We have previously written about debt recycling and family trusts both of which can improve investment outcomes, primarily through tax benefits. Family trusts also offer additional asset protection advantages.
Some may assume these strategies must be used separately, but they can be combined to further enhance tax efficiency. However, this approach comes with additional risks and costs that must be carefully considered. The advantages and drawbacks of each strategy still apply when they are used together.
Before proceeding, ensure you are familiar with the concepts covered in the previously linked articles. This is a complex strategy and should not be implemented without professional tax advice.
The Mechanics
Debt recycling through a family trust differs from a standard approach in one key way: it requires two loans:
- The first is a redrawn loan secured against the home.
- The second is a loan from the individual to the trustee of the family trust.
The redrawn loan is then on-lent to the trust at the same interest rate. As a result, any personal interest expense is offset by the interest paid back from the trust. This means there is no net change to cash flow or personal tax deductibility.
The key difference is that the only remaining interest expense is paid by the trust, making the trust, rather than the individual, eligible for the tax deduction. This has important implications, which will be explored further.
Before explaining this, first you must understand the process of this strategy:
Step 1: Split Home Loan
As with standard debt recycling, the home loan should be split so that the new loan portion matches the amount you intend to invest.
Step 2: Pay Into Redraw
Funds earmarked for investment should be paid into the new loan split. Some banks may close a loan if it is fully repaid, so it may be necessary to leave a small balance to keep it open.
Step 3: Redraw Money and Loan to Trust
Here is where the process diverges from standard debt recycling. The redrawn funds are transferred to a brokerage account in the trust’s name. This transfer must be structured as a formal loan with commercial terms. The interest rate charged should be at least equal to the interest incurred on the home loan split. This ensures that the personal interest expense is fully offset by the interest received from the trust.
Step 4: Offset Trust Income with Interest Payable
The trust can claim the interest paid on the loan as a tax deduction against its investment income. Any remaining taxable income is then distributed to beneficiaries.
This is generally tax-efficient because the income distributed has already been reduced by the trust’s deductible interest expense. However, there is a potential drawback, trusts cannot distribute losses. If the interest expense exceeds the trust’s investment income, the resulting tax loss is trapped within the trust and can only be carried forward to offset future profits.
Diagram of the Strategy
Benefits
The benefits of each individual strategy mostly remain, the most important being:
Family Trust
- Asset protection through the trust structure.
- Ability to distribute income and future capital gains to lower-income beneficiaries.
- Greater estate planning flexibility.
Debt Recycling
- Turns non-deductible debt into deductible debt.
- This is somewhat different when using a family trust due to the trust itself claiming the deduction but mostly results in the same outcome.
- Does not increase total level of debt if using cash to debt recycle.
The combined benefits become particularly valuable once the loan split is fully repaid, and the trust begins generating significant net income. At this stage, income can be distributed to beneficiaries in a tax-efficient manner.
While an alternative approach could involve building investments in an individual’s name and later transferring them into a family trust, this would trigger a capital gains tax event. By using the trust from the outset, this issue is avoided.
Risks and Disadvantages
Before implementing this strategy, it’s essential to understand the potential downsides and risks involved:
Potential Loss of Negative Gearing Benefits
A family trust cannot distribute tax losses to its beneficiaries. Instead, any losses must be carried forward to offset future trust income.
If the trust’s total expenses, including the interest payable on the loan to you, exceed its investment income, a tax loss will be created. If these investments were held personally, this loss could be used to offset salary or other personal income. However, under this structure, the loss remains trapped within the trust and can only be utilised in future years when the trust has a positive tax position.
This is particularly relevant in the current environment, where interest rates are higher than the average dividend yield of shares. If the only assets in the trust are those acquired through debt recycling, it’s likely that the trust will generate a tax loss, reducing the immediate tax efficiency of the strategy compared to holding investments personally.
If the trust holds additional investments or the yield is high enough, this issue can be mitigated, provided the trust maintains a positive taxable income.
Loss of Franking Credits
This is an extension of the previous issue. While tax losses can be carried forward, franking credits cannot. They are lost if not used to reduce taxable income in the year they are received.
One way to mitigate this is for the trust to claim less than the full amount of interest payable on the loan. However, this is not an ideal tax outcome and reinforces the importance of ensuring the trust generates a taxable income each year.
If the trust has sufficient income to distribute, franking credits can still be utilised. A family trust election (FTE) is generally required if the trust intends to distribute franking credits to beneficiaries who are not directly controlling the trust, like children.
Additional Costs
There are additional costs involved in implementing this strategy, some of which may not be immediately obvious.
- The loan to the trust must be structured on a commercial basis, meaning it should be an agreement that an unrelated party would reasonably accept. To ensure compliance with ATO guidelines, a formal loan agreement should be drafted by a lawyer rather than relying on a generic template. This can cost around $1,000 or more.
- Legally, you cannot contract with yourself. If you are the trustee of your family trust, you technically cannot sign a loan agreement with yourself as an individual. To overcome this, a corporate trustee is typically required, allowing the loan agreement to be properly executed. However, a corporate trustee comes with additional setup and ongoing management costs compared to an individual trustee structure.
Summary
Hopefully it is obvious from this article that debt recycling with a family trust is not a strategy for everyone. While it can enhance tax efficiency and asset protection in some cases, it may be detrimental in others.
This approach is most beneficial when the trust holds additional investments beyond those acquired through debt recycling. A trust that relies solely on debt-recycled funds, without other income sources, may maintain a tax inefficiency compared to just debt recycling in your own name.
It should go without saying that specific tax and legal advice should be sought before considering this strategy. A financial adviser may be able to help in the selection of the suitable investments for the trust.
