How not to
structure an investment property purchase
Part I Access to investment losses
Introduction
The holy grail for tax and estate planners is to
structure investment property purchases to have access to
investment losses to reduce the taxpayer’s personal tax
and yet to protect the investment property inside a
discretionary trust.
In Australia, taxpayers are able to use investment losses
to offset against income from other sources, and therefore
reduce their income tax. The discretionary (family) trust
provides asset protection against law suits or bankruptcy of
the taxpayer.
In the decision of Lambert and Commissioner of
Taxation [2013] AATA 442, the Administrative Appeals
Tribunal of Australia, Taxation Appeals Division, (the AAT)
denied the taxpayer (Lambert) access to investment losses
from an investment property held inside a family
discretionary trust that he controlled.
In this article, we look why the AAT found that the
Lambert property investment structure was not
effective to provide the taxpayer access to these investment
losses.
The Lambert property
investment structure
Lambert’s tax planner would have had three considerations
in mind when structuring the purchase of three residential
investment properties, with bank loan finance:
- The first was to use a discretionary trust structure
(the Lambert Family Trust) to buy the properties to
provide asset protection.
- The second was to borrow the whole of the price. As
the loan interest and the outgoings would exceed the
rental income, and the properties would be negatively
geared. Unless a strategy was devised, the negative
gearing losses would be locked inside the trust, and not
able to be accessed.
- The third was to enable Lambert to access the
negative gearing losses to reduce his personal taxable
income.
The Lambert property investment structure was:
- Lambert was appointed the sole trustee of the
Lambert Family Trust. Therefore, the title to the
properties, and the bank loans for the properties, were
to be in Lambert’s name. Lambert needed to show that the
bank loans were his own personal loans so that he could
claim the loan interest as a personal tax deduction.
- Lambert used an off-the-shelf discretionary trust
deed, which had the usual provision that the trust
income be distributed at the trustee’s discretion to
Lambert and his family. He needed to amend the trust
deed to connect the loan expenses to the rental income
because ATO taxation ruling IT 2385 had stated that a
beneficiary cannot claim deductions against a trust
distribution unless they have a present entitlement to
the trust income. Therefore the Deed of Settlement was
varied by way of a Deed of Variation of trust to provide
that Lambert had a present entitlement (as a trust
beneficiary) to all income from the trust ‘until further
notice’. The property rents were paid into Lambert’s
personal bank account.
As a result, Lambert accessed the negative gearing loss –
the shortfall between the rents received and the loan
interest paid out – and applied it against his personal
income to reduce tax payable.
The AAT Decision
The AAT decided that the Lambert property investment
structure was not effective for these reasons:
The property loans
When purchasing the rental properties, the Contracts for
Sale described the purchaser as: Rodney John Lambert as
trustee for the Lambert Family Trust. The rental properties
were therefore trust assets.
But when borrowing the bank loans to fund the purchase,
the plan was for Lambert to borrow personally, and then to
on-loan the funds to the trust interest free to purchase the
rental properties. And so, Lambert would be able to claim
the loan interest as a tax loss personally.
But the plan failed. The AAT found that the borrower was
described in the bank loan documents as the trustee for the
trust. For tax purposes, a trust is a separate entity from
the trustee (s. 960-100 (1) ITAA), and so the Lambert Family
Trust could borrow the bank loans.
Therefore the bank loans were made to Lambert in his
capacity as the sole trustee of the Lambert Family trust,
not in his personal capacity. And so, the AAT denied
Lambert’s deduction of interest expenses.
The property rentals
The AAT considered whether or not the Deed of Variation
of trust was effective to change the treatment of the trust
income (the property rentals) to become a present
entitlement, rather than a mere expectancy, in accordance
with the Deed of Settlement of trust.
The AAT found that by directing the distribution of the
trust income solely to Lambert, the Deed of Variation
represented an invalid exercise of the trustee’s
discretionary power to distribute trust income and was in
breach of a trustee’s fiduciary duty. It was legally invalid
and ineffective because the power was not exercised bona
fide for the benefit of beneficiaries as a whole.
The AAT concluded that Lambert “was not entitled to a
deduction for interest expenditure in the 2009 and 2010
income tax years because there is insufficient nexus between
the outgoings and the derivation of assessable income”. He
was also ordered to pay a penalty of 25% of the tax.
Conclusion
Structuring an investment property purchase properly is
an important task for legal and financial advisors of the
purchaser. In most cases, the best structure depends on the
purchaser’s financial status and objectives. A
one-size-fits-all structure does not work.
In Lambert’s case, the structure failed to meet the
taxpayer’s requirements. Perhaps more consideration should
have been given to using a hybrid trust, or using a unit
trust and a discretionary trust in tandem.
Tax and estate planners seeking to create a tax deduction
for interest paid by a taxpayer on a loan used for property
investment through a trust need to take into account the
ATO’s views on - Uncommercial use of certain trusts – which
are contained in Taxpayer Alert TA 2008/3 and Taxation
Determination TD 2009/7.
This article was first published by Cordato Partners in
Lexology which is an international innovative, web-based
service that provides over 200,000 company law departments
and law firms around the world with a depth of free
practical know-how on specialist areas of law © Copyright
2013 Sydney
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