The use of testamentary trusts in estate planning (particularly for clients with a reasonable level of income producing investments) is relatively standard practice. It is not uncommon in preparing the Will to pass all of the assets of the testator into one or more testamentary trusts.
The tax advantages of testamentary trusts are obvious – distributions to minors are not restricted to a $416 limit as applies to discretionary trusts, as well as the income splitting advantages of discretionary testamentary trusts. Of greater importance are the asset protection advantages that a properly designed testamentary trust can provide.
What is often ignored, however, is the special position of main residences under the tax legislation. A complete exemption from any capital gains subject to a number of conditions – the key condition is the disposing owner is an individual that has used the property as their main residence.
CGT on deceased estates
Example Bruce and Fleur purchased their home in 1992 for a cost of $170,000. The property is held as tenants in common. Throughout the period of ownership they have used it exclusively as their main residence. It now has a value of $1,020,000, and after reduction by costs associated with sale, a capital gain of $800,000 is expected. They are now 73 years of age and executed their Will which passes their interest in the home, together with other income producing assets, into a Testamentary Trust initially controlled by the survivor. Shortly afterwards, Bruce passes away.
The general rule is that post-CGT assets (assets acquired on or after 20 September 1985) passing into a deceased estate are deemed to have been acquired at the cost base of the testator. The Main Residence Exemption is extended if the property is sold within two years of death.
But what of the situation where the property passes to a testamentary trust? A trustee is generally not eligible for the Main Residence Exemption.
Special Cost Base Rules
Division 128 alters the standard cost base rules above in nominated circumstances.
One special cost base rule applies where the property was the main residence of the deceased immediately before they died and was not then being used to produce assessable income. In that instance, instead of adopting the deceased cost base, the cost base is equal to its market value. On the other hand, the dwelling were used to produce assessable income at the date of death (for example, by the rental of a room) the cost base would be $85,000 (½ of $170,000), which could give rise to a capital gain of $315,000 if sold immediately after death. A death tax?
Exemption for deceased estates
The rules in respect of the Main Residence Exemption provide a full exemption for post-CGT dwellings if it was a deceased’s main residence just before death and not being used to produce assessable income at that time (use prior to death is not taken into account). It applies to pre-CGT dwellings irrespective of use prior to death.
The full exemption is available where the dwelling is sold within two years of death, or the dwelling is used throughout the period after death by the deceased’s spouse, a person with a right of occupation under the Will, or the beneficiary to whom the dwelling passes under the Will.
Importantly, the exemption not only applies to an individual but also to the trustee of a deceased estate. Although it might be considered that the term “trustee of a deceased estate” is limited to the legal personal representative, the ATO accepts that the trustee of a testamentary trust satisfies that description (ATO ID 2006/34) which is consistent with its long-standing practice in PSLA 2003/12 to treat the trustee of a testamentary trust in the same way as a legal personal representative for CGT.
A key planning point is if the dwelling is being used as the Main residence of a person other than the spouse, a right of occupation must be provided by the Will.
Failing the conditions: if the property is not sold within two years and not used as a main residence by the people described above, a partial exemption is available. But in that instance any period when the dwelling was not the deceased’s main residence is taken into account to reduce the exemption.
In the event that the property were sold and a replacement residence acquired, the above exemption would not apply to the replacement residence.
On the other hand, if the original dwelling had passed to an individual who sold it and acquired a replacement residence, the replacement residence would be eligible.
A less-known provision, (Section 118-210) extends the Main Residence Exemption to the trustee of a deceased estate that acquires a dwelling for occupation by an individual. With appropriate drafting of the Will and putting in place appropriate processes to demonstrate the dwelling is acquired for occupation by an individual, this provision extends the Main Residence Exemption to a replacement residence.
As outlined above, the ATO accepts that the trustee of a testamentary trust is a trustee of a deceased estate to qualify for this exemption.
Pass to Spouse
Some may be dubious about the ATO continuing to stand by its long-standing practice and for greater certainty the best option is simply to pass the interest in the residence to the survivor. What must not be overlooked is that such a gift would then be subject to any claims that might be made against the surviving spouse (loss of asset protection benefits). Additional processes must be implemented in that case to preserve the asset protection benefits of a suitably drafted testamentary trust.
When implementing estate planning the Main residence of the deceased’s should receive special attention to enable access to the Main Residence Exemption on a subsequent sale during the lifetime of the survivor, and the asset protection benefits of a properly designed testamentary trust.
In particular, drafting a suitable form of right of occupation within the terms of the Will is recommended.
If passing the residence to a spouse, additional processes are required.
NOTE: This article is for general information only and should not be relied upon without first seeking advice from one of our specialist solicitors.