Legal Tip 115: The Gift and Borrow Back Strategy, Part 1

The gift and borrow back strategy, Part 1


There is an asset protection strategy which involves giving something away and then borrowing it back again. Giving something away means it no longer belongs to you, but belongs to the person that you give it to. It is not your asset, but an asset of the gift recipient.


The idea is if the gift giver were to later become bankrupt this asset will be out of reach of creditors.


This can be a cheap and effective strategy to implement and was often employed in the past as an asset protection strategy. The strategy was abused by the sort of people that end up on the TV show ACA. Shonky *******s were defeating creditors. Laws were brought in to limit the ability to do this. There are 2 main laws:

i) Transactions to defeat creditors

ii) Clawback provisions


Generally if you enter into a transaction to defeat creditors that transaction can be reversed – potentially without time limit.


Clawbacks can be made on under market value transactions. A gift is under market value. These claw back provisions generally last from 2 to 4 years after the gift is made.


Where someone has no creditors at the time of the gift, is solvent and is not expecting to go bankrupt and the transaction was more than 4 years ago the gift and borrow back strategy should be very strong.


Even where someone is about to enter bankruptcy it may still be worth considering even though the gift may be clawed back. This is because the trustee is bankruptcy has to go to the effort and cost to get that gift back. This will give the gift giver and the recipient leverage to negotiate with creditors.

Only lawyers can advise on this strategy.

 

I understand you can use this strategy to gift the equity value of an asset you have in your name, say an IP to a trust. The trust then lends it back to you using a second mortgage over the security property. The first mortgage is with the bank. I understand to get a second mortgage, you need permission from your lender, so my question is, how many lenders are willing to do that? And if the LVR with the lender is 80/20, can you gift that 20% equity ownership to the trust, or does the bank have issues with that?

 

You don't need permission.

 

Ok. So you can just ask a solicitor to prepare new mortgage papers on behalf of the trust and the priority lender doesn't even need to know about it?

 

There are 2 forms of mortgages - legal and equitable. Legal mortgages are registered on title - this needs the permission of the earlier mortgagee in some states, in others it doesn't, but they may be notified when a mortgage is registered. Equitable mortgages are mortgages that are not registered. Since there is no registration no one would know about them (which could effect priority).

Granting a subsequent mortgage over the property will probably be a breach of the loan agreement with the first mortgagee.

 

I see. So, for the strategy you described above, you basically have to use an equitable mortgage, right? I would imagine a legal mortgage offers more protection, but it would be almost impossible to get.

 

No, you don't have you. You could get permission to give a second registered mortgage.

Registration takes priority over non registration usually.

 

I would prefer to gift any liquid asset to a safety deposit box or to a suit case in the ground somewhere.

The reason for this is because I feel the human species acts rather strange when gifted with large amounts of assets.

 

Suppose one sets up an equitable mortgage. Then he/she is sued and they're after that asset. Before anyone else puts any caveats that person then registers that mortgage on title. Does that strengthen the asset protection position? Or does it not help and it might even make it more likely to fall into one of the clawback provisions?

 

Yes it would strengthen. But there are various sections of the bankruptcy act to consider such as s123 on relation back, s122 on unfair preferences etc
And the conveyancing acts for the relevant state s 37A for nsw

 

Thanks
It appears such transfer would be void if made in the period beginning 6 months before the petition, so that pretty much covers any notice one would have of impending doom. Is the equitable mortgage without registering even worth considering for asset protection?

 

No, it is still worthwhile considering.
But where they are related parties there will be knowledge of impending bankruptcy.

But what if there is an equitable mortgage which is later converted to a legal mortgage by registering and this occurred within 6 months of a creditors position.

There is a case where this happened - Burns v Stapleton (1959) (haven't read it) which said that the legal mortgage wasn't invalidated even though it was registered during the relation back period.

 

1. Some interesting things in this case: The equitable mortgage was recognised, even though it was only a verbal agreement.
2. The legal mortgage was actually invalidated. I think that's what this says:
" the only relief to which the respondent has established a right in these proceedings is a declaration that the bill of mortgage and memorandum of mortgage are void as against him to the extent to which they would otherwise give the appellant security over or a charge upon the lands"...
3. Even though the legal mortgage was invalidated, the equitable mortgage was valid from when the verbal agreement took place:
" Before the execution of the mortgages the appellant was equitable mortgagee of Fallon's interest as joint tenant with his wife in the subject lands"

 

4. You're right, knowledge of impending bankruptcy or, like in this case, knowledge that someone can't pay their debts, prevents the mortgagor from being deemed to act in good faith and afford the desired protection.
"inference that the appellant knew that Fallon was unable to pay his debts as they became due and that the inclusion of the 232 pounds 10s. 0d. in the mortgage would have the effect of giving him an advantage over the other creditors in respect of that sum. Sub-section (4) of s. 95 therefore prevents the appellant from being deemed an encumbrancer in good faith, and for that reason, if for no other, sub-s. (2) cannot afford the desired protection."

 

Thanks G

here is a link for those that are keen to read the case:
BarNet Jade - Find recent Australian legal decisions, judgments, case summaries for legal professionals (Judgments And Decisions Enhanced)

(I am not that keen at the moment!)

 

And when using Barnet - look down the bottom and you can see a list of cases which cite this case. These are more recent.

 

Hi, it's me again. I can't let seem to let this topic rest
Say, John has an IP worth $500k and he owes $300k to the bank. John wants to protect the capital growth of his IP from creditors, now and in the future, up to when the IP is worth $800k.
1. Can John register a second mortgage on title for a trust for a $800k, so that the trust gets preference over any accumulated equity after the first mortgagee has been paid? Or can he only register interest on the value of the equity currently, $200k?
2. What are the tax consequences of John gifting equity to the trust? Is he still entitled to claim interest he pays to the bank on his tax return? Or is the trust that claims the interest?
3. When the trust lends back the IP to John, seeing that no money is changing hands, does it need a loan agreement?

 

1. He could, but just offering a mortgage for nothing in return would be an undermarket transaction subject to voiding potentially - depending how far creditors dig.

2. You can't give equity to a trust. If Joh borrows and gifts money any interest on the loan won't be deductible.

3. definitely. Without a written loan agreement it would be very unlikely to be recognised as a loan.

 

Thanks Terry, that makes sense.
Re. 2, it seems like a big disadvantage tax-wise to use this strategy to gift money borrowed from equity to a trust, then not being able to claim the interest being paid in your personal tax income or in the trust expenses. I know gifting affords more asset protection, but is there any way to have both the asset protection and the tax deduction?

 

You could just gift you wage everyweek and borrow it back at 0%