REAL ESTATE AGENTS UPDATE SEPTEMBER 2011
There have been a number of changes to the taxation system this year which will be of particular interest to property owners and investors. One of these is the abolition of gift duty. This long-overdue step makes it opportune to review the status and usefulness of family trusts for property owners.
FAMILY TRUSTS
A Family Trust remains a useful device for financial planning, despite the abolition of gift duty from 1 October 2011. The ending of gift duty does not affect rest home subsidies (for which a gifting programme is still required), gift duty could be reintroduced by a future Government, and there remain many other benefits from divesting personal assets, potentially including the avoidance of any future capital gains tax.
Setting Up
A Family Trust is created by the settlor signing a Deed, appointing Trustees and setting out the terms and conditions for the management of the assets that the Trust will own. The settler can then sell or gift assets to the Trust. Once assets are in the Trust, they are controlled by the Trustees appointed in the Deed. Any increase in the value of the assets transferred to the Trust, e.g. property or shares, belongs to the Trust, not to the settlor.
Transferring Assets
Assets can either be gifted or sold to the Trust. Until 1 October 2011 the maximum value which could be gifted without incurring gift duty was $27,000.00 a year. Assets must be sold to the Trust at market value, leaving the price owing as a debt back which could only be reduced by gifting up to $27,000.00 each year. After 1 October the gifting programme may be completed by one deed of forgiveness of debt, as there will be no limit to the amount which may be gifted tax free in any one year. However we note that a gifting programme may still be necessary in many cases.
Tax
Transferring income-producing assets to a Family Trust can be an effective way to spread income to other members of the family, and reduce taxable income. The tax rate payable on trustee income is 30%, which may be lower than the beneficiaries nominal tax rates. There are however now IRD rules which limit income splitting for this purpose.
Procedure for creating a Family Trust
The steps involved in setting up a trust can be summarised as follows:
1. A Family Trust is settled, by the signing of a Deed of Trust.
2. Assets presently held by the individual settlor (or settlors in the case of a couple acting jointly) are then sold to the trustees, in exchange for acknowledgements of debt of equivalent value. The assets must be sold at market value. Evidence of this market value must be held on file.
3. The debt back becomes the settlor’s asset, but this can then be forgiven to the trustees, thus achieving a total divestment of assets in favour of the Trust over a period of time.
Until 1 October 2011, each individual could gift $27,000.00 every 366 days without any liability for gift duty. There was a sliding scale of gift duty between $27,000.00 and $72,000.00 per annum, incurring a liability of $5,850.00 at $72,000.00. Gifts in excess of $72,000.00 per annum incurred gift duty at 25%. If no gift duty was to be paid – i.e. the debt is forgiven at only $27,000.00 per annum, the divestment process could take a long time. After 1 October 2011 there will be no gift duty, and the debt back may be forgiven in its entirely in one step.
4. If the individual’s Will is changed so that the Trust becomes the individual’s major beneficiary upon death, the whole value of the individual’s estate at that time will be transferred to the Trust. Gift duty was not payable for gifts by Will. A Will should also have provided that any outstanding debt back is forgiven.
5. Once the Trust is the owner of all of the assets (even though they have not been fully paid for – as there is a debt back remaining), any increases in value will accrue to the Trust Fund. All income previously derived by the individual from these investments will be derived by the trustees in the first instance, and can then be dealt with in a variety of tax-effective ways. Settlor’s need not be deprived of the use, nor benefit, of assets sold to a trust.
Income-testing or asset-testing for benefits or rest home subsidies will have little or no impact on a technically asset-less person. Furthermore, the creditors of an individual will have no claim upon the Trust’s assets, and will have no means to recover monies from an individual if the individual is asset-less – or if their major asset is an unsecured acknowledgement of debt. However WINZ rules only allow a certain level of gifts for the five years preceding the application (currently $6,000), and only $27,000 per annum before that. It is not currently proposed to change this rule. Accordingly if WINZ considerations are relevant a gifting programme should continue, notwithstanding the abolition of gift duty.
The Trust Deed
It is important that the Trust Deed is carefully drawn to provide:
1. That the individuals who have divested their assets to the Trust retain a significant degree of control over those assets. However they should not have unfettered control or the Trust may be deemed to be a sham.
2. That as a discretionary beneficiary the individual has the prospect of deriving benefit from the assets. This will include access to the income and capital where necessary, and the ability to reside in any house owned by the Trust.
3. If two or more individuals are divesting assets into a single Trust, then the Trust might need to be structured in a way which leaves each individual comfortable that the objectives of the Trust will be met, during their lifetime, after the individual’s death, and – for a couple – in the event of separation.
4. For those who have complex personal circumstances, the one Trust can be the vehicle under which several funds are administered with different objectives, and different final beneficiaries. The same issues as to beneficiaries have to be addressed as should be addressed for an individual’s Will.
Transfer of the Home
Traditional the divestment process could be accelerated if the home is made subject to a Lease to Occupy in favour of the settlors as a term of sale to the Trust. The Lease to Occupy had an actuarial value which was deducted from the market value of the property. This would reduce the amount of the acknowledgement of debt, and thus the length of the gifting programme (should one still be required).
The owners would through this mechanism convert the value of the home into two assets which in total have the same value, namely an Acknowledgement of Debt and a Lease to Occupy. The Lease had a very real value for the individuals, but is of no worth to creditors.
Indicative values for the Lease to Occupy are as follows:
Females: Age 40: 82.42%
Age 60: 59.50%
Males: Age 40: 79.66%
Age 60: 54.60%
The disadvantages of a Lease to Occupy are its complexity, and that it had to be surrendered on the sale of the house. Sometimes acknowledgements of debt are secured by mortgages over the property. This creates an additional risk in that if the mortgagee (the settlor) was bankrupted, the Official Assignee would acquire control over the mortgage, and could require the Trust to repay the balance of the debt which had not already been forgiven. As the debt was secured by mortgage this could result in the forced sale of the property, and defeat the purpose of creating the Trust in the first place.
As gift duty is being abolished, we recommend that any remaining leases to occupy be surrendered after 1 October, and any associated mortgages be discharged. A new gifting programme can be commenced, if required.
General Observations
1. Trusts are not “all or nothing” exercises. Individuals can decide to divest certain assets to the protective umbrella of a Trust, and retain other assets for individual management and control. It is usual to retain family chattels and some “petty cash“, and to transfer assets which are likely to increase in value. There is no significant disadvantage in transferring most personal assets to a Trust.
2. If an individual expects to receive inheritances it makes sense for the will-maker to substitute the Trust as their beneficiary in place of the individual. Otherwise property once received would have to be transferred to the Trust. Furthermore if those assets go direct to the Trust, and are never owned by the individual, the individual cannot be said to have voluntarily deprived himself or herself of an asset (which can be relevant in bankruptcy or relationship property claims).
3. In the simple case of a couple have both died, their children who would otherwise have inherited property and other assets under the Will of the last to die are instead beneficiaries of a Trust which holds all of the subject assets. Each of the children can make individual choices as to whether or not they take their “inheritance” (in whole or in part) out of the Trust. It would be quite common to re-settle their respective interests on separate Trusts, so they would retain the protection of not “owning” the assets (and never having owned the assets), but not be involved in each others affairs on an ongoing basis.
4. Inherited property is separate property under the Property (Relationships) Act 1976, and it does not fall for division in the event of a separation. Separate property can however be converted into relationship property during the course of a relationship, depending upon the way in which it is managed. Once it has been so converted it falls available for division. Property held under a Trust in which the individual has an interest only as a discretionary beneficiary does not fall within the scope of the Property (Relationships) Act 1976 at all. If, for example, inherited property was used to upgrade the family home then effectively one-half of the amount so used would be claimable by the partner. If, on the other hand, the trustees lent the couple the amount required to upgrade the family home, that would be a loan which was repayable (even if not interest-bearing), and accordingly not merged into relationship property.
5. The benefits of the arrangements described above flow from generation to generation. There will be an ultimate saving in estate administration costs. Where there are non-income earners in the family unit, whether spouses or children or other discretionary beneficiaries, and there is investment income being derived, then advantage can be taken of the lower tax rates applying to those beneficiaries on low incomes. Use can be made of this fact to pay school fees in certain circumstances on a “no tax paid” basis. Charitable beneficiaries can receive tax-free income.
6. In dealing with specific assets particular considerations can arise depending upon an individual’s circumstances, e.g. GST consequences, and assessments under the Income Tax Act. An individual might have the freedom to deal with land which had been owned for ten years, but such freedom would not be enjoyed by trustees who had recently acquired the land. There may be depreciation clawback, or the deductibility of certain interest payments might be lost, or have to be carefully preserved. Private company shares might have to be dealt with carefully to preserve the availability of tax losses and/or imputation credits.
The abolition of gift duty
There have been rumours for many years of the abolition of gift duty. Gift duty has existed since 1885. Its original purpose was to protect the revenue base by discouraging the gifting of assets prior to death. However once estate duty was abolished in 1992, the rationale for gift duty largely disappeared.
Gift duty was retained as a “temporary” measure to protect against income tax avoidance, support welfare benefit targeting (particularly the Residential Care Subsidy) and to protect creditors. However reduction in income tax rates, and the reduction in means testing, has reduced the need for this measure to protect the integrity of the revenue. Furthermore the Inland Revenue Department has determined that the protection of creditors offered by gift duty is overstated, and acknowledges that the cost of administering the duty is high. The direct cost to the IRD was only $430,000 per annum, but the cost of compliance (gifting programmes) was estimated at over $70 million a year. The total gift duty collected averaged only $1 million per annum.
Legislation was passed in August to abolish gift duty. The abolition will take effect from 1 October 2011.
There may be additional measures introduced after 1 October, if the Government sees a need for greater protection of creditors or the revenue. It is possible that there will be some additional measures to strengthen creditor protection under the Insolvency Act 2006, the Companies Act 1993, or the Property Law Act 2007. Accordingly we would recommend that settlors with outstanding debts should gift these immediately after 1 October 2011, unless there is a need to maintain a gifting programme.
Prospective investors in residential property often transfer their own homes to family trusts at the time of purchasing the investment property. Traditionally this would mean commencing a gifting programme. A programme can take years to complete. Until it is completed the residual debt back is an asset of the settlor.
If a settlor of a trust were to be bankrupted whilst a gifting programme was underway, the programme would likely be scrutinised by the Official Assignee. Once gift duty is abolished gifting will occur on one occasion, with no ongoing programme. Unless an asset has been transferred to a trust within two years, the likelihood of a gifting being investigated is greatly reduced by the abolition of gift duty. Given that the gifting programme does not stretch out for decades, personal bankruptcy is less likely to result in gifts being scrutinised by creditor, or recovered by the Official Assignee.
The abolition of gift duty will create a “window of opportunity” to obtain the protection of a Trust with a much simpler structure.
If avoidance of rest home subsidy restrictions are the primary or a major reason for establishing a Trust, it may be appropriate to continue with a gifting programme. Similarly, if a programme has been largely completed the process should be continued notwithstanding the abolition of gift duty.
Conclusion
A Family Trust is not the right option for everyone. There are many considerations, and other ways of managing assets e.g. Relationship Property Agreements. Nevertheless, in preparing financial and estate plans, and when buying or selling real estate, we believe that it is worthwhile considering a Family Trust.
Please feel free to discuss any of the above matters directly with John Cox.