The death of testamentary trusts?

Managing Associate Kimi Shah discuss this important topic.

The death of testamentary trusts?

For years, testamentary trusts have been one of the most effective and flexible estate-planning tools available to Australian families. They have offered tax efficiency, asset protection, and control over how wealth passes between generations.

But a recent shift in thinking from the Australian Taxation Office has prompted a growing concern among advisers: are testamentary trusts quietly losing one of their most valuable tax advantages?

Some commentators are already calling it the “death of the testamentary trust”. While that may be overstated, the warning signs are real.

Why Testamentary Trusts Have Always Worked So Well

A testamentary trust is created under a will and only comes into existence on death. Unlike an ordinary family trust, it benefits from special tax concessions — most notably the ability to distribute income to children at adult marginal tax rates.

In addition, when a deceased person’s main residence passes into a testamentary trust, families have traditionally assumed that the capital gains tax (CGT) main-residence exemption would generally be preserved. In practice, this meant:

• flexibility about when the home was sold; and
• confidence that a large CGT liability would not arise simply because the property sat in a trust structure.

That assumption is now being questioned.

What’s Changed?

The ATO has released draft guidance suggesting a much narrower interpretation of when the main-residence CGT exemption applies to homes held in testamentary trusts.

Under this emerging view, it may no longer be enough that:

• the home was the deceased’s main residence; or
• a beneficiary informally occupies the property with the trustee’s consent.

Instead, the exemption may only continue if the will gives a specific beneficiary a clear, enforceable right to occupy the home. Broad trustee discretions — a common feature of modern wills — may no longer be sufficient.

This is a significant departure from how many practitioners have historically understood and applied the law.

Why This Matters in the Real World

If this interpretation is adopted, the consequences could be substantial.

Many families deliberately use testamentary trusts to:

• protect assets from relationship breakdowns or creditors;
• manage blended families; or
• delay the sale of the family home while beneficiaries decide what to do next.

If the CGT exemption is lost simply because the home is held in a trust — or because the will lacks the “right” wording — families could face unexpected and sometimes very large tax bills when the property is eventually sold.

That outcome feels particularly harsh given that Australia has no formal inheritance or estate tax. For some, this looks less like technical clarification and more like a back-door tax triggered by death.

Does This Mean Testamentary Trusts Are Obsolete?

Not quite — but it does mean they can no longer be treated as a one-size-fits-all solution.

Testamentary trusts will continue to play an important role in:

• income splitting;
• asset protection; and
• long-term family wealth planning.

However, their interaction with residential property — especially the family home — now requires far more careful drafting and strategic thought than in the past.

What Should Be Done Now?

While the ATO’s position is still in draft form, the direction of travel is clear. Estate plans that rely on assumptions rather than precision are increasingly vulnerable.

Practical steps include:

• reviewing wills that pour the family home into a testamentary trust by default;
• considering whether a specific right of occupation should be included; and
• reassessing whether a trust is the best structure for holding the main residence at all.

The Bigger Picture

Calling this the “death of testamentary trusts” may be premature — but it is fair to say the era of set-and-forget estate planning is over.

As tax authorities take a closer and more literal approach to the legislation, the effectiveness of testamentary trusts will depend less on tradition and more on careful drafting, clear intention, and proactive advice.

For families and advisers alike, the message is simple: testamentary trusts aren’t dead — but they are changing. And ignoring that change could be costly.

If you have any questions relating to testamentary trusts, reach out to Kimi Shah or Jane Song.

How can HHG Legal Group help?

Email us to find out more

*The information provided in this website serves as a general guide and does not constitute legal advice. It is based on our research and experience at the time of publication. Please consult our knowledgeable legal team for any specific inquiries or advice relevant to your circumstances, as the content may not have been updated subsequently.