Legal Tip 257: Dangers of having a friend act as trustee and mortgage your property

Discussion in 'Legal Issues' started by Terry_w, 9th Dec, 2019.

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  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    Legal Tip 257: Dangers of having a friend act as trustee and mortgage your property



    There is a dangerous strategy being promoted out there where someone sets up a trust, gets a friend to act as trustee and then have the friend take a mortgage out over the ‘equity’ in your property – to secure a ‘debt’ which has a whole lot of tax issues ( a post for another day). They alternative is to gift to the trust and borrow it back with the trustee taking a mortgage (often the gift will fail where the asset is not transferred to the trustee, but this is also a topic for another day).

    There are a large number of legal issues with this strategy, and its variation..


    One of these legals issues is the risk that your friend, the trustee, will be attacked. This could happen in 2 ways


    a) Death

    If your friend dies someone in their family could make a family provision claim against their estate. Under NSW law this could lead to a ‘notional estate order’ which is an order against property that they don’t own, but control. This includes assets held as trustee, s 76 Succession Act NSW 2006.


    b) Family Law

    If the friend goes through a marriage or defacto separation their former spouse can make a claim for a property settlement. The Family Law Act empowers Courts to make orders to rearrange the ownership of property, including properties owned by third parties such as trustees. The court could order the trustee to transfer property to the former spouse for example. The fact that the trustee is not a beneficiary of the trust doesn’t prevent orders being made – see Kennon v Spry for example.

    Note that in this strategy the ‘property’ will be a debt owed to the trust.


    Example regarding death

    Bart sets up a trust and gets his best friend Millhouse to act as trustee. Bart is the appointor and can sack Millhouse and replace him with a new trustee if he goes rogue, but all is going good so far. Bart has $500,000 equity in his property so he lets Millhouse, as trustee, lodge a second mortgage over the property for a ‘debt’ he owes the trust. The idea is that if Bart goes bankrupt the trust will be a secured creditor.

    Millhouse has no assets himself, but he has a spouse and some kids.

    Millhouse has a car accident when his glasses fog up, causing him to crash. He has a will in place, and leaves everything to his spouse. Trust assets don’t form part of his estate, but the spouse makes a Family Provision application as she ‘needs’ more from the estate to help live and bring up the kids. She is an eligible person under NSW law and can make the application. Because the estate doesn’t have enough assets, she asks the court to treat the assets of the trust as part of Millhouse’s estate – a notional estate order. Millhouse was the trustee of the trust and had the power to make a distribution of the trust assets.

    This is the case even though Millhouse may not be a beneficiary under the trust. For NSW law see S 72(2)(a) Succession Act 2006

    SUCCESSION ACT 2006 - SECT 76 Examples of relevant property transactions


    Example Divorce

    As above, but Millhouse survives his crash and his wife decides to leave him. She wants to take as much of his assets as she can. Millhouse is required to disclose his property, including interests in trusts. Millhouse might not be a beneficiary but the trust assets will come up as he is the legal owner of the trust assets and failure to disclose would be non-disclosure.

    Wife can then argue to include the trust property as property of the marriage, and/or a financial resource of a party to the marriage.

    Millhouse will no doubt argue that he was not a beneficiary of the trust – but that is also what Dr Spry argued when the court ordered the trustee of ‘his’ trust to pay his wife.


    The risks of both of these might not be high, but for those trying to implement this strategy have you sought legal advice on this aspect?

    One more aspect of risk is:

    c) Going Rogue

    Other risks are that the Trustee friend goes rogue. This is where the trustee tries to ‘rip you off’. At law a trustee cannot follow orders of another person. This is known as ‘fettering their discretion’. They can’t do it.


    You as a discretionary beneficiary can request they lend you some money that you have gifted to the trust. They don’t have to say yes though. As the trust is a discretionary trust there will be 100s or more potential beneficiaries, just like you. Guess what? They can also request to borrow money too. The trustee might lend them over you. The trustee might even distribute capital of the trust to others.


    The trustee could be doing all of this legitimately too, so you could not sue them for not following orders or for lending or giving assets to other beneficiaries as they would be empowered to do this. The deed could be changed to prevent this, but then the trust would not be a discretionary trust and before more like a fixed trust which means the asset protection benefits are lost on bankruptcy of yourself.


    There is also a chance that the trustee really goes rogue. They could start stealing from the trust – directly or making interest free loans to themselves or their relatives – the deed may even permit these loans.


    Finally, they might refuse to remove the mortgage from your property if you wish to sell. The mortgage would be there securing a debt. You have borrowed from the trust to pay your living expenses so have consumed this money. You probably would be unable to repay the loan to the trust to enable the mortgage to be discharged so you could not even get the courts to order the removal of the mortgage. Your only hope here would be to try and remove the trustee using the appointor powers. But then the title of all the trust assets would need to be changed as well, a bit of a hassle.


    In Summary

    I wouldn’t be gifting money to a discretionary trust where a friend was acting as trustee, and I would not be asking that friend to mortgage my property.
     

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