Family Trusts and Why Property Investors Use Them

Should You Hold Your Investment Property in a Trust?

If you own an investment property or you're thinking about buying one, you've probably heard someone mention holding it in a family trust. The question that usually follows is: should you?

The rules around trusts are changing. Before you make any decisions about setting up a new structure or changing an existing one, you'll need to understand what a discretionary trust actually is, why investors use them, and what the Government is proposing to change. This article walks through the first part of that question: what trusts are and how they work.

Disclaimer: These proposed changes are not yet law. This article is general information only and does not constitute tax or financial advice. Readers should speak with their adviser before making any decisions.

What Is a Discretionary Trust?

A discretionary trust is a legal arrangement where a trustee holds property or assets on behalf of a group of beneficiaries. The trustee decides each year how income and capital are distributed among those beneficiaries. You might also hear it called a family trust, because the beneficiaries are usually family members.

There are three key parties. The settlor sets up the trust and contributes the initial amount (often a small sum like $10). The trustee manages the trust and makes decisions about distributions. The beneficiaries are the people or entities who can receive income or assets from the trust.

The defining feature of a discretionary trust is flexibility. Unlike a fixed trust, where each beneficiary has a set entitlement, the trustee can decide each year who receives what. One year you might distribute all the income to your spouse. The next year you might split it between your adult children. The trust deed sets out who can be a beneficiary, but the trustee has discretion within those rules.

Why Property Investors Use Trusts

Investors use discretionary trusts for four main reasons: asset protection, income splitting, estate planning, and flexibility.

Asset protection is often the first reason people consider a trust. If you hold your investment property in your own name and you're sued personally or your business fails, creditors can usually access that property. When the property is held in a trust and you're not the trustee, it's generally harder for personal creditors to reach it. The level of protection depends on the structure and timing, so this isn't foolproof, but it's one of the reasons investors choose trusts.

Income splitting lets you distribute rental income each year to family members on lower tax rates. If you're earning a high salary and your spouse is working part-time, distributing rental income to your spouse can reduce the overall tax bill for your household. The trustee decides how much each beneficiary receives, within the rules set out in the trust deed.

Estate planning is another advantage. When you hold property in your own name, it forms part of your estate when you die and must go through probate. A trust can continue after your death, and the trust deed can set out how assets are managed and distributed. This can reduce delays and give you more control over who benefits in the long term.

Flexibility ties all of these together. The trustee can adjust distributions year to year based on each beneficiary's circumstances. If your adult child finishes university and starts earning a full-time income, you can reduce their distribution. If your spouse takes time off work, you can increase theirs. You're not locked into a fixed arrangement.

How Rental Income Flows Through a Trust

Consider an investor who holds a property in a family trust. The property earns $50,000 in rental income over the financial year. The trust also incurs $15,000 in deductible expenses: loan interest, council rates, property management fees, and maintenance. The net income for the trust is $35,000.

At the end of the financial year, the trustee decides how to distribute that $35,000. The investor is on the top marginal tax rate, so distributing all the income to them would mean paying close to 47% tax (including the Medicare levy). Their spouse works part-time and earns $30,000 a year, so they're on a much lower marginal rate.

The trustee distributes $30,000 to the spouse and $5,000 to the investor. The spouse pays tax on $30,000 at their marginal rate, and the investor pays tax on $5,000 at theirs. The overall tax paid by the household is lower than it would have been if the investor held the property in their own name.

Income must actually be distributed for this to work. The beneficiaries are assessed on what they're entitled to receive under the trust deed and the trustee's distribution resolution, not on what the trust earns in total. The trustee prepares a distribution resolution each year setting out who receives what.

How the CGT Discount Has Worked for Trusts

When a trust sells an investment property that it has held for more than 12 months, it can access the 50% capital gains tax discount. The trust calculates the capital gain, applies the 50% discount, and then distributes the discounted gain to beneficiaries.

Each beneficiary includes their share of the discounted gain in their own tax return and pays tax at their marginal rate. If the trust makes a $200,000 capital gain, applies the 50% discount, and distributes the $100,000 discounted gain equally to two beneficiaries, each beneficiary reports $50,000 and pays tax on that amount at their own rate.

Companies cannot access the 50% CGT discount. This becomes important when you understand how bucket companies work, because it affects the way trusts distribute capital gains. A trust can distribute income to a company, but if it distributes a capital gain to a company, the company pays tax on the full gain without the discount.

What Is a Bucket Company?

A bucket company is a private company set up to act as a beneficiary of a family trust. Instead of distributing income to high-earning individuals, the trustee distributes it to the company. The company pays tax at the corporate rate, which is 25% for small companies (those with turnover under $50 million) or 30% for larger ones.

The income sits in the company after tax is paid. When the company pays that income out to shareholders as dividends later, those dividends are franked. Franking credits represent the tax the company has already paid, so shareholders receive a credit for that tax when they include the dividend in their own return.

This has been a popular strategy for property investors with strong positive rental income. If the trust earns $50,000 in net rental income and the investor doesn't need that cash immediately, distributing it to a bucket company means paying 25% or 30% tax now, rather than 47%. The after-tax income stays in the company and can be invested or paid out later when the investor's circumstances change.

Bucket companies don't help with capital gains, because companies don't get the CGT discount. Trusts that use bucket companies typically distribute rental income to the company and distribute capital gains directly to individuals so those individuals can access the 50% discount.

Whether a trust with a bucket company is right for you depends on your income, your cash flow needs, and your long-term plans. Trusts come with setup costs, annual compliance costs, and additional complexity. For some investors, the tax savings justify the cost. For others, holding property in their own name or through a different structure makes more sense.

Speak with your accountant or financial adviser before setting up a trust or making changes to an existing structure. The rules are changing, and what worked in the past might not work the same way going forward. If you're thinking about buying an investment property and you're not sure how to structure it, starting with professional advice will save you from costly mistakes later.

Call one of our team or book an appointment at a time that works for you. We'll walk you through the lending side of the decision and connect you with advisers who can help with the structure.

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