To trust or not to trust – the benefits of a discretionary (family) trust for minimising income tax

A few weeks ago I blogged about the insignificant benefits of a discretionary (or family) trust compared with a basic 50-50 joint split when it came to Capital Gains Tax (CGT), this week I will compare the two when it comes to rental income.

Rental income is different to CGT in that rental income is generally a lot less, and secondly, it is an annual income so any tax benefits can be compounded yearly. The results should be the same for values when Capital Gain and Rental Income are he same.

Again, I have based the below charts on a 50-50 split were one person has an supplementary income of $100,000 per year. I have ranged the annual rental income from minus $250,000 to plus $250,000, this is a huge sum for rental income and would require around $5000 rental income per week, and this is all after management costs and deductions.

A basic comparison between the two, with annual rental income versus total tax payable, it can be observed that that at values less than -$163,500 (a significant yearly loss), the 50-50 split can use negative gearing to offset the individual $100,000 supplementary income, whilst the discretionary trust cannot take advantage of negative gearing. This means there will always be a $25,000 tax bill as long as the properties are negatively geared.  As the net rental income approaches zero (or neutrally geared), the 50-50 split tax and trust tax merge.

50-50 split tax versus family trust tax

Finally, once the property is positively geared, the benefits of a discretionary trust are visible; the first $18,200 is tax free and following from there the tax bill is always slightly lower than the 50-50 split.

Plotting the tax difference between the two, a positive value being when a discretionary trust is beneficial, it can be observed that the maximum difference is around $3,300 with incomes around $18,000 to $36,000, this is a significant yearly saving.

The tax difference between a 50-50 split and family trust

Looking at the percentage difference compared to the yearly income, it can be again observed that at $18,000 or income a maximum of around 18% can be saved when a discretionary trust is used. It dips and stops at around a yearly income of$70,000 were it then hovers around 1% percentage difference.

The tax percent difference between a 50-50 split and family trust

So what does this all mean?

Firstly, a discretionary trust should not be used for negatively geared properties, this is obvious.

Secondly, a discretionary trust has significant benefits when used for positively geared properties. And because this in annual income, these benefits are compounded yearly. A saving of $3,300 yearly is a saving of $33,000 over ten years.

So one would think it would be wise to move the properties into a discretionary trust as soon as the properties are positively geared.

I will investigate this in my next post.

Update September 2012

Something I failed to mention was that whilst a trust is not beneficial for negative gearing, losses stay in the trust, meaning when the income is positively geared, tax will be minimised while the losses are accounted for.

To trust or not to trust – the benefits of a discretionary (family) trust for minimising CGT

Discretionary or family trust is a trust where the income generated in the trust can be distributed to the beneficiaries at the discretion of the trustee, or simply the income can be divided up however one pleases.

It is commonly known that a discretionary trust can be used as a form of tax minimisation, but to what extent is a trust beneficial.

In this example I will look at a simple case, a married couple with an investment property that has had a capital gains tax trigger. One person works with a salary of $100,000 a year while the other doesn’t. Logical sense would suggest that a trust would be beneficial in this situation since the capital gain can be distributed to the person with the lowest income, the person not working.

For the below charts I have calculated the tax of a 50-50 split and the tax of a discretionary trust from a capital gain from zero to $1,000,000 incremented by $10,000. One of the persons has a salary of $100,000.

First a direct comparison, it can be observed that up to around $400,000 that the 50-50 split pays slightly more tax, after $400,000 the tax is exactly the same. The reasons for this is the upper limit of the maximum tax threshold for an individual is $180,000, for two people it is $360,000, therefore when this is reached, it doesn’t matter whether it is a direct 50-50 split or a discretionary trust, the capital gains tax will be exactly the same.

Trust vs 50-50 split and CGT

Zoomed in to the zero to $400,000 range, it looks like there are some definite benefits to a discretionary trust.

Trust vs 50-50 split and CGT

Let’s look at the difference between the two scenarios in tax paid, a positive value is how much a discretionary trust minimises tax compared to a 50-50 split. It can be observed that a maximum of $4000 is saved when the capital gain is $260,000, not much of a saving. Further, as per above, at capital gain greater than $360,000 there is no difference.

Trust vs 50-50 split difference

Now one of the problems with a discretionary trust is the yearly management and compliance costs, let’s assume this is $1,000. Let’s add this to the differences chart. As expected this shifts everything down by $1,000.

Trust vs 50-50 split difference with management fees

And what this does is makes a trust scenario a bad choice for any capital gains greater than $360,000.

So what does this mean, simply, in the above situation a discretionary trust does not provide any significant benefits for capital gains tax minimisation compared to a 50-50 split.

One also needs to take into consideration the cumulative costs associated with a trust. If a property is held in a trust for four years, this is $4,000 of cumulative yearly costs which negates any benefits of a discretionary trust.

Further, if both parties are not working, there will be a disadvantage with a discretionary trust due to the yearly costs.

A discretionary trust may be beneficial for positively geared investment properties, and I will discuss this later on. But when asked the question, should I purchase an investment property into a discretionary trust to minimise future capital gains tax, it makes no difference as the CGT is relatively the same.

I will also add, what about a married couple with children, surely I can distribute the capital gains within my family, yes you can, but minors (children under the age of eighteen) are taxed at the highest tax bracket, so it is beneficial only when the beneficiaries are adults.

Next I will investigate the benefits of a discretionary trust for minimising annual income tax.

Triplex Development – Contour Survey

One of the first things you should arrange prior to designing the buildings on the block is a contour survey of the land, a contour survey provides information on the elevation of the land and also situations of sewerage, water and power connections as well as positions of existing fences and trees.

Generally, a builder will arrange for a contour survey prior to providing a building design, I found the most benefit of arranging the contour survey myself was the home builders took me more serious, after all a contour survey is a one-thousand dollar investment.

I arranged my contour survey with Cottage Engineering, a Perth based surveyor company. It cost me $975 which also included $180 for Australian Height Datum (AHD). AHD is an elevation standard which assumes a zero metre elevation is at the average mean sea level. One of the builders informed me it wasn’t really necessary and only needed if the land is situated near the ocean.

Cottage Engineering even provided the AutoSketch SKF file, which was handy for the builders.

Contour Survey for Cloverdale PDF

Contour Survey Cloverdale

Triplex Development – Zoning, updated

In my last post I introduced zoning and how to calculate the allowed housing density depending on the R codes. Well, that didn’t provide the whole picture, the minimum land is a little less than 10,000 divided by the R code

I am located in Western Australia where the planning of land use is governed by the Western Australian Planning Commission, the WAPC has allowed lower minimum land requirements then the  those obtained by using the standard R codes.

The reason for this is back in the old days, blocks where measured in the Gunter Chain, literally a metal chain consisting of known Links used to measure distances. 1 Gunter Chain is equal to 20.1168 metres.  Blocks of land were commonly measured out in multiples or fractions of the Gunter Chain, my 911sqm land is actually 0.9 chains by 2.5 chains. Now the problem with these imperial measurements, is it didn’t work well with the new metric system, the R codes being the later.

When the WAPC wanted to increase the housing density to allow owners of large blocks of land to build a duplex behind their existing home, at R20 many people with these 911sqm standard imperial blocks would not be able to implement this. This is one of the reasons why the WAPC decreased the minimum land to 440sqm.

The below is an excerpt from the State Planning Policy 3.1 Residential Design Codes.

As you can see the minimum land for R20 is 440sqm.
WAPC R-codes

Triplex Development – Zoning

In the last post I introduced my planned triplex development, I skipped over something, why specifically a triplex development?

This comes down to zoning, zoning is one part of the general council’s land use Planning Scheme, in simple terms, zoning determines the minimum land size a dwelling must reside on.

My land is zoned R20/R40, depending on what specific additional requirements are met for each.

Lets use R40, as this allows for more dwellings, to calculate the minimum land size;

1hector /40 = 10000m2/40 =  250m2

Therefore, each dwelling needs to sit on a minimum 250m2 of land.

My land is 911m2, so to determine the number of dwellings;

911/250 = 3.644 dwellings

hence a triplex development.

Triplex Development – Introduction

A few years ago together with the misses, we bought an old house sitting on a decent parcel of land, enough to build three houses when the time came. You can further read about the purchase on our joint blog sonyaandtravis.com, “Buying a house and making a home”.

Well the time has now come to start developing, as a first time developer and builder, there will be a lot of learning and experiences which I will document and share, and hopefully it will be useful for others in the same situation.

Some information on the land;

  • 3×1 double brick house
  • Land area 911 metres squared
  • Approximately 18 x 50.3 metres
  • Zoned R20/R40
  • Purchased for $500k

Cloverdale lot diagram and zoning

Calculate Stamp Duty with Excel

A quick post of how to calculate the Stamp Duty of a property with Excel, in my example I am using the Western Australia Residential Rate Dutiable value.

Stamp Duty
Cutoff [$]  Rate [%]  Duty [$]  Formula
0           1.9       0    0
120000      2.85      2280      =C3+(A4-A3)*B3/100
150000      3.8       3135      =C4+(A5-A4)*B4/100
360000      4.75      11115     =C5+(A6-A5)*B5/100
725000      5.15      28452.5   =C6+(A7-A6)*B6/100

Property Value        500000    
Duty                  17765     =VLOOKUP(C9,A:C,3,TRUE) + (C9-VLOOKUP(C9,A:C,1,TRUE))*VLOOKUP(C9,A:C,2,TRUE)/100

Download the Excel WorkBook.

Update, next day
This also works for Individual income tax rates;

Tax Rates            
Cutoff [$]  Rate [%] Tax [$]  Formula
0           0        0        0
6000        15       0        =C3+(A4-A3)*B3/100
37000       30       4650     =C4+(A5-A4)*B4/100
80000       37       17550    =C5+(A6-A5)*B5/100
180000      45       54550    =C6+(A7-A6)*B6/100
            
Income               100000    
Tax                  24950    =VLOOKUP(C9,A:C,3,TRUE) + (C9-VLOOKUP(C9,A:C,1,TRUE))*VLOOKUP(C9,A:C,2,TRUE)/100