The Negative Gearing Loophole Using a Trust
Negative gearing is one of the most widely discussed property investment strategies in Australia.
But what happens when an investment property is owned through a discretionary trust?
Normally, this creates an obvious problem: rental losses incurred inside a trust generally stay inside the trust. Unlike an investment property held personally, you generally can't simply distribute the loss to yourself and use it to reduce your salary or other personal taxable income.
However, for some business owners who already operate through a discretionary trust, there may be another structure worth discussing with their accountant.
Instead of trying to move the property loss out of the investment trust, could you potentially move other income into the trust containing the property deductions?
It sounds a little like a negative gearing loophole.
The reality is more complicated — but the concept is worth understanding.
What is negative gearing?
A property is generally described as negatively geared when its deductible expenses, including interest on money borrowed to purchase the property, exceed the rental income it produces.
For example, imagine an investment property produces:
Rental income: $30,000 per year
Deductible interest and property expenses: $55,000 per year
The property has produced a $25,000 net rental loss.
Where an eligible individual owns the property personally, that rental loss may generally be deducted against other assessable income, including salary, wages or business income, subject to the normal tax rules.
But owning the property through a discretionary trust changes the equation.
The problem with negative gearing through a trust
Suppose a discretionary trust purchases a $700,000 investment property and borrows 80% of the purchase price.
The property is rented and all rental income is received by the trust.
The trust also incurs the associated deductible expenses, potentially including loan interest, property management fees, council rates, insurance, repairs and other allowable deductions.
Imagine the result is:
Rental income: $30,000
Deductible property expenses: $55,000
Net tax position before other income: -$25,000
The important difference is that a trust generally can't simply distribute that $25,000 tax loss to an individual beneficiary.
Subject to the trust-loss rules, the loss may instead be carried forward within the trust and potentially used against income in a future year.
That's one reason negatively geared residential property is often thought to be less attractive inside a discretionary trust.
Can Business Trust Income Offset Investment Property Losses
But what if you also operate a profitable business through another trust? This is where things become interesting.
Many Australian small-business owners operate through a discretionary trading trust.
The business might generate significant taxable income each year, which the trustee then distributes among eligible beneficiaries in accordance with the trust deed and applicable tax laws.
Now imagine there are two trusts:
Trust 1 – Business Trust
Operates a profitable business and has income available for distribution.
Trust 2 – Property Trust
Owns the negatively geared investment property and has allowable deductions exceeding its rental income.
What if the Property Trust is an eligible beneficiary of the Business Trust?
Instead of distributing all of the Business Trust's income directly to individuals, could some of that income potentially be distributed to the Property Trust?
Conceptually, the numbers might look like this.
Property Trust
Rental income: $30,000
Distribution received from Business Trust: $25,000
Total assessable income: $55,000
Deductible property expenses: $55,000
Potential taxable income: $0
In economic terms, the property deductions have potentially absorbed income originating from the business.
Instead of trying to transfer the loss out of the Property Trust, you've effectively considered whether income can be brought into the trust containing the deductions.
Is that effectively negative gearing?
Economically, there are similarities.
Traditional negative gearing might look like:
Salary/business income − rental property loss = lower taxable income
The trust structure described above potentially looks more like:
Rental income + other trust income − allowable deductions = reduced trust net income
The mechanism is different, but the underlying idea is similar: allowable property deductions are being used against assessable income.
While it might look like a negative gearing loophole, it’s really a different way of structuring income, losses and distributions across trusts.
Australian tax legislation contains specific rules dealing with trusts, losses, deductions and arrangements involving the injection of income into trusts.
The big issue: the trust income injection rules
This is where professional tax advice becomes essential.
Schedule 2F of the Income Tax Assessment Act 1936 contains trust-loss provisions, including an income injection test.
Broadly, these provisions are intended to prevent arrangements where income is injected into a trust in order to take advantage of losses or deductions in circumstances covered by the legislation.
The Australian Taxation Office specifically states that the income injection test can apply where there is a scheme to take advantage of a deduction allowable to a trust.
So simply establishing two unrelated trusts and moving taxable income into the trust containing the deductions should not be assumed to produce the desired tax outcome.
There are, however, important rules relating to family trusts.
Family Trust Elections can change the position
A discretionary trust isn't automatically a "family trust" for tax purposes simply because a family owns or controls it.
For tax purposes, a trust generally needs to make a valid Family Trust Election (FTE) to receive the relevant family-trust treatment.
Importantly, the ATO states that the income injection test doesn't apply to income-injection arrangements taking place wholly within the family group of a trust that has made a Family Trust Election.
The rules can also recognise certain other entities within the family group, including entities that have made an appropriate Interposed Entity Election (IEE) and, in some circumstances, another trust with the same individual specified in its Family Trust Election.
This is where the structure becomes considerably more technical.
It means the tax outcome could potentially depend on matters including:
the beneficiaries permitted under each trust deed
whether Family Trust Elections have been made
who is specified as the relevant individual
whether the entities fall within the same family group
whether an Interposed Entity Election is required
whether the deductions are current-year deductions or carried-forward tax losses
the source and character of the income being distributed
the trust's distributable income and net income for tax purposes
whether the arrangement satisfies the trust-loss provisions
whether other anti-avoidance provisions could apply.
There can also be significant consequences when a family trust makes distributions outside its defined family group, including potential Family Trust Distribution Tax.
This isn't something to implement based on a blog article.
A simple hypothetical example
Consider a self-employed couple whose business operates through the Smith Business Trust.
They also establish the Smith Property Trust, which purchases a $700,000 investment property using an 80% investment loan.
During the year:
Property rental income = $30,000
Allowable property deductions = $55,000
Potential property shortfall = $25,000
Separately, the Business Trust generates substantial taxable income.
If the Property Trust is an eligible beneficiary of the Business Trust, the trustees might ask their accountant whether the Business Trust could distribute $25,000 of income to the Property Trust.
If the structure, elections and tax provisions allow the arrangement to operate as intended, the Property Trust could potentially have:
$30,000 rental income
＋ $25,000 trust distribution
− $55,000 allowable deductions
= $0 net taxable income
Without the additional assessable income, the $25,000 loss would ordinarily remain in the Property Trust, subject to the rules governing its future utilisation.
That's the concept.
Whether it actually works for a particular taxpayer is a very different question.
Is this a negative gearing loophole?
Probably the better description is a potential trust structuring strategy involving property deductions and trust distributions.
It isn't a way of magically transferring a trust's rental loss onto your personal tax return.
And it isn't something every property investor can do.
It is potentially relevant to a narrower group of investors who:
already operate a profitable business or investment structure through a trust and are considering owning an investment property through another trust.
For those investors, the traditional statement that "you can't negatively gear property in a discretionary trust" may not tell the entire story.
The more useful question could be:
Can other assessable income legitimately be derived by the trust that contains the property deductions?
That's a question worth putting to a suitably qualified accountant or tax adviser.
Don't structure an investment property around tax alone
There are many other considerations when deciding whether to purchase an investment property personally, jointly, through a discretionary trust or using another ownership structure.
These can include:
Asset protection
Land tax
Capital gains tax
Access to the 50% CGT discount
Borrowing capacity
Loan structure and interest rates
Estate planning
Trust establishment and accounting costs
Future distributions
State-based taxes and surcharges
The ability to use property losses
Family Trust Election consequences
Your accountant, tax adviser, solicitor and mortgage broker may therefore look at the same proposed purchase from very different perspectives.
The best ownership structure isn't necessarily the one producing the largest immediate tax deduction.
Considering buying an investment property?
Before purchasing an investment property, it can be useful to model the numbers before deciding how much to borrow or what type of property to purchase.
Our free Rosh Partners Property Investment Analyser allows you to model a proposed investment property, including purchase costs, borrowing, rental income, expenses, cash flow and estimated tax outcomes.
It can help you understand how an investment may perform before you commit to purchasing it.
Important disclaimer
This article provides general information only and does not constitute tax, legal, accounting or financial advice. Rosh Partners is not providing tax advice in relation to the structures discussed above.
Trust taxation is complex and the examples in this article are simplified hypothetical illustrations only. The actual tax treatment will depend on the trust deeds, ownership and control arrangements, Family Trust Elections and/or Interposed Entity Elections, the character of income and deductions, applicable trust-loss provisions, anti-avoidance provisions and the individual circumstances of the parties involved.
You should obtain independent advice from a suitably qualified accountant, registered tax agent and/or tax lawyer before establishing a trust, purchasing property through a trust, making or changing a Family Trust Election or Interposed Entity Election, or implementing any arrangement involving distributions between trusts.
Tax outcomes should not be the sole reason for selecting an ownership or lending structure.
