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Tax treatment of provider of capitalised interest loan

Discussion in 'Accounting, Tax & Legal' started by try anything once, 12th Mar, 2010.

  1. try anything once

    try anything once Well-Known Member

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    If a family trust makes and loan to another party, and the terms of the loan are such that no repayments are required until a future date, and interest is capitalised and added to the principle balance (ie like a reverse mortgage), what is the taxable income of the Trust when the loan balance is finally paid out? Is the original loaned amount subtracted from the loan balance and the remainder (being accumulated interest) is treated as taxable income for the trust?

    Or is the trust "deemed" to have received interest income every year that the loan is in place and taxed on it each year (even though no actual repayments have been made?)
     
  2. Rob G.

    Rob G. Well-Known Member

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    If it is a commercial loan, likely the trust is deemed to derive income on an acruals basis.

    Similarly the borrower can only deduct on this basis if the loan is for a taxable purpose..

    If you are playing funny games with the outstanding interest no compunding, the ATO could argue that it is a non-commercial loan, or that there is some debt forgiveness.

    You will need to get some advice on whether this applies.

    Cheers,

    Rob
     
  3. try anything once

    try anything once Well-Known Member

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    thanks Rob

    Taxed on an accrual basis? - ouch! Well that kills off that option!

    I am trying to work out the best option for providing re-financing for my wife's parents so they can stay in their home - I would be very grateful if you could take a look at my other post on this subject a couple of days ago and let me know which option you think is best from a tax perspective.

    thanks and regards
    Scott
     
  4. Rob G.

    Rob G. Well-Known Member

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    Are you hoping to claim interest deductions for the trust ? This needs to be commercial.

    Are you hoping to claim costs of depreciation on the property ? This requires the trustee to be the "holder".

    A reverse mortgage usually involves the purchaser acquiring the property by instalments of capital which provides the income stream to the vendor (your parents), while property passes at some later date. i.e. the trust is purchasing, but if there is no income derived by the trust from the property then interest expense is most likely capitalised.

    Not too sure how Centrelink would treat this for the assets test because the income stream has been "purchased", or whether it is just an income test. I try to stay clear of Centrelink ... they are too complex and too hard to deal with.

    Sorry ...

    Cheers,

    Rob
     
  5. try anything once

    try anything once Well-Known Member

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    Rob
    Not trying to do anything funny/dodgy - just want to help the inlaws! Not looking to claim interest in the trust....

    Per my other post, my wife's parents need to find an alternative source of finance so they can stay in their home. They received a loan of $150k from another family member to help buy the house and he needs the money returned now. We have the $150k cash (without borrowing) in our family trust we can use and definitely want to help..

    Options I am looking at are:

    1) a reverse mortgage where the in laws remain the title holders and our family trust is the financier of a $150k loan to the in-laws- but from what you have said this would mean the trust would need to be paying tax on interest charged on an accrual basis - if true I think I can discount this option.
    2) Trust buys the house from them for the market value ($300k) then immediately sells them an enduring right to live in the house for the remainder of their lives for a consideration of $150k (Centrelink calls this a "Granny flat arrangement" and they have advised that this will not effect their pension eligibility.
    3) The Trust gifts $150k to them, and they amend their wills to leave their home to us/our Trust.

    Obviously each option has a different risk profile, but from the perspective of the Trust's tax position, which would be the best option?

    I assume the answer is option 3) as under current laws no taxes/death duties would be payable on the house if left in a will? The main risk with this I imagine would be that the will is either changed or contested.

    your thoughts?
     
  6. GregR

    GregR Reid Consultants

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    Scott,
    I answered your other stream first, so will only touch on a couple of points here.
    A true reverse mortgage is only a first mortgage, just like any other first mortgage except that there are no requirements for principal or interest repayments during the life of the loan. Interest capitalises.

    There is no transfer of ownership, it is just a mortgage. The funds can be advanced by way of lump sums, one or more, or a 'income' stream. The reverse mortgage itself has no pension implications, the use of funds may.

    The answer to the trusts best option will depend on the level of gearing and opportunity cost. My preference would be ownership 100% and rent the property to the parents. You set up auto debits and the money is in the trusts account each month (or fortnight). I suggest you do the numbers to see the best option for the parents but if the $150k net is then their only financial asset, it will not trigger the asset test if they sold the home and it will most likely have a positive benefit as the rent assistance may be more then the effect of the deeming rates on the income test (if any).
    Greg
     
  7. Rob G.

    Rob G. Well-Known Member

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    Sorry ... assumed tax considerations were a major driver.

    Are your wife's parents in a class of potential income or capital beneficiaries of your family trust according to your trust deed ?

    Be mindful of any Family Trust Election, and any corporate beneficiaries with unpaid present entitlements.

    If so, the possibility may exist to loan them the $150k, secured by a first mortgage over their house (or at least some sort of caveat) for security. That way, any non-commercial loan terms won't make the loan statute barred, whilst making low and/or deferred interest terms seem like pure family arrangements and so not assessable income to the trust.

    Just think of it this way, if that $150k had been invested then you would otherwise have been assessed and taxed as a beneficiary for the income, and then gifted it to your parents-in-law without any deduction !!

    Also, if they are in a class of income beneficiaries then you could stream some income to them at their low tax rates as some assistance.

    Remember that Centrelink will be interested in them being beneficiaries so make sure they have no control of the trust.

    Of course the trust could loan you (as a capital/income beneficiary) the $150k and you could on-lend (with security), all within family arrangements and so most likely no tax considerations (provided you don't make a capital gain out of the loan !!).

    Note these ideas cannot possibly address your precise personal/family asset protection strategies, estate planning and tax situations based on such brief facts. They are just another approach.

    Cheers,

    Rob
     
  8. try anything once

    try anything once Well-Known Member

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    I don't understand what you mean here Rob. Are you saying that if the loan is made on deferred interest terms that it is considered "non-commercial" and therefore the trust would not need to declare income associated with the accrued/deferred interest until the future repayment date?

    I thought you were suggesting in your initial reponse that where interest is capitalised/deferred the trust would be deemed to be deriving income on an accrual basis each year and therefore subject to tax (even thoug no interest cash income is actually received)?
     
  9. Rob G.

    Rob G. Well-Known Member

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    For a loan on commercial terms, interest would be income to the lender and would be deemed to be derived even when deferred.

    Wholly non-commercial loans, such as loans to family members on non-commercial terms, do not derive income ... therefore timing is irrelevant.

    This could be deemed a purely family arrangement and the loan regarded as a personal use asset of the lender.

    The danger here is if the borrower defaults or the loan becomes statute barred, because then your capital losses are disregarded on personal use assets !!!

    Cheers,

    Rob
     
  10. Rob G.

    Rob G. Well-Known Member

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    Maybe a capital loss is not ignored if the borrower defaults because this might give rise to a right to pursue them in court.

    However, loan fogiveness or loans which become statute barred can be a problem.

    Cheers,

    Rob
     
  11. try anything once

    try anything once Well-Known Member

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    Rob

    thank you for the additional clarification. So to summarise: the trust could loan them $150k, under a deferred or capitilised interest loan (ie no repayments for 20+years), and the Trust would not be required to include accrued interest on its annual income statement provided:

    1) the in-laws are eligible (but not controlling) beneficiaries of the trust
    2) the loan is a non-commercial loan
    3) there is no debt forgiveness

    Is this correct?

    If so what renders the loan non-commercial? ie can one just set an interest rate say 1% below the applicable reserve bank rate to make it non commercial?

    A concern with the reverse mortgage route is that in the long term the loan value may exceed the house value, so I was planning on writing into the loan agreement that any debt in excess of the hosue value upon sale is to be forgiven. What would be the impact of that?

    I appreciate you taking the time to answer this...
    regards
    Scott
     
  12. Rob G.

    Rob G. Well-Known Member

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    1) If Centrelink perceive you in-laws have any control, then assets of the trust could be counted !!!

    2) A non-commercial loan is less likely to be deemed as producing income, and more likely to be a family arrangement.

    3) Debt forgiveness is fine if you want your in-laws to have the loan principle as a gift. However, "at call loans" are in danger of being statute barred after a number of years, and *maybe* regarded by Centrelink as an asset of your in-laws.

    Note that the ATO could apply different responses to non-commercial loans.

    First, they could merely regard this as a family arrangement = no income and no deductions.

    Secondly, they could limit deductions to the amount of assessable income derived (in negative gearing cases).

    Where you have the money already so there are no deductions you clearly want to show that the purpose of the loan is not to derive income, and so the first case should apply.

    However, you may want to charge to nominal amount to avoid the loan becoming statute barred, or Centrelink deeming it a gift or even the executors deeming the money as assets in the event of their death.

    I cannot put a figure on what you should charge, if any, but make sure your trustee makes a documented resolution that it is a loan AND gets a letter of acknowledgement from you in-laws that this is so.

    Really, you should have a quick talk with your Accountant about your exact circumstances to avoid any possible unforeseen consequences with tax, Centrelink, debts etc.

    Cheers,

    Rob
     
  13. try anything once

    try anything once Well-Known Member

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    thanks Rob

    I have decided to not provide the money through a reverse mortgage and instead buy the property under what centrelink refers to as a "Granny flat arrangement"

    Basically the house title is transferred into our name in return for providing the parenst with a life tenancy in the property. I have checked with centrelink and this won't effect their pension eligibility (which they would have received anyway).

    We will probably put the house title in our family trust's name. Stamp duty will be payable and the cost base for CGT purposes will be the market value on date of transfer.

    Even though it is not strictly required by centrelink, I am having an agreement drawn up by a lawyer to give my wife's parents piece of mind. The lawyer has suggested we consider an alternative to a life tenancy - instead providing a "life interest".

    Still waiting for more details on this but it looks as if the difference is that with a life interest, in addition to the right to live there, the parents retain some interest/ownership of the house until they die. The agreement allows for that as they get older, their interest in the house diminishes according to an actuarial table. When they die, their remaining interest automatically passes to the "Remaindermen" - which in this case would be the trust.

    The apparent advantage of this is that since only part (eg 50%) of the value of the property is being acquired by the trust on day 1, duty is only payable on this share. Likewise for CGT purposes, only 50% of the house value is cost based on today's value.

    What I am still trying to get specifics on is how the acquisition of the remaining interest in the property over time is handled from a stamp duty and CGT cost base perspective.

    Has anyone heard of this arrangement before and have any answers?
    thx
     
  14. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Have you checked back with Centrelink whether this "interest" in the property will affect their pension? Since they have an effective partial ownership of the property, perhaps that would be considered an asset by Centrelink?
     
  15. try anything once

    try anything once Well-Known Member

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    yes I have checked. Whether they have a life interest or a life tenancy, they are considered to be home owners from centrelink's perspective (therefore exempt assets), unless the consideration for the life tenancy/interest (ie the house value) is less than $128k. In which case they would be non home owners and have a higher assets limit, but would declare the interest as an asset not subject to deeming rate. But where can you find a house worth less than $128k??:confused:

    Just heard back from the lawyer that they do not know how the CGT cost base would be treated and suggested I ask my accountant. My accountant said he didn't know either. doh!

    Anyone know an accountant who would know the answer to this?
     
  16. Rob G.

    Rob G. Well-Known Member

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    Hmmm ...

    Looks like a granny flat arrangement can involve a separate property.

    http://www.centrelink.gov.au/internet/internet.nsf/filestores/fis027_0911/$file/fis027_0911en.pdf

    Also, if all they are doing is exchanging the the property for a right to live there then seing as it was already their exempt main residence there would not be a "reasonableness test" nor any asset deprivation test.

    That's how I read it from their glossy overview brochure anyway. The devil is always in the detail.

    Are you asking about the cost base of the life interest for your parents or the cost base for you acquiring otherwise than at arm's length and also there is an encumbrance on the legal title ?

    Cheers,

    Rob
     
  17. try anything once

    try anything once Well-Known Member

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    thats how I read it as well - hence the comment that there are no centrelink implications.
    Whether we give a "life interest" or a "right of occupation for life", both will qualify as a granny flat interest for Centrelink purposes. The resident will be treated as a homeowner either way.

    If the title is transferred to us in return for a "right of occupation for life", full stamp duty is payable and the cost base for CGT would be the market value at the time of transfer.

    Transferring the property but retaining a "life interest" is still a dutiable transaction, but the dutiable value of the property being transferred is reduced because of the life interest encumbering the property. The dutiable value of the property can be estimated by multiplying the market value by the relevant factor in the table at the end of the attached document (eg, where the factor is 0.6, then dutiable value is 40% of market value). Where there are two life tenants, the lower factor will apply.

    So I think that only 40% of the stamp duty is payable up front, and I presume likewise the first 40% of the cost base for CGT purposes would be set at the market value. What is not clear to me is how/when the remaining 60% of stamp duty becomes payable and likewise what the cost base of the remaining 60% would be?

    At its simplest, this would be when both the interest holders passed away, at which time their interest (60%) would transfer to the "Remaindermen" - remaining stamp duty payable at that point based upon the then market rate for the property. Cost base for the remaining 60% would likewise be the then market value.

    But I suspect it is more complex than this as I think the % of their interest in the property reduces as they age (according to the life interest table in the attachment). If this is the case, it may be that with the Remainderman each year receiving incrementally more interest in the property, this incremental interest is dutiable and adjusts the CGT cost base incrementally. If this is the case, the whole thing will be very difficult (and expensive) to administer I think?

    Anyone know for sure?
     

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