVELY TO BILLY AS IT IS CAPITAL PROCEEDS...???

BEAR IN MIND ALSO THAT HALF THE INVESTMENT COMES FROM THE $300K BORROWED BY THE TRUST SO ALL INCOME FROM THAT PROPORTION CAN BE PROPERLY STREAMED TO BILLIE AND HIS LOWER MARGINAL TAX RATE...
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Is that correct, and if so, did Millie have to pay any tax on the selling of her units back to the trust? YES AND NO. SEE ABOVE. MILLIE WOULD IN TIME PROBABLY JUST REDEEM HER UNITS FOR THEIR COST PRICE...
This is confusing stuff... YEAH T'IS. BUT DON'T BE DISCOURAGED YOU'RE WAY OUT IN FRONT IN TERMS OF AWARENESS AND KNOWLEDGE THAN MANY ACCOUNTING AND LEGAL PROFESSIONALS. YOU DO NEED A GOOD ACCOUNTANT AND LAWYER THOUGH. THE FORUM HAS VARIOUS RECOMMENDATIONS.
Thanks,

Glebe.

 

[Glebe]

Thanks Nigel. I'm still confused, the borrowing part baffles me - I'm going to re-read a bit of Trust Magic tonight and get back to the forum tomorrow.

 

[NigelW]

Thanks Nigel. I'm still confused, the borrowing part baffles me - I'm going to re-read a bit of Trust Magic tonight and get back to the forum tomorrow.

Just think of it like borrowing to by an IP in your own name - you borrow money from the bank to buy a house which will produce rent. As a result the interest you pay the bank is deductible.

With a HDT, you borrow money from the bank to buy the units which entitle you to receive the income produced by the house which the trust buys uses the money from the "sale"* of the units to you. As a result the interest you pay the bank is deductible.

*(it's not a sale but an issue ie a creation of the units...but let's not bog down for now.)

From memory there's some good diagrams in Trust magic which describe the process.

Cheers
N.

 

[Glebe]

Thanks Nigel.

I've read your posts a few times, searched the forums, re-read the HDT chapter in Trust Magic...

I get the way it works to borrow for an IP:

1. The bank lends $300k to Millie.
2. Millie buys 300k units in the HDT.
3. The HDT uses $300k to buy IP.
4. The trust draws a profits, distributes to Millie.
5. Millie's distribution is less than the cost of her borrowing.
6. Difference is her negatively geared tax deduction.

But I've done lots of searches and can't find people taking out margin loans and investing through a trust. I don't get how they do it! It can't be the same! With a margin loan, if I am not mistaken, Millie would be providing the bank with $300k, and whilst they lend her $300k, they don't actually give it to her. The $600k appears on their systems so they retain control over what I invest in and what LVR's I'm at.

So if that is right, how does Millie get $300k of borrowed money to buy 300k units?

The more I probe the dumber I feel!

 

[Mry]

So if that is right, how does Millie get $300k of borrowed money to buy 300k units?

By getting it through a normal loan in her own name rather than a margin loan. Of course Millie's asset position would have to be rather good since there would not be any specific assets in the trust it could secure itself against, and certainly none that it could register a charge against. I suppose you could sign a guarantee saying that the assets of the trust would be available to repay the loan should it default but you would need a VERY understanding lender to even contemplate that scenario and that lender would have to understand that they would be playing second fiddle to the margin loan lender.

My concern is that you would have to make sure there was distributable income after taking out the margin loan interest deduction in the trust. You could lose negative gearing benefits if the interest is higher than the income. Of course, you could deny yourself some of the interest deductions so that the distributable amount was at least $1 and then transfer that into Millie's name for her to claim the other $300k interest against but you would lose the non-claimed interest. It may also attract attention from the ATO, receiving $1 in income and claiming $21,000 against it.

 

[DaleGG]

HI

Some banks will use the new property bought by the trust as full or part security for the lending if the trust is buying property. Banks refer to this as "third party lending".

If the trust is buying shares, then, the bank will look for security from the individual which may or may not include existing shares owned by the trust.

I understand that this is not something that all banks will consider.

Dale

 

[NigelW]

Thanks Nigel.

I've read your posts a few times, searched the forums, re-read the HDT chapter in Trust Magic...

I get the way it works to borrow for an IP:

1. The bank lends $300k to Millie.
2. Millie buys 300k units in the HDT.
3. The HDT uses $300k to buy IP.
4. The trust draws a profits, distributes to Millie.
5. Millie's distribution is less than the cost of her borrowing.
6. Difference is her negatively geared tax deduction.

But I've done lots of searches and can't find people taking out margin loans and investing through a trust. I don't get how they do it! It can't be the same! With a margin loan, if I am not mistaken, Millie would be providing the bank with $300k, and whilst they lend her $300k, they don't actually give it to her. The $600k appears on their systems so they retain control over what I invest in and what LVR's I'm at.

So if that is right, how does Millie get $300k of borrowed money to buy 300k units?

The more I probe the dumber I feel!

Not dumb at all. It has nothing to do with smarts, its purely a matter of experience and being exposed to particular types of knowledge... (I know nothing about brain surgery for example...altho on occasions it has been suggested I should have my head examined )

I'll use your steps from above to demonstrate:

1. The bank lends $300k to Millie.
2. Millie buys 300k units in the HDT.
3.1 The HDT says to the margin lender - hey we've got $300k in cash which we're gonna invest in that fantastic Navra Blue Chip Wholesale Fund (or to buy XYZ shares directly).
3.2 The margin lender says - that's such a great fund/share I'll lend you up to 70% on the security of those Navra units/XYZ shares you're going to buy.
3.3 <lots of really annoying paperwork, including you selling your left kidney and first born child to the margin lender (they also take a charge over the units/shares to be acquired )>
3.4 You decide what LVR you're comfortable with - let's say 50% on margin..
3.5 The margin lender on-forwards your application for $600k worth of units to NavraInvest/you use your on-line account to buy $600k of XYZ shares
3.6 You get a great distribution each quarter/you get XYZ dividends twice a year
4.1 The trust draws a profits, distributes to Millie half of the distributions/dividends (cause only $300k of the money is from her unit subscription, the other half is from the trust borrowing against the NI units/XYZ shares)
4.2 The trust distributes the other half of the profits to Billie cause he's on a lower tax rate...
4.3 Remember that the trust will have had to pay the interest on the margin loan which is a deduction it has against the income of the trust, namely the NI distributions/XYZ dividends
4.4 maybe things can get even better by using the franking credits, if any, on the advice of your very clever accountant...
5. Millie's distribution is less than the cost of her borrowing.
6. Difference is her negatively geared tax deduction.

So it's just the same...

ps. the more conservative amongst us will note this is effectively a "double gearing" strategy, ie Millie's using her property equity to get her $300k and then using the asset purchased with that money as security to get another $300k. Just like using your equity to buy the next IP...ie leapfrogging as some people call it. It's a strategy which must fit your risk profile and isn't for everyone but certainly gets your assets out there working for you so you perhaps don't have to

Cheers
Nigel.

 

[Glebe]

Nigel,

Things are good, I understand everything you wrote. But I think I've sent you down the wrong path

In my scenario Millie doesn't want to double gear - in fact she can't - because she has no property. All she has is $300k and all she wants is to get another $300k for a margin loan. But she wants it to go through the trust so she has a choice as to distribute the losses/profits as she sees fit.

So using your steps, which were fantastic for me I might add, we have:

1. Millie buys 300k units in the HDT.
2.1 The HDT says to the margin lender - hey we've got $300k in cash which we're gonna invest in that fantastic Navra Blue Chip Wholesale Fund (or to buy XYZ shares directly).
2.2 The margin lender says - that's such a great fund/share I'll lend you up to 70% on the security of those Navra units/XYZ shares you're going to buy.
2.3 <lots of really annoying paperwork, including you selling your left kidney and first born child to the margin lender (they also take a charge over the units/shares to be acquired )>
2.4 You decide what LVR you're comfortable with - let's say 50% on margin..
2.5 The margin lender on-forwards your application for $600k worth of units to NavraInvest/you use your on-line account to buy $600k of XYZ shares
2.6 You get a great distribution each quarter/you get XYZ dividends twice a year
3.1 The trust draws a profits, distributes to Millie half of the distributions/dividends (cause only $300k of the money is from her unit subscription, the other half is from the trust borrowing against the NI units/XYZ shares)
3.2 The trust distributes the other half of the profits to Billie cause he's on a lower tax rate...
3.3 Remember that the trust will have had to pay the interest on the margin loan which is a deduction it has against the income of the trust, namely the NI distributions/XYZ dividends
3.4 maybe things can get even better by using the franking credits, if any, on the advice of your very clever accountant...
-------------------------

And that part all seems really hunky dory, this is good

But the last two steps:

5. Millie's distribution is less than the cost of her borrowing.
6. Difference is her negatively geared tax deduction.

...are not applicable because Millie didn't borrow, the trust did.

So if the trust runs at a loss, can it distribute the loss to Millie?

And if I invisage the trust being positively geared, it's better if Billie buys the units in the trust isn't it?

I'm getting closer to my goal.. thanks Nigel...

 

[austini]

Hey Nigel,

Thanks for providing such a detailed example. I'm sure there will be a number of members here who are or will be very appreciative of that information.

Cheers - Gordon

 

[Glebe]

Somersoft is an amazing place - select people here go the extra mile. I think it creates a great atmosphere. Regular bums like me get to stand on the shoulders of giants - NickM, DaleGG, Rolf, Nigel, Steve Navra, Acey... I'm priviliged.

 

[NigelW]

Nigel,

Things are good, I understand everything you wrote. But I think I've sent you down the wrong path

In my scenario Millie doesn't want to double gear - in fact she can't - because she has no property. All she has is $300k and all she wants is to get another $300k for a margin loan. But she wants it to go through the trust so she has a choice as to distribute the losses/profits as she sees fit.

So using your steps, which were fantastic for me I might add, we have:

1. Millie buys 300k units in the HDT.
2.1 The HDT says to the margin lender - hey we've got $300k in cash which we're gonna invest in that fantastic Navra Blue Chip Wholesale Fund (or to buy XYZ shares directly).
2.2 The margin lender says - that's such a great fund/share I'll lend you up to 70% on the security of those Navra units/XYZ shares you're going to buy.
2.3 <lots of really annoying paperwork, including you selling your left kidney and first born child to the margin lender (they also take a charge over the units/shares to be acquired )>
2.4 You decide what LVR you're comfortable with - let's say 50% on margin..
2.5 The margin lender on-forwards your application for $600k worth of units to NavraInvest/you use your on-line account to buy $600k of XYZ shares
2.6 You get a great distribution each quarter/you get XYZ dividends twice a year
3.1 The trust draws a profits, distributes to Millie half of the distributions/dividends (cause only $300k of the money is from her unit subscription, the other half is from the trust borrowing against the NI units/XYZ shares)
3.2 The trust distributes the other half of the profits to Billie cause he's on a lower tax rate...
3.3 Remember that the trust will have had to pay the interest on the margin loan which is a deduction it has against the income of the trust, namely the NI distributions/XYZ dividends
3.4 maybe things can get even better by using the franking credits, if any, on the advice of your very clever accountant...
-------------------------

And that part all seems really hunky dory, this is good

But the last two steps:

5. Millie's distribution is less than the cost of her borrowing.
6. Difference is her negatively geared tax deduction.

...are not applicable because Millie didn't borrow, the trust did.

So if the trust runs at a loss, can it distribute the loss to Millie?

And if I invisage the trust being positively geared, it's better if Billie buys the units in the trust isn't it?

I'm getting closer to my goal.. thanks Nigel...

Ahhh I see. A couple of options:

1) as Dale has mentioned, a bank may accept third party security for the loan, ie Millie is the borrower but BM Pty Ltd as trustee of the B&M Family Trust provides the security (namely the shares acquired). It may be an uphill battle to get the margin lender to accept this arrangement though...in my experience they can't think outside the box unless there's big $ involved. (as an aside I've seen Not Another Bank agree to a limited recourse $15m loan to a HNW individual secured only on the $15m worth of shares to be acquired with the loan ie. 100% LVR )

Query whether Millie can get a personal loan (interest rate will be higher than margin loan probably). Query whether the personal loan can be secured by a third party security given by the trust as above. (Conceptually there's no reason why not - it's just like if you get a personal loan to buy a car the bank will take a bill of sale ie a mortgage over the car as security)...this would lower interest rate a bit...
(Another complication is that if it is listed shares to be mortgaged as security then you'll need a sponsorship agreement with the trusts sponsoring broker on the CHESS system for the lender to get effective security)

Altho you'd have to be pretty confident of a good return to borrow at say 11%+ on a personal loan (even considering that Millie's tax rate may reduce this to effectively 5.6%)...

Query whether the CommBank/Colonial "portfolio loan" concept may be helpful here...Rolf????

2) if there's just cash then Millie and/or Billie can gift it all to the trust and distributions go all to Billie (with or without margin loan by the Trustee) cause he's got the lower marginal tax rate. Maybe they should then use all that untapped borrowing capacity to buy some real estate with plenty of non-cash deductions through the trust!

Hope that gives B&M some more options. But let's not get too obsessed with tax deductions...

Cheers
N.