We all know that Australians have an unhealthy obsession with owning their own home. And with house prices surging over the past 5 years there is every right to be obsessed. But why sacrifice so much to purchase your dream home only to watch it fall into the hands of creditors?
As farfetched as this may sound, it is in fact a very realistic consequence for individuals who may be exposed to personal liability for claims or losses incurred by their business or company. This is particularly so for sole traders, professionals such as accountants, doctors and lawyers, and company directors.
Luckily there are 3 simple steps which may be a big help in protecting your assets for future generations from potential creditors or trustees in bankruptcy.
The process for protecting your asset is simple and best illustrated by way of an example.
Let’s pretend that you are a sole practising doctor who owns a $2 million Potts Point property that is held personally in your name. You want to ensure that in the unlikely event that a patient sues you for malpractice your property will not be seized by creditors. Assuming that there are no other relevant factors to be considered, you will execute and document with your lawyer the following 3 simple steps-
1. Initial advance
A third party will advance you a loan of $2 million and take (at their discretion) a first registered mortgage over the Potts Point property to the value of $2 million.
The third party can be any person or business not a related party to this 3-step transaction, for example, a friend, family member, company or bank. Whilst the loan can be interest free, a market interest rate is preferable. This will be documented by a Deed of Loan and a Deed of Mortgage.
2. Trust gift
You will then gift the $2 million received from the third party into your trust (usually a family trust). This will be documented by way of a Deed of Gift.
3. The loan from the trust
The next day, your trust will make a $2 million interest free loan back to you. This will be documented by a Deed of Loan.
You will use the $2 million advanced from your trust to repay the outstanding $2 million loan to the third party. This will discharge any mortgage that was taken by the third party.
As security for the $2 million trust loan, your trust will take a first ranking mortgage over the Potts Point property for an amount equal to $2 million. This will be documented by a Deed of Mortgage.
The net effect is:
- your trust has replaced the previous third party as the first registered mortgagee on title meaning your family trust will have first priority to the $2 million Potts Point property if any claim is made against it by a creditor; and
- you have an outstanding interest free loan of $2 million owing to your trust which can be waived by your trust at any time.
When is this strategy most successful?
This strategy is most useful for any individual who may be exposed to personal liability for any claims or losses incurred by a business such as sole traders, partners in a partnership or directors of companies.
However, upon executing this strategy there must be no present known claims against you or circumstances that have arisen which might lead to such claims, and that there are otherwise no foreshadowed or threatened personal claims against you.
You must also ensure that your trust deed allows for the trust to borrow and lend money.
In the event that you become bankrupt, there is a risk that the $2 million gift by you to your trust may be voided and become the property of the bankrupt’s estate which may be accessed by the trustee in bankruptcy.
A trustee in bankruptcy is entitled to seek to recover or make void certain past transactions. Under section 120(3)(a) of the Bankruptcy Act 1996 (Cth) (Act), if a gift of property was made by a bankrupt for no consideration to a related entity of that bankrupt at the time the bankrupt was solvent, the trustee in bankruptcy may recover any gifts of property made within four years before the commencement of bankruptcy. If the gift of property was made by a bankrupt at the time the bankrupt was insolvent, then the trustee in bankruptcy may recover any gifts of property made within five years of the commencement of the bankruptcy.
For the purposes of the Act, a related entity of a bankrupt will include the trustee of a trust under which that person is a beneficiary. Therefore, the 4 year relation back period is likely to apply to this example.
Failure to obtain first mortgagee consent
Let’s now change the scenario slightly. We will now assume that, instead of you owning the Potts Point property outright, you have granted a $1 million mortgage over the property registered in favour of Westpac. You are left with $1 million of personal equity to protect from potential creditors.
In such a scenario, the above 3 steps are still applicable, however they cannot be executed without Westpac’s consent to the registration of a $1 million second-ranking mortgage over the property. The requirement for consent will be dictated by the terms of the Westpac loan and relevant mortgage documentation.
In the event that you are unable to obtain Westpac’s consent, you may wish to execute (but not register) mortgage documentation and simultaneously lodge a caveat on title to note your interests. However, a caveat only gives an equitable interest and therefore does not afford the same protection as a registered mortgage.
The Westpac security documents must be reviewed to ensure that the registration of a caveat does not in itself constitute a breach under the Westpac loan terms.
Whilst every circumstance is different, you are only a short chat with your lawyer and 3 simple steps away from protecting your most valuable asset(s).
Do not delay having your lawyer draft the necessary documents, particularly given that there is a relation back period, and not to mention in the short time it took to read this article, Sydney’s house prices likely rose by another 50%.