Lee Sharpe looks at tax aspects of using trusts to hold investment properties for loved ones.
This article is based on English law and readers should note that there are differences between the UK jurisdictions. Treatment in the EU, and further afield, can also be quite different.
Why use a trust?
Trusts are usually taxed very heavily. Nevertheless they are in some cases well placed to expedite a person’s wishes, such as:
- To legally hold assets for the benefit of young children until they are old enough to take direct ownership of them.
- To give someone the temporary benefit of assets until they pass to their intended beneficiaries (typically, a will providing assets for the occupation of/to provide income for, the surviving spouse as ‘life tenant’ until they pass to the children of the marriage).
- To protect assets from ‘spendthrift’ beneficiaries, or claims arising from ‘bad marriages’, etc., so that someone cannot be forced to yield the underlying assets to creditors or other claimants – typically treasured assets such as the family home or shares in the family company.
Note that it is relatively rare these days for one of those reasons to be simply to save tax (although writing a life policy into trust, so that on death/claim it falls outside of one’s taxable estate for inheritance tax (IHT) purposes, is a relatively simple and common tax-saving measure).
Basic use of trusts: typical inter-generational lifetime planning
Parents and grandparents who are landlords may get to the point that they do not actually want to hold investment property that is generating more income than they need (and which they are paying income tax on), and which is at risk of increasing their IHT exposure on death.
The simplest way of addressing this growing problem would be to give one or more rental properties to their adult children or even adult grandchildren. Provided they survive making the gift by at least seven years, the property will fall outside their estates on death and escape IHT. But this lifetime transfer usually triggers a substantial charge to capital gains tax (CGT).
Spouses/civil partners aside, there is no automatic relief from CGT for gifts or transfers at a discount. A gift or discounted sale of property to another family member will usually trigger a CGT liability, as if the asset had been sold for full market value. Simply put, HMRC is not that concerned at any lack of monetary proceeds from which to pay the CGT that is due.
At this point, it is also worth highlighting that, from 6 April 2020, individuals (and some other taxpayers) must make a return and payment on account of any disposal of UK residential property to HMRC within 30 days of completion; this applies in addition to any ongoing self-assessment reporting that the taxpayer might have. While this new regime applies only where there is a CGT liability (so transfers between spouses/civil partners, or where 100% of the gain is covered by only or main residence relief, are not caught), gifts are generally chargeable as above, and landlords and their agents need to be aware that penalties could be triggered for non-compliance under this new regime long before the usual self-assessment reporting deadline.
Postponing the CGT charge on transfer into trust
Many mature landlords have wealth tied up in their properties but little cash, relatively speaking, so it would be counter-productive to transfer an investment property to avoid an IHT charge that may be many years away, only to suffer an immediate 28% CGT charge.
One cannot usually ‘hold over’ (or postpone) the capital gain on transferring an investment property, because it does not count as a qualifying business asset (broadly in this context, a qualifying asset used in a trade). Properties that meet the criteria to be treated as furnished holiday accommodation (FHA) are one of the key exceptions; another – which we shall focus on here – is where the transfer can trigger an immediate or lifetime charge to IHT.
The key point to this exception is that a transfer to a discretionary trust will trigger a lifetime charge to IHT – so that the corresponding CGT can then be postponed – but that IHT charge can be nil, typically where the property gifted is worth less than the donor’s IHT nil rate band. This is currently £325,000; but note:
- Any IHT-chargeable transfers made in the previous seven years can reduce the nil rate band available for this transfer – potentially to nil; but
- Couples may be able to ‘double-up’ the value that they can transfer, if they are moving jointly-held property.
Note that it is the value of the property being transferred into the trust that is relevant at this stage, not the gain.
While property is in the trust
The trustees act as custodians of the asset(s) and any income arising therefrom. The settlors – in this case it is the parents or grandparents who are ‘settling the assets’ into the trust – provide a set of instructions in the form of the trust deed, as to how to look after the assets, apply any income and ultimately distribute any property as the trust matures. The settlors can also be trustees but:
- The property no longer belongs to them personally – they are merely looking after it;
- They must follow the instructions in the trust deed; and
- They must deal with the property in the best interests of the parties intended to benefit from the trust (i.e. the beneficiaries).
A discretionary trust will pay punitive rates of tax of 45% on any rental profits received while the property is held by the trust. However, as and when the income is applied for the beneficiaries, it will carry a 45% income tax credit, and if a beneficiary is taxable at less than 45%, he or she will get a refund of the difference.
Beware mortgaged property
Transfers into trust work best with property that has no mortgage, because:
- The mortgage lender may have the legal power to block the transfer, (or charge a participation fee); and
- The trustees may become chargeable to stamp duty land tax (or its equivalent) for having agreed to take over the burden of the mortgage when they take over the property. A similar charge could arise on transfer out as well.
Settlor(s) must not benefit
Trust planning is largely ineffective if the settlor keeps any rights in the property, such as a right to rental income or a right to occupy the property. The settlor is automatically deemed to ‘retain an interest in the property’ if the settlor (or his or her spouse or civil partner, or any child of theirs under the age of 18) can benefit from the trust property.
This is why such trusts are usually set up for adult children; young grandchildren will not automatically trigger the anti-avoidance provisions.
How long does the rental property stay in the trust?
The trustees can potentially use the same CGT/IHT arrangement to transfer the property from the trust to the beneficiaries in very short order. The property does not ‘escape’ CGT because the beneficiaries will have acquired the property at the settlors’ original base cost, so will pay the full amount of CGT as and when they dispose of the property.
Discretionary trusts are sometimes used solely for this purpose – to transfer a property standing at a substantial gain to the next generation, without triggering a CGT bill that neither generation could afford without selling the property in the first place.
Alternatively, the property could remain ‘protected’ within the trust for many years, paying out an income to children, until (say) the youngest grandchild is old enough to legally own his or her share in the property. If so, the trust will be exposed to IHT:
- On every tenth anniversary; and
- When property leaves the trust (i.e. the ‘exit charge’).
However, the rate of IHT is relatively modest (i.e. no more than 6%) and will be charged only on the aggregate value deemed to have accumulated over and above the nil rate band(s) available when the property was transferred in. The IHT charge might well remain at nil.
Conclusion
Trusts can be useful as a device to keep important assets for the benefit of family or loved ones – either as a long-term vehicle or simply as a stepping-stone to transfer them to adult beneficiaries. In either case, the advice of a suitably qualified professional is essential. Trusts can be very expensive to unpick if they do not work as intended.
