Tax Tip 48: Hybrid or Unit Trust with loan in the wrong names

Not many people understand Hybrid or Unit trusts and I have found that many of those using HDTs or UTs do not under stand the basisc. Many think that the interest can be claimed in their personal names just because the trust is called a hybrid or because it is a fixed unit trust etc. This is not the case. It is how the transaction is set up that determines deductibility of interest.

Where a person borrows to purchase units in a hybrid or a unit trust the interest on this loan will be deductible to the borrower if certain conditions are met. One of the conditions is that the units are income producing and that the unit hold has a right to all the income and capital distributions of the trust. If the person is not so entitled then they may only be entitled to deduct a portion of the interest or none at all.

Being able to deduct the interest will enable an individual to claim a loss and negative gear even though the investment property is owned by a trustee of a hybrid or a unit trust.

However, If the loan is not in the individual name then there will be no deduction for the individual because they will not have borrowed to acquire any income producing units. However the trust itself may be able to claim the interest - then any loss will be trapped in the trust.

If the loan is in the wrong name, which seems to happen a fair bit, it doesn’t matter what the reason for this mistake was - the bank got the documents wrong or the broker set it all up wrong. That is all irrelevant under tax law.

Recently I had a client that I did the loan for and we submitted it on the basis of the clients borrowing with the trustee owning the property and providing the security. The loan was all approved on this basis. Documents went out and the clients signed the documents and posted them back to the bank. Then, I discovered that the documents were produced incorrectly and were actually in the name of the trustee and not the clients as borrowers. Had this gone through undetected the client would not have been able to have claimed any interest at all.

Refinancing such a incorrect loan will not solve the problem either. Because the units have already be acquired at this point so it would not be possible to borrow to buy them.

So if you are claiming the interest on a property owned by the trustee of a Hybrid or Unit Trust is the loan in your name?

For a private ruling where someone got it wrong see PBR Authorisation Number: 1011424541485
https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1011424541485.htm

 

How strong is the asset protection of a HD? If a beneficiary purchases units in a hybrid trust, is the value of those units available to creditors of the beneficiary? If the trust can't pay back the units to the beneficiary, would the trust have to sell its assets?

 

It is weak for the bankruptcy of a unit holder. Strong for a discretionary beneficiary on bankruptcy

It will depend on the terms of the trust. Units are property that can fall into the hands of a trustee in bankruptcy. If the unit holder has a right to the income and/or capital that right will pass to the trustee in bankruptcy.

 

Ok. Can the trustee in bankruptcy force the sale of the trust assets to pay the debts of one beneficiary, thus harming other beneficiaries that are not bankrupt and/or involved in the dispute?

 

Depends on the trust deed. If the majority of the unit holders can do this then yes.

 

Say this happens in an open class trust. George, his sister and all his children and grandchildren are the beneficiaries. George owns units, but his children and his sister are simply discretionary beneficiaries. The trust deed says units cannot be paid to beneficiary if that will harm other discretionary beneficiaries. Would this protect the assets of the trust?

 

It would depend on the deed.

If there was a discretionary element in the trustee being able to pay or not pay unit holders then the interest would not have been deductible. The trustee may then choose not to pay income to bankrupt unit holders.

but don't forget clauses in deeds can be void because of s302B Bankruptcy act

see Legal Tip 6: Bankruptcy and Terms in Trust deeds

 

I see. It sounds like putting such a clause there would defeat the purpose of setting up a HD for the tax benefits I.e negatively gear

 

@Terry_w , would it make a difference if the assets are in the name of the corporate trustee as part of a HD, the loan in the name of the trustee, however the beneficiary's are directors of the trustee and beneficiary of the HD?

 

A difference to what?

If a unit holder were to end up bankrupt their assets would fall into the hands of trustee in bankruptcy (creditors). So the creditors would now own the units. The unit holder would have borrowed from a bank to buy the units, but the security for this loan is the property. The director of the trustee would need to change because bankrupts cannot be directors.

The change in director's and the bankruptcy of a unit holder would also cause a breach of the mortgage agreement so the loan would need to be renegotiated.

The debt of the unit holder is still owed to the bank and the trust assets have been used to secure this loan so the trust assets may need to be sold to pay this debt out.

It would be very messy.

 

If its neg geared then the trust would accumulate losses. This loan arrangement is now the norm for banks. They want to lend to the legal owner ONLY. So they expect that the solo borrower be the Corporate Trustee. The old days of the human unitholders seeking finance and the trustee giveing security for the unitholders borrowing has changed.

There are way around this but it can be difficult especially where high leverage is needed.

I have also seen loan covenants that prevent changes to the Corporate Trustee.

 

I am doing a loan right now for a person with the property owned by a company as trustee - St G are still good at this.

 

Tax implications aside, using a Hybrid Trust to hold property is probably going to be detrimental to building a larger portfolio. For the most part, lenders don't like Hybrid Trusts and they won't lend against them, I can only think of two right now that will and they've both changed their policies on this several times in the past.

There's not much point in using a HDT as an ownership structure if it won't allow you to borrow against the property.

 

I understand banks don't like lending to HDs. But I think there is still merit in setting up a HD to buy property and be able to negatively gear on the first years when your expenses are higher until the property becomes positively geared and you can convert the HD into a standard DT.

 

@Terry_w , Thanks for your feedback. It definitely sounds like a problem if there's a bankruptcy involved.

@Paul@PFI , this is my experience with HD's. Our current lender (one of the majors) had no problem with the HD however they reviewed the trust deed and requested additional reports to satisfy themselves that everything was in order.

 

If the units are correctly financed I agree provided the deed complies AND you don't breach the Commissioners views when you redeem etc. Also that the non-arms length finance of the units is actually correctly settled...You would be shocked how many people think its OK to skip that step. The ATO can then consider the units were not settled and the trust is effectively a discretionary trust.

In NSW it doesn't usually work due to the land tax problem but that can be taxpayer specific. Peter has clearly described the difficulty in actually achieving this outcome as finance is very difficult if its even available. Ther are some hybrid trusts still floatinga round with income retention clauses which IMO is a serious concern - I would think it means the trust does not give a fixed right to income so the taxpayer cant deduct interest.

Investors with access to equity elsewhere may find it far easier to use a HDT than a geared borrower who is bound to have the trustee borrow the bulk of the $

 

Was it a MGS deed. I have seen better acceptance of them v's others.

 

It is not that lenders don't like hybrid trusts, but the fact that they do not like lending to non legal owners of a property used as security.

 

I agree with your logic. HDTs can be terrific tools. The best tool is moot however when nobody at all is willing to service that tool.

If you invest through a HDT your choice of lenders will be sevearly restricted, and there's every likelyhood that the available lenders will implement further restrictions in the future. In this case the restriction tends to be, they simply won't deal with HDTs, no exceptions.

 

This will depend how it is structured.