There's a common saying that you should ‘begin with the end in mind’ - this is especially true for property investment.
The problem is that too many investors begin their investment journey without considering what will be the best ownership structure.
Without much thought to it, they put their entire portfolio in their personal name.
This might be perfectly acceptable in many circumstances, but there are other options out there that might be more beneficial.
Such as a family trust, for example.
In this article, I’ve detailed everything you need to know about family trusts, including how to set one up, why you might use one, and all the benefits and risks of doing so.
In the beginning, it can be a little tricky to understand the ins and outs of family trusts so here’s a very basic explainer:
A family trust is a trust set up to hold a family's assets or to conduct a family business.
Generally, they are established for asset protection or tax purposes.
Who can be beneficiaries of a family trust?
A beneficiary of a family trust is someone who can benefit from the assets held in the trust.
This can be a person, a company, or even the trustee of another trust.
A trustee of the family trust can also be a beneficiary so long as they’re not the sole beneficiary.
Generally, in most cases, the trustees of a family trust are usually the parents, and the beneficiaries would be their children, grandchildren, or even their parents.
How does family trust work?
A family trust in Australia works in a similar way to a bank account.
A parent can open a bank account for their child, which then belongs to the child but is ultimately controlled by the parent.
A family trust works in the same way.
A parent may set up a family trust and name their children the beneficiaries of the trust, thereby giving them entitlement to income and assets within the trust.
Like any type of legal documentation, setting up a family trust does cost money.
In fact, the initial start-up cost can be about $2,500 and then the same amount again annually in maintenance-type fees.
These types of ongoing costs are necessary because there are significant rules and regulations around family trusts, including meeting the requirements for asset protection and all the Australian Taxation Office registrations on ABN as well as Tax File Numbers.
Family trusts can also attract stamp duty with the cost varying from state to state:
- WA – Nil
- ACT – Nil
- NSW – $500 (due 3 months from the date of the deed)
- NT – $20 (60 days from the date of the deed)
- QLD – Nil
- SA – Nil
- TAS – $20 (due 3 months from the date of the deed)
- VIC – $200 (due 30 days from the date of the deed)
Tax rates for family trusts
There are not just the setup costs to consider, trustees in a family trust are also liable to pay tax on any income they get from the trust.
Adult and company beneficiaries pay tax on their share of the trust's net income at the tax rates that apply to them.
And tax also needs to be paid on undistributed income.
If the trust income is not fully distributed to beneficiaries, whether it's by choice or not, the trustees have to pay tax on the income retained in the trust at the top marginal rate of 45%.
Then there are beneficiaries who aren’t Australian residents - when trust income is distributed to someone who isn’t a resident, the trusts have to pay tax on their behalf.
Trustees also have to pay tax on behalf of beneficiaries who are under the age of 18, which is usually at the top marginal tax rate of 45% (where the minor receives $1,308 or more).
Why so much?
Well, the high tax rate was put in place to deter families from making trust distributions to minors.
There are seven key steps when it comes to setting up a family trust in Australia and done right, it’s a fairly simple process.
1. Choose a trustee and beneficiaries
First of all, obviously, you need to choose a trustee and decide on the beneficiaries of the fund.
Given that the trustee is the legal person or entity responsible for administering the trust in line with the trust deed, it's an important role.
2. Create a trust deed
You’ve assigned your trustee and decided on the beneficiaries, so the next step is to create a deed of trust.
The trust deed is basically the terms and conditions of the family trust.
It’s the legal agreement that sets out how the family trust will operate and how the trustee will need to administer the family trust.
Given each trust deed needs to be created according to the financial goals of your family trust, it’s best to get financial advice at this step.
3. Settle the trust deed
The trust deed then needs to be signed by a settlor (the settlor can’t be related to the beneficiaries of the trust).
The settlor will then sign the trust deed and give an initial settlement sum to the trustee.
4. Hold a trustee meeting
Once the family trust deed has been settled, the trustees and beneficiaries should have a meeting to formally accept their roles in the trust and agree to be bound by the terms and conditions of the deed.
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5. Lodge a trust deed and pay stamp duty (if applicable)
The trust deed needs to be lodged for assessment with the revenue office in the state or territory where the trust was created.
Trust deeds in some states also incur a stamp duty, which needs to be paid by a set date.
For example, in NSW there is a $500 stamp duty fee that needs to be paid within three months for each new discretionary trust.
In Victoria, the stamp duty fee is $200, due within 30 days, in the Northern Territory and Tasmania the fee is $20, due within 60 days and 3 months respectively.
6. Apply for an ABN and TFN
The next step is for the trust to apply for an Australian business number (ABN) and a tax file number (TFN).
An ABN registration usually happens instantly while a TFN can take up to 28 days - both can be completed online.
7. Open a trust bank account
The final step in setting up a family trust is to open a bank account in the name of the trustee.
Then the settlement sum can be deposited into the bank account, at which point the family trust is then operational and other transactions, deposits, or investments can occur.
Family trusts offer a variety of benefits, that's why plenty of people choose to set one up.
Some of the benefits of setting up a family trust include:
- Asset protection – such as the ability to buy a house for a child to live in without ownership being forfeited because the ownership remains within the trust.
- Minimising tax – trust distributions means lower incomes for tax purposes.
- Planning for retirement savings – the flexible structure of trusts presents an opportunity to accumulate wealth that can supplement superannuation savings.
- Flexibility to invest in property – unlike super, holding assets within a trust doesn’t have the same strict rules.
- Capital Gains Tax (CGT) – family trusts have CGT advantages compared to companies. This is because the 50 per cent discount factor on capital gains received for assets retained for at least a year applies to trusts but doesn't apply to companies.
One of the major risks or disadvantages of a family trust is that it can't distribute capital or revenue losses to its beneficiaries. As a result, should a trust incur a net loss, its beneficiaries won't be able to offset that loss against any other assessable income that they may derive.
Other risks and disadvantages to setting up a family trust can include:
- Tax risks – tax avoidance can be a risky business and a tax accountant should be consulted before you unknowingly get yourself in trouble.
- The name holding the assets – the trustee is the legal owner and this individual’s name will appear across all documentation.
- Loss of ownership of assets – personal ownership of property is lost when managed through a trust.
- Additional administration – this costs time and money long-term.
Of course, with any type of legal documentation or taxation advice, it's always advisable to consult the experts to best understand your individual situation.
Unfortunately, if incorrectly used, a Family Trust can create serious financial repercussions.
The secret is understand what these are at the outset to ensure you're not one of the people who makes one of these common mistakes.
1. Taxes on foreign income distribution
Various state governments have introduced additional real estate stamp duty and land tax applicable to foreigners.
The thing is the definition of a foreigner is very broad.
Family trusts allow for a very flexible distribution of income to a wide variety of people in your family group.
Plus, this income distribution can range from nil to all of the trust income in any year.
What this means is that if the beneficiaries have a relative who is a foreigner, that person would be entitled to be considered for a distribution.
Under recent legislation, therefore, the various state governments would see this as falling within the foreigner category and would apply the higher taxes to the trust.
Note: An actual trust distribution does not need to be made to the foreigner!
The mere fact that it is possible to make such a distribution is enough to be caught out.
Fortunately, there is a solution that ensures that your Family Trust is not impacted by the new State foreign ownership rules - if the right clauses are included.
2. Trust loss lessons
A Family Trust allows for the distribution of income to any family member.
However, if the trust has a loss it is trapped inside of the trust and needs to be funded with after-tax income.
This is because the use of this type of trust does not push down losses to a taxpayer to claim against their PAYG income.
As an example, if the trust holds a property where the rent is insufficient to cover interest and other costs – so it's negatively geared – then the loss is trapped inside.
The bank and other suppliers still need to be paid but this is achieved without getting a tax deduction.
Any accumulated losses in the trust are available to offset future profits, including a capital gain.
This issue can be adjusted, with the correct advice and implementation, to allow any negative gearing to effectively flow down to the taxpayer.
The end result being that the losses will be offset against PAYG tax to improve cash flow.
3. Asset protection issues
Family trusts are a great structure for asset protection.
However, in many cases, they are set up with an individual person as the trustee, which effectively neutralises a major component of asset protection.
For example, if the trust is sued, say, by a tenant, the trustee would be at risk, as would any personal assets.
The appropriate trust amendment can fix this but if not correctly implemented it could trigger a full stamp duty event.
[note]Family trusts can be a valuable tool, especially for families who want to share the financial fruits of their success.[/notes]
However, it's vital that you access professional advice before considering whether Family Trusts will benefit your long-term wealth creation and protection goals.