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A Guide to Mortgages & Trusts

This information has been reproduced with permission by Mark Maxwell 1

A large number of trusts established in recent times have been for ownership of property, whether the family home or investment property. In most cases these properties have loans secured by a mortgage. There are plenty of options when it comes to loans, mortgages and trusts and it is important you understand the implications of how yours is structured. Many people are placing their trusts at risk of being challenged as a sham through the conduct of their loans. Often insufficient thought has gone into the structuring of borrowings by the professionals involved in establishing the trust.

This information gives an overview of the options for structuring your borrowing; it does not replace expert advice. It is recommended that you seek professional advice on structuring whenever you undertake new borrowing.

Definitions

Before we start talking about different structuring options we need to make an important distinction between a mortgage and a loan. Many people think of their mortgage as the amount of money they owe the bank, which is not the case.

A mortgage is the lien the owner of the property gives to the bank to secure a particular loan or loans. This allows the lender to recoup any loan amounts not repaid by the borrower by selling the mortgaged property.

A loan on the other hand is the actual funds lent to the borrower. The mortgage and the loan are both documented separately although both are often signed together giving the impression they are one in the same. This is an important distinction as one can have fully repaid their loan but still have a mortgage in place.

Mortgage Structuring

The first question you need to consider with your borrowing structure is whether the loan should be held inside or outside the trust. At first glance this may not seem to make much difference. However, it does have implications for protecting your property as well as how you should make loan repayments.

Mortgage Inside The Trust

This is the most common option chosen by those establishing trusts. The key advantage with this option is that you only have to gift the equity (difference between the property value and the loan balance) into the trust. This usually significantly reduces the gifting period thereby speeding up your wealth protection. When the loan is inside the trust it is the trustees who are the borrowers. In almost all cases however the trustees will want to limit their liability for the loan to the assets of the trust. This will generally mean the bank (or other lender) will require the settlors to provide personal guarantees for the loan.

With most of these structures the trust itself does not earn any income in order to meet the loan instalments. This means the beneficiaries living in the property (normally the settlors) are required to meet loan instalments as well as other outgoings. Most of this is straightforward to establish and, as long as appropriate trust resolutions are in place, does not in itself create any risk. It is the conduct of the beneficiaries and how they treat the loan that can create either a gift duty liability or a sham trust. Normally the settlors are undertaking a gifting program for the equity at $27,000 per annum each. Of course they are also paying at least some principal off the loan each time they pay instalments. This principal is capital in the trust and therefore must either be documented as a loan or gift.

Without appropriate loan documentation it is likely Inland Revenue would determine the payments a gift and assess duty accordingly.

Loan Outside Trust

With this option the settlors remain the borrowers owing the bank in their own names. However, the trustees allow the settlors to secure their lending against the trust property, with the trustees providing guarantees accordingly. Once again the trustees will look to limit their liability to the assets of the trust. A key feature of this structure is that the settlors will be required to gift the entire value of the property to the trust, not just the equity portion had the loan been inside the trust. This will extend the gifting period, often by many years, leaving the assets exposed to claim.

The major advantage of this structure is that the issues around loan principal repayments are removed because the loan is not being repaid by the trust. As with the other structure any renovations or additions to the property must be documented as a loan or gifted to the trust.

Revolving Credit Facilities

Special mention needs to be made of revolving credit facilities as these have become very popular. Often these facilities are part of the total borrowing commitment to the bank. The principle behind these facilities is that income is credited to the loan account regularly and then expenses paid progressively as they arrive, thereby saving interest. While this type of facility can be good for those with the discipline to maximise the advantages of them, they can pose problems in connection with trusts.

The key issue here is whether the revolving credit facility is inside or outside the trust. Where it is inside the trust each salary payment either needs to be documented as a loan or it could be assessed as a gift. Depending on the salary payments being made, the gift duty liability could be substantial. Any personal expenses paid from the facility will also need to be documented as either a repayment of loan or a distribution to a beneficiary. For many of these mortgages this documentation could be considerable depending on the number of transactions involved.

Lack of adequate documentation around these revolving credit transactions will likely give anyone seeking to challenge a trust added evidence with which to argue a sham. Their argument will be based around the settlors intermingling personal and trust transactions, which is something most lawyers will look for in any challenge. We recommend time be taken to consider the likely future borrowing needs of both the beneficiaries and the trust. Any highly transactional revolving credit facility should then be maintained outside the trust in the settlors’ own names unless there is a compelling reason not to.

It may well be that an additional revolving credit facility is held within the trust but this should be limited to larger more irregular transactions.

Managing a loan attached to a trust need not be difficult but it does require vigilance to ensure transactions are documented adequately to avoid unforeseen gift duty liability or creation of a sham. There are many trusts that have been operating with inappropriate borrowing structures or inadequate documentation for many years. It is important to rectify these situations as soon as possible because the longer they remain in place the greater the potential liability being created and the greater the chance of being declared a sham.