Should You Gift a Family Home Into a Testamentary Trust?

While a testamentary discretionary trust (referred to as a testamentary trust for ease in this blog post) certainly can own land and where a property is intended to be the ongoing family home for one or more beneficiaries of the estate, careful consideration needs to be given to whether a testamentary trust is the appropriate ownership structure for the property to ensure there are no potential long-term, unintended consequences.

Essential Steps for Gifting a Family Home Into a Testamentary Trust

As owning a family home via a testamentary trust can result in increased complexity, here are the essential steps for due diligence:

 
1. Convert to Tenants in Common

A family home held by two people as joint tenants cannot be gifted into a testamentary trust.

The tenancy must first be converted into tenants in common.

Once the family home is held as tenants in common, and the will gifts the deceased's share of the property into a testamentary trust (either via a specific gift or as part of the residue), the result is the deceased's half-share is owned by the trustee of the testamentary trust, while the surviving spouse's half-share remains owned directly by the surviving owner (i.e. outside the testamentary trust).

 2. Preserve the Principal Place of Residence Capital Gains Tax Exemption

A family home qualifies for a capital gains tax exemption.

It is possible to maintain this exemption, even when the property is either wholly or partly owned by the trustee of a testamentary trust, if the dwelling is the main residence of:

• The deceased owner’s spouse, or

• A person who has been granted a right to occupy the dwelling under the will, or

• A person to whom the dwelling "passes" in satisfaction of their entitlement under the will.

However, for an unsophisticated client, satisfying the additional tests to preserve the principal place of residence capital gains tax exemption can add a layer of complexity which may be unwarranted if there are no asset protection drivers in support of owning the property in a testamentary trust.

Unless the circumstances justify it, I favour keeping it simple.

As an example, where you are acting for a couple who are each in high-risk occupations (e.g. directors of trading companies, or at risk of being sued for professional negligence), it is justified to gift their respective interests into a testamentary trust under their will, so that the surviving spouse can use the testamentary trust to protect that interest in the property if there is a claim against them personally.

If neither member of a couple was in a high-risk occupation (e.g. they are not carrying on a business, they are employees) and they intend to remain in the property as their family home if one of them died, then it is much simpler to gift the property directly to the surviving spouse in the first instance, and then to a testamentary trust only after they have both passed away.

 3. Preserve the Principal Place of Residence Land Tax Exemption

A family home is typically exempted from annual land tax.

This exemption may not be available once the family home is owned by a trust.

In some jurisdictions, the land tax exemption can be claimed even when the family home is held in a trust if the will grants a right to occupy. Be aware of the position in your state of practice when it comes to land tax exemption once the family home is held in a trust, as we are doing a surviving spouse a significant disservice if an annual land tax becomes payable on the family home because half of it is owned by the trustee of a testamentary trust.

 4. Exclude Foreign Persons as Beneficiaries

If a testamentary trust owns residential real property, the terms of the testamentary trust contained in the will must exclude foreign persons from being beneficiaries of the trust. This is important both in relation to avoiding the need for approval by the Foreign Investment Review Board (which requires an application fee upwards of six figures) and, in some jurisdictions, to avoid an annual land tax surcharge.

 5. Consider the Practicalities

Unless the family home was owned solely by one spouse, the end result is that where one spouse dies, the house will be held 50% by the surviving spouse and 50% by the trustee of a testamentary trust.

It’s essential to stress-test the logistics of who is going to be responsible for funding the ongoing bills, maintenance, and other ownership expenses.

Another issue is that the testamentary trust cannot borrow (at least without jeopardising the excepted trust income treatment of the income earned by the trust i.e. the tax-free income for minors).

If there is going to be a mortgage on the property after the estate is administered, how will this be funded and serviced?

If there is significant debt on the home, and the testamentary trust cannot borrow without jeopardising its tax-free income treatment, what is the expected outcome? We do not want the surviving spouse to be forced to sell the home.

In many cases, there will be sufficient liquidity in the estate from the life insurance proceeds and superannuation death benefits which may mean there is no need to maintain a mortgage on the property. However this is an important consideration.

It is important to walk through these scenarios when guiding clients, ensuring they understand the added layer of complexity of gifting part of the property into a testamentary trust.

This complexity might be appropriate for a sophisticated client, one accustomed to dealing with trusts, and who has a strong advisory team.

However, for a layperson with no prior experience with trusts, having a testamentary trust own half their home places them in an unnecessarily complex situation.

6. Long Term Succession Plan for the Family Home

When gifting a family home into a testamentary trust, it is essential to determine the long-term succession plan. For instance, who is intended to benefit from the home after both spouses in a couple have died? If the intention is to divide the home (or the sale proceeds) equally between three adult children, having 50% of the property owned by a single testamentary trust can significantly complicate that ultimate division.

Rules of Thumb

I do not typically advocate for gifting a family home into a testamentary trust when designing an estate planning strategy. However, here are my rules of thumb, depending on the following circumstances:

Individual Clients 

If the client is an individual, there is generally no concern with gifting the family home into the testamentary trust.

If the property is intended to be liquidated, there is a two-year disposal period for capital gains tax purposes which allows for either selling the home tax-free, or keeping it in the testamentary trust and investing it. If a beneficiary of the testamentary trust intends to use the property as their main residence, then the will should grant them a right to occupy the property.

Young Couple Who Have Minor Children  

For a young couple with minor children whose affairs are straightforward and simple (meaning they are not a blended family, neither spouse has a high-risk profile, and they have no trusts or companies), I would typically encourage passing the family home directly to the surviving spouse and only gifting the property into a testamentary trust once both spouses have passed away.

Couples with High-Risk Profiles e.g. Running Businesses 

If one or both members of the couple have a high-risk profile (e.g. are running businesses, directors of trading entities, or are in high-risk occupations where they could be sued for professional negligence) and they are already familiar with trusts and companies, then gifting part of the property into a testamentary trust can enhance asset protection over that asset for the surviving spouse.

However, as mentioned above, careful consideration needs to be given to drafting the will appropriately so there are no adverse capital gains tax or land tax consequences.

It is also important to note that there will be two testamentary trusts when both spouses pass away: one established under each spouse's will. Each of those testamentary trusts will own part of the property.

Baby Boomer Generation Couple with Adult Children 

For a couple with adult children, the simplest approach is to gift the home directly to the surviving spouse and only gift the property into one or more testamentary trusts after both members of the couple have passed away.

Blended Families

Things get complex when dealing with a blended family, and the general rules of thumb, are often disregarded, as a highly customised approach is necessary.

This includes future planning for portability of any right to occupy, dispute resolution processes, and other related issues. 

Key Takeaways

When discussing the gifting of a family home into a testamentary trust with a client, it is best practice to raise the following questions: 

• Is protecting the asset from relationship breakdown a priority?

• What is your risk profile concerning bankruptcy?