Strategy of Borrowing from a Testamentary Trust instead of Winding it Up
Testamentary Discretionary Trusts (TDT) are the best sort of trust out there, but someone has to die for them to come into existence. So, they are relatively rare. Also, the capital of the trust has to come from the deceased for the extra tax benefits to work (excepted trust income).
So, I cringe when clients approach me wanting to wind up a TDT that their parent has left them in control of.
Their idea usually goes something like this. I have a $1mil loan on my main residence and the trust holds $1mil worth of assets. If I wind up the trust, I can pay off my home loan and save interest.
It is a valid point, but once a TDT is closed it can’t be reopened again, and even if kept open new capital can be injected, but income generated from it would not qualify as except trust income and would not get the concessional tax treatment in the hands of children.
There is a simple way around this though, and that is to get the trustee to make you an interest free loan.
Bart’s dad Homer dies and leaves $1mil to a trustee of a TDT set up under his will. Bart has a $1mil home loan so winds up the trust and pays off the loan.
Lisa is in the same position, but she controls a separate, but identical trust. Lisa gets the trustee to lend her $1mil interest free which she uses to pay off her loan. She has not no deductible debt now. So, she uses the $3,000 she was paying the bank each month to pay back the trust.
The trust now has money with which to invest. The income from these investments can go to Lisa’s children tax free – because they can each earn $20,000 pa tax free so it will be ages before the trust’s income is more than this.
Meanwhile Bart is making the same investments as Lisa, but he receives the income himself and is taxed at 47%
Over the next 15 years or so Lisa would have probably repaid the full $1mil back to the trust so it is now generating about $40,000 per year in income which comes out tax free to her kids.
Once the kids start working, she will have to reassess where the income goes, but until then there are huge savings.
Tip – Don’t wind up a testamentary trust without careful consideration and legal advice.
Note that this would also give great asset protection as well.