As an investor’s portfolio grows, it’s important to start thinking about legal structures for property and other investments, with the goal of minimising risks while maximising profits. Figuring out the right structure is no easy task. Investors should focus on creating long-term strategies (20-30 years) and not focus solely on the short-term. A common approach used by many is to create either a trust or company as a way build a solid foundation. Once a structure has been set up, it can become very costly and time-consuming to reorganise. Investors would need to pay stamp duty again and their capital gains tax would diminish greatly.
A discretionary trust is the most common method used by investors when setting up a structure. Trusts are different to companies in that a trust is an agreement between beneficiaries who have ownership of certain assets as dictated by an agreement. Each discretionary trust must have a ‘trustee’ who is either a person or company who manages the property on behalf of all the beneficiaries, as there needs to be a legal entity owning the property. More often than not, the trustee is set up as a proprietary company for legal and tax reasons.
Opting for a trust has several advantages including tax incentives, protection against assets and better planning options.
How a trust works
In a trust, the property will be owned by the trustee and not the trust. The name on the deeds of the property will be the trustee. When taking out a loan for the property, it must also be done in the trustee’s name. This can be under their company or even the trustee’s actual name when implementing a ‘hybrid’ trust (we will discuss this later).
Let’s create a common scenario to better explain a discretionary trust. Bob is an investor who owns his own house in his own name. The new investment property Bob wants to buy is valued at $500,000 and he has taken out a loan of $100,000. As this is Bob’s first ever investment, he has been advised by experts to set up a discretionary trust.
Bob’s first step is to create a lending facility to leverage the equity in his existing home to put down a deposit of 20% plus costs for his new investment. As Bob lives in Sydney (remember each state will have different costs), his costs will be around 4% ($20,000), meaning he would need a loan for $120,000 (20% + costs).
It’s quite possible for Bob’s lender to give the $120,000 loan straight to the trustee of his newly created trust, however, this would depend on who the beneficiaries are.
Since the property is worth $500,000, Bob now needs to get pre-approved for another $400,000 in order to buy the property. This loan will also be in the trustee’s name. However, since the trust is new and there is no proof of stable income the loan must be guaranteed by the director(s) of the trustee. Meaning the structure of this loan would look very similar to this:
Name on loan: Trustee
Guarantor of loan: Director(s) of the trustee.
Bob pays 10% upfront as a deposit and, once the loan is settled, will pay the remaining 10% plus costs. The bank will then create the new lending facility in the name of the trustee company and release the funds. Setting up this kind of structure has two major benefits. They are:
No cross-securitisation – The loan is not cross-secured meaning Bob’s assets are not combined with the loan, which acts as a safeguard if the investment doesn’t go as planned.
No mortgage insurance – As the total loan amount is less than 80% of the property’s value, Bob is not required to take out mortgage insurance.
Other structures include taking out a loan of 100% plus costs in the name of the trust, although we strongly advise against this. Why? Because it means the loan is cross-secured which brings greater risk and merges the investor’s personal assets with their investment.
Note: Some investors choose two separate lenders for their home loan and their investment loans. This method will be impossible when taking out a loan of 100% plus costs.
Understanding directors and beneficiaries
To obtain a loan from a lender, each loan needs to be guaranteed by the director of the trust to ensure they can pay the debt if the trustee cannot make repayments. Lenders only accept a guarantee from a person who is in the trust as either a director or beneficiary.
This won’t be a big hassle for investors who are setting up family trusts. Usually the trust will include all family members anyway. Trusts that involve members outside the family or other entities can limit the serviceability of the trust.
In a hybrid trust, a property is in the trustee’s name but the loan is in the individual’s name (third party). Investors may need to shop around for lenders as only some will allow a third party to be the guarantor of the loan. When putting the loan in the individual’s name, it’s imperative the lender takes rental yield from the property into account as they won’t take into account the serviceability of the guarantor, only the trustee. In a nutshell, the trustee needs to show they can pay the loan themselves, rather than the lender relying on the guarantor (third party) to make the payments.
In Hybrid trusts, the individual and the guarantor is usually the same person and banks will understand this and proceed with the loan. When this is not the case, lenders will not take into consideration the rental yield of a property and investors may be forced to alter their structure.
Note: Before creating a hybrid trust we suggest talking to a professional mortgage broker who has adequate experience with these sorts of trusts.
Trust or Company?
In all honesty, there’s hardly any major differences when creating a company or a trust. There are three types of lenders for investors who are thinking about starting a trust and company, they are:
- Lenders who will not deal with trust or company applications.
- Lenders who treat all trust and company applications as ‘commercial lending’ which means higher costs and less flexibility for investors.
- Lenders who charge no extra costs or fees for trust or companies.
It should go without saying that investors should always go with the third option as it’s the easiest and cheapest.
Setting up a trust may not be suitable for every investor but for some it’s the best way to keep their personal assets separate from their business investments. When structuring any kind of trust or company one should seek the professional advice of other investors, lawyers, industry professionals and so on to get a better understanding of which suits their needs best. If you need help, contact an expert at Red & Co Finance.
**This information is not intended as advice and should be viewed as general information only.