In episode 8 of our Talking Real Estate with Peter and George video series, George Dube and Peter Cuttini discuss how real estate investors can use family trusts as part of their tax planning strategy. They’ll answer the questions about what a family trust is, why use a family trust as part of your real estate investing strategy, when investors should and should not use family trusts, and more.
Peter: Hello everyone, welcome to the next episode of Talking Real Estate with George and Peter. Today we are going to be talking about a subject that is near and dear to our hearts, and we’ve been discussing it a lot with clients recently, we’re going to be talking about family trusts. Definitely an area that is more applicable to real estate investors today than it ever was. I’m going to ask George a bunch of questions, and we will go from there. Welcome everyone.
So George, what is a family trust?
I don’t know the exact legal definition if you will, but I’ll describe it as a relationship between people where somebody’s holding, typically assets, on somebody’s behalf. It’s an interesting thing, in my mind, from a tax perspective in that it provides, in a stereotypical example, a way for mom and dad to control assets, control income, but they don’t actually own it. Or, they don’t own it directly. It’s again, a series of relationships of trust, oddly enough, in doing that.
For most people, of course, that’s fairly confusing and I’m not sure it’s much better for the professionals that are specifically familiar with the definitions. But, I think if we can get across that idea of it helps us define some relationships, in terms of how we’re going to deal with assets. How are we going to deal with … Is it real estate, is it shares or corporations, some stocks, some mutual funds? How are we going to take care of people we’re going to call some beneficiaries, or people we’re trying to help out with the trust. Which, typically, is mom and dad, kids, grandkids, whether born or not. There might be somebody special in the family relationship, or nieces, nephews. Again, whether these people are born today or not, someone that mom and dad ultimately want to provide some assistance for, or leave a legacy to.
Okay. Why do it? Why set up a family trust?
There’s different reasons, I think, for different people in terms of setting up a trust. Similar to if we’re setting up a corporation, or this, that, or the other thing, but there’s probably a couple of in particular reasons that most people would gravitate towards. From an income tax perspective, being able to define who may be eligible to receive profits, assets is really nice, because we don’t have to necessarily figure out today who is going to receive everything.
So as a quick example, let’s say there’s two children involved, and we don’t know how many grandchildren yet are going to be around, that process may or may not have started. We also don’t know, perhaps, one of the children or grandchildren, they may need more intensive assistance. Maybe there’s a medical issue, for example. Maybe one of the kids has 18 kids themselves and the other has two kids, and as we’re trying to divide up the family assets, well, a natural thing of course to do is divide things 50-50. But, maybe the parents decide dividing things equally doesn’t mean 50-50. Sorry, dividing things fairly doesn’t mean 50-50.
Maybe, if one of the kids or some of the grandkids are more involved in the business, again, maybe some of the ratios change. Maybe that idea of fairness changes, or maybe there’s different components of that portfolio. So for example, there may be more real estate intensive assets, there may be some more second mortgages, or a stock, or a mutual fund type of investments, some insurance for example. And maybe, when we’re trying to allocate out to the kids or grandkids, depending on their involvement with the business activities, we’re going to change our mind down the road how things get divided. So for many people, that succession planning, the legacy planning in terms of that flexibility is quite nice.
I understand there can be, from a legal perspective, keeping in mind I’m certainly not a lawyer, and this is my interpretation of what’s been explained to me by some different lawyers, but there’s potentially some creditor protection aspects. The example that was given to me was the concept of, if I run Peter over in the road for example, he’s now dead. See you later, Peter. Now, the estate comes and sues me for $1 gazillion. If I own my assets personally, or if I own shares or corporation, they presumably now belong to the estate.
Whereas, if my assets are owned by the trust, or shares or corporation’s owned by that trust, then the trustees, often which the husband and wife are two of the trustees, will politely explain, “Hey, we’re really, really sorry to hear about your loss, but George wasn’t going to get any the assets. They were going to go to the wife, the grandkids, the neighbor’s dog, whoever, but definitely not to George.” Again, I can’t emphasize enough I’m not a lawyer, I can’t say that that works, but I have heard similar types of explanations from lawyers.
I understand there can be some benefits from a family law perspective, in that if there’s a child or grandchild that having some issues with a relationship, or maybe the parents don’t approve of a relationship, there’s some protection there for some of the assets. That helps out, of course, on the legal side.
Back to the tax side, well if I don’t have to know exactly today who is going to receive assets, who I’m going to pay dividends to, I’ve got flexibility to decided later on, well that makes the structuring, the planning much simpler, it keeps more doors open.
On a very long-term basis, or hopefully long-term for most of us, is the idea back to the ownership. Well normally, if mom and dad owned, for example, a real estate portfolio, hula hoop factory, stocks, mutual funds, if they own it personally they own shares of a corporation. The second of them passes away, all of their assets are deemed to have been disposed of for fair market value, from a tax perspective.
As a real, real rough number, they may give up about 25% of their estate by the time all is said and done, assuming we’re not dealing with a basic estate, to the government in taxes. But if mom and dad didn’t own anything because the trust did, there was nothing to give to the government, there was nothing to be deemed to have been disposed of. Now, those assets have gone to the next generation, the church, the Cancer Society, much easier and more fulfilling. Not that the tax is going to be zero, but it can certainly be a lot closer to zero than 25%.
What would be the typical situations where you’d recommend?
Certainly, if somebody’s looking at it from a legal perspective, the actual tax portion doesn’t matter of course. So it’s some people that we’re working with, they’re bound and bent they want what they understand to be some additional protection.
If we’re dealing on the tax side of things, it doesn’t take a big tax figure, or a value figure, really to justify from an estate succession planning perspective, the tax savings. So if I had $1 million that otherwise I was going to taxed on at capital gain rate, using today’s inclusion rate in taxes, roughly speaking again, $250,000 is going to go to the government. Well, if that family trust protects that $250,000, or defers that tax for a generation or two, $1 million isn’t a lot of money in today’s world. It doesn’t take a lot.
Often, what we’re looking for are people that are looking to leave a bit of a legacy to the kids. And often, we’ll see that the parents won’t necessarily set up a structure specifically for the kids, because this is for their retirement, this is for their lives if you will. And then, we get into discussions, for example, well how much do you need before you take your last breath? So of course, it’s hard to predict when we’re going to pass away, what our healthcare needs are going to be. What lifestyle do we want? Do we want to go and fly to Venus, do we want to go around the world, do we want to take our grandkids several cruises a year? Or, do we want to live on $30,000 a year? It’s not that one of those is right or wrong, but we have different justifications or different ambitions, if you will.
Again, that trust where, well wait a minute, if I have to predict how much money I am going to need, and try to predict how long I’m going to live, what my healthcare requirements are, that sounds a whole lot like I’m trying to pretend I’m God and figure all that out in advance. Whereas, if I’m going to try and live, instead, on the income that’s generated from my portfolio, then that’s a lot easier to work with. And if I’ve got kids running around and what have you, I want that to be part of it, I want that family trust to be part of it so it can assist me in not having to draw down in principle but to live off the income. And therefore, should I give the taxes on that portfolio to the government, or should I give them to my kids? Well, pretty easy decision for most of us.
Does it matter the age of the kids? I’ll give you an example. A husband and wife, the husband’s a really good looking accountant, he has kids around 11 and seven. I don’t know if you know anyone like that.
No. Would it make sense with kids at that age, should they be older, should they be younger? When would it make sense?
In my mind, actually, I think it can make sense for different situations. I think it can make sense when the kids are very, very young, as in less than five years of age. I think it can make sense when they are teenagers, I think it can make sense when they’re young adults or, for that matter, older adults.
I used to be really drawn to the argument that the kids should be early 20s, if you will, before you start thinking of setting up a trust. I stopped thinking that way, more I accept that from an income tax perspective you are … Because of what they call the TOSI rules, which limits our ability to pay younger children or young adults, well yes … Let me rephrase that. It doesn’t limit us, what it does is creates a maximum tax bracket, automatically, if we pay these people in that situation.
A number of people are already in a maximum tax bracket so one, they don’t care about that rule. But two, particularly with a real estate portfolio, or a stock portfolio, a lot of the value is in the appreciation of those assets over years. So now, it’d have an opportunity to get that appreciation while the kids could be younger. So I don’t have a probably anymore, in doing that.
I don’t have a problem with the concept that a “normal family,” they may have two or three family trusts in their lifetime. Instead of trying to say there’s going to be one family trust created, well where does it say that? Why can’t I have two or three trusts, over time? I’m not fixated any longer, although admittedly I used to be, on this idea of when the kids ages were.
There’s certain businesses, Peter, and you’re certainly aware of some, where it’s possible that we potentially could sell the shares of a business and realize what we call the capital gains exemption. Which, in English, means we could sell a business, if it qualifies, potentially for, I’m just going to round off the numbers and I’m going to call it $800,000, and those shares, that sale can be tax free. And that I can do that, in the right circumstances, for everybody that’s a beneficiary.
So if I’ve got two young kids, potentially again, you’ve got husband and wife, two kids, that was over $3 million that I could potentially realize tax free. Whereas, if I waited until perhaps it was too late before I got around to doing this, I’ve already, without getting into the mechanics, waited too long while all the appreciation was going in my hands, or the spouse’s hands, instead of having that opportunity to allow some of that growth to go to the kids.
Back to your question, I don’t think it hurts, in many cases, to have it when the kids are quite young.
Okay. What would be some disadvantages of setting a trust up? When wouldn’t you do it?
I’m not so sure it’s when we wouldn’t do it, but yes I do believe, as much as I think there’s a lot of rainbows and lollypops associated with family trusts, in my mind there’s what I’ll call three disadvantages. Maybe a fourth. The three disadvantages, all of which I believe have solutions, but it’s far from perfect.
The first disadvantage, it costs more to set up a family trust. It’s not quite as simple as a corporation. But in saying that, we can still deduct the costs. It’s going to be done over some time, as compared to all at once. And, if we start contrasting that cost with the tax savings available, it’s a no brainer in my mind. But, I don’t want to pretend that there’s not a cost factor there.
Secondly, in terms of actually setting up that trust, it’s something they have a few hoops and hurdles to run through. And, it’s a process that’s, roughly speaking in my mind, going to take about three months to do. Whereas a corporation, if we absolutely, positively needed one, we could probably still get one this afternoon type of thing. You might have to fix it afterwards, but we could get it in place. In contrast, the family trust, there’s roughly a half a dozen things that, if between the accountant and the lawyer they do something incorrectly, it would forever taint the trust. It would make it useless.
So I want to go slowly and methodically through our process. I don’t want to have to explain to a beneficiary 10 years from now, “George was really, really trying to get this out the door fast, your parents were really wanting this quickly to close on a deal, and I’m sorry, I made a mistake. The whole thing was a waste of time.” Not a pleasant discussion. I’m sure my insurance coverage person would be less happy with me. It’s not good. Take the time to do it right.
And there’s some aspects to that trust, such as deciding who the beneficiaries are going to be, deciding who the trustees are going to be, for some families that’s something that they can think of, in five minutes they’ve got the answer. Others, it’s I’ll call it the bottle of wine solution where they’re going to need a bottle of wine over a couple weekends, maybe more than one bottle. But they, I think, should take some time to think about it because there’s certain parts to that trust that we can’t change in the future. This is not a once in a lifetime thing, but certainly a once in a while scenario that we need to do it properly.
The third disadvantage is that the trust is good for 21 years. After 21 years, any assets remaining in the trust are deemed to have been sold for fair market value. In most cases, that’s a tax disaster. So what would typically happen is prior to that 21st anniversary, there’s already been a plan created, hopefully about a year in advance at least, where we’re going to figure out how we’re going to distribute those assets. And the majority of cases, I expect, the distribution would be, and certainly the ones I’ve been involved with, they will be to the family members. It could be back to mom and dad, it could be to the next generation. And properly done, that can be done on a tax deferred basis, so again, there’s no income tax triggered at that point.
In many cases, I think most families, they’re going to set up a new family trust at that point. So every 20-ish years, they’re going to go through the process again. 20 years is a long time, but clearly not a long time from an intergenerational wealth transfer perspective. But on the same token, I think most of our clients, if they’ve got a corporate set up for example, every 10 to 15-ish years they were going to change that anyway because there was going to be a change to tax rules, legal rules, financing rules. There was going to be a change to business or family situations.
I don’t think that the 21 years is horrible. Would I prefer to see that rule gone? Absolutely. But on the same token, I was probably going to play with the system, or the structure, anyway, so probably not a big deal.
That fourth thing that I mentioned may be, for some people, a little bit of a disadvantage, and there’s certainly ways around this, many ways. But, with some of the tax restrictions in terms of who to remunerate in a family member, we call the TOSI rules, using the family trust, it takes away one little possibility. I shouldn’t say little, one good possibility, in some situations, of being able to income split with other family members. But in saying that, again, I can’t emphasize enough, there’s other ways around that.
But I acknowledge, each one of this is a disadvantage. Each one of those, I think though, has solutions around it for real estate investors, in many cases. Again, we’re getting contrasting information from some of the financial institutions, but for the last little bit, many of the real estate investors are almost getting pushed to a family trust scenario. That’s because, I don’t know, 25-ish years prior to this, we were in many cases recommending … many people may recognize this idea of a three tier structure, having a parent company own a real estate holding company, and may or may not have a property management company.
Financial institutions were beginning, in 2018, really, really apprehensive of financing those types of structures, in many cases. Certainly Peter, you and I have been beating our heads against walls dealing with that issue, since 2018. And same with my own structure, for sure. Whereas, when I put in the family trust owning the real estate holding companies, it was like a light bulb went on. All of a sudden, it was significantly easier for me to finance properties.
Now in saying that, most of the properties that I acquire are, from a financing perspective, considered commercial properties. Meaning, they’re five or more residential units, or truly commercial units from what I’ll call a tax perspective. Those, I think, are pretty easy to fund through the trusts, from our experiences. We are certainly seeing clients where they’re trying to acquire a number of four units or less, in terms of residential properties, they’re struggling with the family trust but they’re also struggling with the corporation. And I think more so, and Peter again, you’ve dealt with this as much as I have, where dealing with the financial institutions, depending who you’re talking to at the institution, which group within the institution, just having a certain number of doors, typically five-ish will all of a sudden create the limit. And then, you have to move onto the next entity, the next financial institution.
But, financing can be a big plus and it can be a very, very frustrating point to this. And I think that’s worthwhile to have the conversations about, depending on what somebody’s investment strategy is, how that trust fits in.
Excellent. Well George, I don’t have any further questions. Is there any remarks you would like to make in closing?
I would say that a lot of our clients, I think, it’s not a question so much of whether they need a family trust, I think it’s more of will the family trust be created now or over the next five-ish years. If that’s the case, I think most of our clients that we’ve been putting them in place for, even myself as an example, when a variety of tax rules came into place and these financing rules, I put my trust into place in 2018. As a result of that, then I didn’t say everything was going to have to … everything, meaning my other corporations, were going to immediately be transferred to the family trust. Often, I was waiting. When do mortgages come up for renewal, for example? When does it make sense, from a tax, a legal, a business investment perspective? And develop a five-ish year plan to move those properties over to the trust.
So everything doesn’t have to be done at once. This is something we can budget for. We can have a conversation and figure out, yes we know where the concept is that we want to be in five years, how do we get there? It doesn’t mean to be an all or nothing solution, immediately.
Perfect. Thanks, George.
I hope everyone enjoyed this Talking Real Estate with George and Peter. Take care everyone, and have a great day.
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