The benefits and drawbacks of using trusts to hold property

Additionally, successful property investors may, as they enter mid to later-life, find their thoughts turning to inheritance tax and discover that their investment successes have resulted in an inheritance tax problem that can’t easily be remedied without incurring potentially high capital gains costs.

In this article, I will therefore consider the use of trusts to hold property in different scenarios and the advantages and disadvantages that come with this type of ownership.

The main residence

Where the estate is below the threshold for inheritance tax and comprises of little more than the family home, lifetime trusts can provide an acceptable solution to the asset protection issue. However, this is not guaranteed as ‘deliberate deprivation’ rules exist which can operate to deny local authority funding where it can be shown that the main or a significant motive for making the gift was to avoid or reduce the contribution the homeowner would otherwise have to pay towards their care and support costs.

The onus is on the local authority to prove deliberate deprivation. In this connection the time that elapses between the date of the disposal and the entering of care accommodation is significant but not decisive. It is the purpose of the disposal that is all important. However, if an individual makes a disposal whilst fit and healthy and some years before going into care, it is unlikely that deliberate deprivation will be alleged.

It is also worth noting that the home is a disregarded asset for as long as it is occupied by the spouse of the claimant. So, for married couples, a transfer of the main residence a lifetime trust will only provide an asset protection benefit where both parties require care and their other assets are below the upper capital limit (£23,250 in England and Northern Ireland, £50,000 in Wales and £35,000 in Scotland).

For those who have an inheritance tax issue, or who are reliant on the availability of the residence nil rate band to avoid a liability, the position is more complex.  The transfer of the home to a lifetime trust will, unless the trust is an absolute trust, be a chargeable lifetime transfer. This means that if the home is worth more than the available nil rate band or bands of the settlor(s) (i.e. taking account of any other chargeable lifetime transfers made in the previous 7 years); an immediate liability to inheritance tax will arise at the lifetime 20% rate. Further, as the homeowner(s)/settlor(s) will usually want to remain living in the house rent-free, the gift to the trust will be a gift with reservation – meaning that the value of the gifted property will remain in the estate(s) of the settlor(s) for inheritance tax period beyond the 7-year gift period and the use of the trust will therefore achieve no inheritance tax advantage.

There will also be an impact on the availability of the residence nil rate band. The legislation provides that gifted property which remains in the estate for inheritance tax purposes due to a reservation of benefit can still be a qualifying residence for residence nil rate band purposes but will only be deemed to have been closely inherited if the original transfer placed the property into the estate of a qualifying beneficiary. In other words, if a homeowner was to gift their home outright to their adult children as a potentially exempt transfer (PET) but carried on living in the property without paying rent, this would be a gift with reservation. However, as the lifetime transfer would place the property into the ownership and estates of the adult children (i.e. qualifying beneficiaries), the residence nil rate band will be available to the homeowner’s estate on his death. Of course, where the property is gifted to a discretionary or interest in possession trust during lifetime, this condition is not met which means that even though the property remains in the settlor’s estate as a gift with reservation, residence nil rate band will not be available to his estate on his death.

When you also consider that the trust will be subject to a periodic charge at year 10 (and typically there will be no other assets in the trust with which to fund the liability), it is clear that extreme caution needs to be exercised when considering the use of trusts to hold the main residence if either the value of the home, or the estate of the homeowner including the home, exceeds or is close in value to the available standard nil rate band(s) of the settlor(s).

Buy-to-let property

While the transfer into trust of a property that is occupied by the homeowner will rarely achieve any inheritance tax advantage; there may be inheritance tax benefits to giving away an investment property – particularly if it is producing an income that is surplus to the needs of the property owner and so is accumulating in the estate adding to the inheritance tax problem.

Of course, a lifetime gift of a chargeable asset, such as an investment property, will constitute a disposal for capital gains tax (CGT) purposes; however, where the gift is made to a discretionary or interest in possession trust, a hold-over claim may be possible.  The effect of making a hold-over claim is that the gain – and any CGT liability – is deferred until the property is sold or otherwise disposed of by the trust (although the trust and beneficiary can also elect to claim hold-over relief on an in specie transfer of the property out of trust so that the gain ultimately falls to be assessed on the beneficiary rather than on the trustees at the potentially higher trust rate). There are some important points to note about hold-over relief:

·         Hold-over relief will not be available if the trust is a settlor-interested trust for CGT purposes. This means that neither the settlor, his spouse nor his minor children can be included as possible beneficiaries. While this will be prohibitive for some, it nonetheless provides grandparents or parents with adult children with a way of passing property to later generations without crystallising a CGT liability.

·         A hold-over relief claim does not eliminate the gain – it simply defers it. Consequently, a disposal of a property standing at a significant gain may not be advisable where the property owner is elderly or in poor health – even if a hold over claim is made – as this will mean that the opportunity to benefit from a CGT-uplift on death is lost (and potentially with no compensatory IHT benefit if they have not survived their gift by 7 years).

 

Example

·         David, aged, 79, gifts a rental property worth £325,000 to a discretionary trust for his two adult children

·         He makes a holdover claim, deferring his gain of £100,000 - so no lifetime tax

·         David dies 5 years later and the trustees wind up the trust and distribute the property – now worth £375,000 - to David’s three children in equal shares – again claiming hold over relief

·         The children sell the property, each crystallising an £50,000 gain (i.e. a third share of the total gain of £150,000)

·         Assuming a rate of 24% and that each child has an available annual exempt amount of £3,000, the total CGT payable (which would have been eliminated if David had died owning the property) will be £33,840. This exceeds the IHT saving that has been made (i.e. 40% of the extra growth of £50,000 that would otherwise have accrued in David’s estate).

·         Obviously if David had survived the gift by 7 years, the planning would have been worthwhile as he would have made a saving of 40% of £375,000 i.e. £150,000.

Of course, hold-over relief is not the only reason to consider using a trust to gift property. Using a discretionary trust to gift or hold an investment property can provide additional advantages such as flexibility and continued control for the donors as well as some protection against future third party claims, for example on divorce or death of the beneficiary.

However, a gift to a trust will be a chargeable lifetime transfer and care will therefore need to be taken to ensure that the value of the property being gifted is below the nil rate band available to the donor(s). If the property value exceeds the available nil rate band, there will be a 20% IHT charge on the excess at the time the gift is made.

The other downside of using a discretionary trust to hold buy-to-let property is that rental income will be taxed at 45% in the hands of the trustees. While it is possible for some or all of the tax paid to be reclaimed if the income is distributed to a beneficiary who pays tax at a lower rate than the trustees, it may be possible to avoid this additional layer of admin altogether by using an interest in possession trust.

By using an interest in possession trust, the rental income will belong to and so be taxed in accordance with the tax positions of the beneficiaries with the interest in possession. This solution can therefore work well if, for example, the donor has adult children who are non- or basic rate- taxpayers and he is happy for them to receive the rental income while the property is in the trust. The trust can be flexible in nature with the trustees having the discretion to change the interest in possession beneficiaries and/or to transfer the property (or the sale proceeds arising from its ultimate sale) to another beneficiary entirely. The only thing the trustees won’t be able to do is accumulate the income – meaning that complete control and flexibility comes at a higher tax/admin cost.

What if access to rental income is required?

In many cases, clients will have invested in property to provide them with income in retirement and will be unwilling or unable to relinquish access to all of the rental income. A gift of a whole property where rental income is retained by the donor will be caught by the gift with reservation rules. However, it may be possible to make an inheritance tax effective gift with retained access to income if a share only of the property is gifted. This because of a specific provision in the 1986 Finance Act (s102B(3)) which provides that a gift of a share of a property that is not occupied by the donor cannot be a gift with reservation.

The usual way to structure the arrangement would be for the property share (ideally no more than 50%) to be gifted to a trust where the settlor (original property owner) has the interest in possession. The settlor’s interest in possession under the trust entitles him to the income from the gifted share; and he can, of course, continue to receive the income from the retained share by virtue of his continued ownership of it.

Because this arrangement involves the gift of a share of a property that is not occupied by the donor, s102B(3) Finance Act 1986 is in point. This means that the property owner continues to receive 100% of the rental income without any gift with reservation issues. His gift (having been made to a trust) would be a chargeable lifetime transfer however, provided the value of the gifted property share is within the available nil rate band, there will be no IHT to pay at the time the gift is made and it will fall completely out of account for IHT purposes after the passage of 7 years in the normal way.

There would of course still be a disposal of the half-share for CGT purposes – which means there is potential for a tax charge at 24% if the donor is a higher rate taxpayer. And there is no scope to claim gift hold-over relief in this scenario due to the fact that the donor will be a beneficiary of the trust. Consequently, this type of planning may be most appropriate where there is no capital gain on the property to be gifted perhaps because it is a newly acquired property or where any gain can be offset by the CGT annual exempt amount(s) or brought forward losses of the property owner(s) or reduced by an amount of private residence relief and/or renovation costs.

Conclusion

It can be seen from what has been said above that extreme caution should be exercised when considering the use of a lifetime trust to hold the main residence.  A more practical approach to the asset protection issue for married couples – especially those who are reliant on the availability of the residence nil rate band – might be to leave a tenant in common share of the property to a life interest trust for the survivor on the first death. Should the survivor go into care, only the share owned outright by the survivor would then be included in any assessment of means (and there is a possibility that this would be devalued due to the existence of a third party owner of the other half share who would have equal rights of occupation to any open market purchaser for value).

Property investor clients who find themselves facing IHT liabilities but are unwilling or unable to make gifts to trust or otherwise due to the existence of mortgages, CGT concerns and/or access requirements could, as an alternative, consider using some of the rental income (which will often be surplus to needs) to fund for the IHT liability with whole of life insurance written under trust. Where clients are in good health and premiums are affordable, making provision for the liability through life insurance may be the most straightforward approach.