This article will look at using trusts to buy property for children. It will look at reasons why this may be beneficial – such as keeping the ‘principal private residence exemption’ for capital gains tax (CGT) purposes – and some implications and practical considerations.
Background
Trusts are much maligned. There was a time when trusts were more commonly used, such as for crystallising retirement relief from CGT, or washing out principal private residence (PPR) relief. Alas, this is no longer the case, as the tax regime is now more restrictive.
Not all trusts, however, are set up simply to reduce tax.
Why set up a trust?
A key reason for setting up a Trust is to protect assets. Typically, a cherished property or shares in the family company.
This may be to protect assets from claims against the original owner, or on behalf of the intended beneficiary so that he or she cannot then sell the property, or have it taken from them in a divorce court or similar (however, merely putting something into a trust does not necessarily put it beyond the reach of creditors or other claimants).
Another related reason is to place assets ‘on hold’ until (for example) the intended beneficiary reaches a suitable age.
What is a trust?
Very simply, it is when someone makes a second person(s) (the trustee) responsible for something on behalf of a third person(s) (the beneficiary).
Example 1 – Trust for asset protection
John is a wealthy investor. His daughter, Antonia, is about to get married. John wants to buy a property for his daughter to live in, but he wants to make sure that his substantial gift doesn’t end up getting lost in an acrimonious divorce years down the line.
Rather than give money to his daughter directly, he instructs his solicitor to set up a trust with Antonia as beneficiary. His solicitor agrees to act as trustee, responsible for custody of the property – but always with Antonia’s interests at heart, in line with the trust’s constitution.
Once the property is in the trust, John usually has no more say in what happens to the trust property, unless perhaps he also becomes a trustee – and even then, his duties are to the beneficiary, not to his own interests (John could reserve some interest in the trust assets making it a ‘settlor-interested trust’, but that is beyond the scope of this article).
Basic types of trust
There are many kinds of trust. Below are some categories which are particularly relevant for property.
Bare/simple trust
Essentially, the beneficiary can demand the trust property be handed over at any time. Very common where the beneficiaries are children under the age of 18, and cannot legally own property directly in their own names. Income and gains are attributed directly to the beneficiary.
Interest in possession trust
Broadly, where a beneficiary has the right to enjoy, occupy or similarly benefit from trust property – but not to take outright possession. For example, it may apply when one spouse dies and his will grants the surviving spouse the right to occupy his share in the family home for (say) the rest of her life, whereupon the property passes to their children. Interest in possession trusts are not as popular as once they were, when the tax regime was more favourable to this category. Note also that the beneficiary’s having an enforceable right can be problematic in cases such as divorce proceedings, where it will almost certainly count as an ‘income asset’.
Discretionary trust
The most flexible category of trust; the trustees have at least some say or discretion as to how the trust property is to be applied for the benefit of the beneficiary. It tends also to be more complex to administer, and to be the most heavily taxed.
Example 2 - How to use trusts to protect capital and still keep PPR relief
David and Janet want to help their elder daughter Lucia to buy a home near her chosen university. Mindful of the fact that she is just 19, they want to make sure the capital is protected. Nevertheless, they would like to get the surplus funds out of their own estates for inheritance tax (IHT) purposes – while keeping the PPR ‘exemption’ for CGT purposes as if Lucia lived in her own home.
They set up a flexible discretionary trust, with themselves as trustees and with their children as beneficiaries, and put £300,000 into it – sufficient to buy a first home in the area. The trust deed affords the trustees discretion to allow Lucia to live in the property for as long as the trustees see fit.
Assuming Lucia lives in the property as her main residence, it will qualify for PPR relief provided she has an interest in possession, or the trustees simply exercise discretionary powers in accordance with the terms of the trust.
Let’s say that Lucia gets her degree and leaves university to go and work in London. Her younger sister, Henrietta (perhaps with an eye to the free accommodation) starts her degree at the same university later that year. Since Henrietta is also entitled to occupy the property, her period of occupation as her main home will also qualify for CGT relief.
If Henrietta also lets a room in the house, this income could fall to the trust or to Henrietta, depending on the arrangement and the terms of Henrietta’s occupation. Discretionary trusts are heavily taxed, so you might think that it would be a bad idea for the trust to receive rental income. While it is true that a discretionary trust would currently pay 45% income tax on rental profits, it also means that any income distributed out to beneficiaries would carry a 45% tax credit – so if Henrietta were to get funds from the trust, she might be able to get all of the trust’s tax back through her own tax return, assuming the gross income is covered by her tax-free personal allowance.
So far, any uplift in value in the trust property has been protected from CGT on sale by the PPR exemption, save perhaps a brief period when not occupied by either Lucia or Henrietta. As a discretionary trust, the trustees may decide to sell the property after the children no longer need it – effectively CGT-free – or, if it provides a decent rental income, perhaps keep the property and distribute the income to the children as and when deemed appropriate.
Use your nil rate band!
Note that, unlike a lifetime gift between individuals, putting money or other assets into a trust is not normally free of IHT at the point of gift, but a one-off gift below the £325,000 nil rate band should escape IHT. As a couple, David and Janet could put up to £650,000 into the trust, without triggering an immediate IHT charge. Provided they survive the gift by seven years, the gift will have fallen out of the estate(s) of whoever put up the funds.
Most trusts now have to pay IHT every ten years, or when capital is appointed out to beneficiaries. Here again, however, the nil rate band is in point and there may be no tax to pay if the value in the trust is adequately covered.
It is generally not a good idea to gift property you already own into a trust because, by default, it is chargeable to CGT as if you were selling it. It is possible to ‘hold over’ any capital gain when transferring to a trust in most cases but the trust cannot then claim PPR when the property is sold on (unless the hold over is disapplied).
Practical Tip:
Trusts can be very useful instruments and can provide some ‘nice’ solutions in the right circumstances. However, competent advice and careful drafting are absolutely vital to make sure you get what you intended.
