Negative Gearing Using Hybrid Trusts: What You Need to Know
The extremely controversial “Negative gearing” and “hybrid trusts” are actually popular tax strategies. That is more so with folks that invest in property. At a simplistic level, it happens when the costs of owning an investment, like a property (including interest on loans), are higher than the income the investment earns. This loss can usually reduce taxable income for individuals. Obviously, watching the RBA like a hawk is part of the game here! Paying close attention to who gets elected. Close to 2.5 Million people own residential properties in Australia, so pollies beware! Don’t touch our trusts, they all say!
However, when properties are held in a discretionary family trust, the rules are weird. Losses from negative gearing cannot be used to lower an individual’s taxable income anymore. Instead, these losses stay in the trust. Sadly, they can only be used to offset future income earned by the trust.
Hybrid Trusts
Enter hybrid trusts. Investors buy “income units” in the trust, hoping to claim tax deductions for the losses.
While courts have sometimes allowed this, it largely depends on how much control the trustee has over income and capital distributions. And you may be surprised with what usually happens.
If the trustee has the power to distribute income to people other than the unitholders, unitholders generally can’t claim tax benefits from negative gearing. In these cases, it’s unlikely that the tax office will accept their claims. However, the hybrid trust itself may still be able to use negative gearing to claim deductions for costs tied to its investments. More on this later.
The misunderstood trust structure
This means that using negative gearing in trusts can be tricky and depends on the trust’s structure. And a host of other variables, that are beyond the scope of this summary you found online & are reading now. Investors should be cautious when trying to use this strategy with hybrid trusts. If you’re considering this, it’s important to understand the limits and risks involved to avoid tax trouble. They are a complex beast. Either you have done many of these, or are good mates with an accountant that specialises on property. Most accountants don’t come across hybrid trusts every day. Although negative gearing is quite common under other structures.
What Is Negative Gearing? Here’s What You’re Not Being Told
It’s been in the news. Pollies have used to used to polarise their demographics. But negative gearing is more than just a fancy and hyped up word—it’s a strategy investors use to turn today’s losses into tomorrow’s gains. But what does it really mean? How can it actually work for you?
Gearing can simply means borrowing money to invest. The investment could be property, shares, or other assets. Whether the investment is “positively” or “negatively” geared depends on one key factor: does it earn more income than it costs?
When negatively geared, the expenses (like loan interest and maintenance costs) outweigh the income generated. But here’s where it gets interesting. Many investors use this “loss” to reduce their taxable income, cutting their tax bill now while betting on the asset’s value rising in the future.
So why is negative gearing such a hot strategy?
It’s not just about tax savings—it’s about using borrowed money to grow your wealth over time. You can do that when cash flow is tight. For those playing the long game, it’s a way to leverage capital for bigger gains down the road.
But here’s where things get a bit strange. When negative gearing happens within a trust, the rules change. What does that mean for your investments? And how can a negatively geared trust potentially shape your financial future? Up next, uncover the details that could make or break your investment strategy.
Hybrid Trusts: Can You Use Negative Gearing for Units in a Hybrid Trust?
Hybrid trusts are a unique type of trust that combine features of fixed and discretionary trusts. They aim to provide the certainty of fixed trusts with the flexibility of discretionary trusts. For many investors, hybrid trusts can seem like the perfect solution, especially when it comes to navigating the tricky waters of negative gearing. But when can you actually use negative gearing for investments in hybrid trusts?
What Is a Hybrid Trust?
A hybrid trust allows for both fixed and discretionary distributions. In simpler terms, some income or capital from the trust is fixed for certain unitholders, while the rest is distributed at the discretion of the trustee. Investors sometimes turn to hybrid trusts to overcome the limitations of discretionary family trusts, where losses (e.g., from negative gearing) are quarantined in the trust and can’t be deducted against an individual’s income.
The Case of Forrest v Commissioner of Taxation
The legal case of Forrest v Commissioner of Taxation [2010] highlights the complexities of negative gearing in hybrid trusts.
- What Happened?
- Mr. Forrest borrowed money to purchase units in a trust and paid interest on that loan.
- He claimed tax deductions for the interest paid, arguing that the income derived from the units would cover the expenses.
- The Tribunal’s Decision:
- The Administrative Appeals Tribunal (AAT) ruled against Mr. Forrest, stating that the trust deed gave the trustee broad discretion. This meant that Mr. Forrest did not have a “present entitlement” to the trust’s income because income classification as either capital or income was determined by the trustee’s discretion.
- The Full Federal Court’s Decision:
- The Full Federal Court overturned the AAT’s ruling, emphasizing the parties’ intention to create a fixed trust for income purposes. The Court found that Mr. Forrest’s units were tied to a fixed share of the trust’s income, allowing him to claim tax deductions on the interest paid.
Implications for Hybrid Trusts
While Forrest provides a pathway for claiming tax deductions in hybrid trusts, it hinges on whether the trustee’s discretion is limited or fixed. If the trustee has wide-ranging discretion—such as the ability to distribute income to beneficiaries outside the unitholders—the case’s findings may not apply.
For example, in many hybrid trust deeds (most templates you find online):
- Trustees can distribute income to both unitholders and other beneficiaries (e.g., family members like spouses or children).
- This broad discretion means that losses from negative gearing are typically “trapped” in the trust and cannot offset an individual’s taxable income.
Why Negative Gearing May Not Work for Hybrid Trusts
The flexibility of hybrid trusts introduces complexity. While they allow trustees to spread income broadly, this same flexibility often disqualifies unitholders from claiming deductions on negative gearing. The income isn’t fixed or guaranteed for unitholders, which is a key requirement for claiming tax benefits.
Key Takeaways for Investors
- Understand the Trust Deed: Ensure the trust deed clearly defines income entitlements. If the trustee has wide discretion, negative gearing benefits may not apply.
- Assess the Investment Goal: Hybrid trusts are great for flexibility but might not suit those relying on negative gearing for tax deductions.
- Seek Expert Advice: Before setting up or investing in a hybrid trust, consult with a property tax specialist to align your trust structure with your investment strategy.
Try “Hybrid trust negative gearing” or not? What I recommend to people is to talk to their accountants first. And if their accountants don’t specialise on trusts or property, then have a chat with us on 1 800 672 670.
References
- Forrest v Commissioner of Taxation [2010] FCAFC 6.
- Australian Taxation Office. “Trusts and Taxation: Understanding Discretionary and Fixed Trusts.”
- Molesworth, B. (2019). Australian Tax Law: Key Concepts and Practices. Sydney: LexisNexis.
Can Hybrid Trusts Use Negative Gearing? Here’s What You Should Know
Negative gearing isn’t just for individuals—trustees of hybrid trusts can use it as part of the trust’s investment strategy. This means the trust itself borrows money to invest and claims deductions for interest costs against its income. But while the idea sounds appealing, negative gearing for hybrid trusts comes with its own set of risks and considerations. Is this strategy right for your trust? Let’s explore.
When Is Negative Gearing Appropriate for Hybrid Trusts?
- Risk Tolerance
Negative gearing increases financial risk. If your trust has a low tolerance for risk, this strategy may not be the best fit. Borrowing to invest can magnify both gains and losses, so a clear understanding of the trust’s risk appetite is critical. - Certainty of Income / Cash Flow
Does the trust have a steady income stream? Negative gearing relies on a stable cash flow to cover ongoing expenses until the investment generates profits. If the trust’s income is unpredictable or irregular, relying on negative gearing could lead to financial strain. - Investment Horizon
Negative gearing is a long-term play. Investments typically take years to appreciate and yield positive cash flow. For trusts with short-term goals, this strategy may not provide the returns or stability needed within the desired timeframe. - Tax Profile of the Trust
For negative gearing to work, the trust needs to have taxable income to offset the losses. If the trust doesn’t generate enough income to make use of these deductions, the strategy loses its appeal. The trust’s overall tax profile should be carefully analyzed before adopting this approach.
Risks of Negative Gearing in Hybrid Trusts
While it’s possible to negatively gear within a hybrid trust, the risks should not be underestimated:
- Increased Debt: Borrowing to invest means the trust takes on more debt, which could become unsustainable if returns don’t meet expectations.
- Market Volatility: Investments may not appreciate as planned, leaving the trust with prolonged negative cash flow.
- Regulatory Risks: Tax laws and rulings can change, potentially impacting the deductions the trust can claim.
When Does This Strategy Work Best?
Negative gearing within a hybrid trust works best when:
- The trust has reliable and consistent income streams.
- It’s part of a long-term investment plan with well-researched opportunities.
- The trust’s tax profile ensures that losses can be offset by other income.
Key Takeaways
While trustees of hybrid trusts can use negative gearing to boost investment potential, the strategy isn’t suitable for every situation. It requires careful planning, a solid financial foundation, and a clear understanding of the trust’s goals. Trustees should weigh the risks and consult a property tax expert to ensure the strategy aligns with the trust’s financial and tax objectives.
References
- Australian Taxation Office. “Taxation and Trust Structures.”
- Forrest v Commissioner of Taxation [2010] FCAFC 6.
- Smith, L. (2020). Investment Strategies for Hybrid Trusts. Sydney: Thomson Reuters.
5 things you should also know about Negative Gearing using Hybrid Trusts
- The Allure of Hybrid Trusts for Investors
Hybrid trusts blend features of discretionary and unit trusts, offering both flexibility and potential tax benefits. This structure allows investors to hold income units, aiming to claim negative gearing advantages while retaining control over asset distribution.
- The ATO’s Stance on Negative Gearing in Trusts
The Australian Taxation Office (ATO) has scrutinized arrangements where taxpayers use borrowed funds to acquire interests in trusts that invest in income-producing properties. These setups often aim to provide tax deductions for interest payments, even when income or capital gains benefit other trust beneficiaries.
- Legal Precedents Impacting Hybrid Trust Strategies
Legal cases have highlighted the complexities of negative gearing within hybrid trusts. The outcomes often depend on the specific terms of the trust deed and the trustee’s discretion in income distribution. Investors should be cautious and seek professional advice to ensure compliance.
- Potential Pitfalls: When Negative Gearing Backfires
If a hybrid trust’s deed grants the trustee broad discretion over income distribution, unitholders might find themselves unable to claim anticipated tax deductions. In such scenarios, losses can become “trapped” within the trust, negating the benefits of negative gearing.
- The Importance of Trust Deed Specificity
For negative gearing to be effective in a hybrid trust, the trust deed must clearly define income entitlements. Ambiguities or excessive trustee discretion can jeopardize tax deduction claims, making precise drafting essential.
A few more fringe things on the list above, no doubt. But it all adds up in the end. Some win, some lose. The former usually has very good accountants that specialise on this & tell everyone they do. Want one of those?
Reach out to us on 1 800 672 670