Meg Saksida looks at the ‘pros’ and ‘cons’ of tax planning in the context of trusts and rental property.
Unlike capital gains tax (CGT), there are virtually no exempt assets for inheritance tax (IHT) purposes.
For example, motor cars and the family home, both generally exempt for CGT purposes, will still be liable to IHT at the death of the taxpayer. Landlords may therefore find themselves considering ways in which they can reduce their death estate by the value of their rental properties to lower their IHT exposure.
Disposing of the property by sale is an option, but by selling the property, the landlord will instead simply replace the property with cash, which will remain chargeable to IHT in their estate. However, if the landlord gifts the property seven years post the transfer, the property will no longer form part of their estate, leading to an IHT saving of up to 40%. This is particularly attractive for older landlords who perhaps no longer require the rental income and have their younger generation for whom they wish to provide.
The gift is possible through directly transferring the rental property to the next generation; but depending on the characteristics of the recipients, there could also be benefits of gifting the property into a trust.
Advantages of gifting the let property into trust
The main benefit of gifting the property is the fact that so long as the landlord survives for seven years post the gift, there will be no IHT (up to 40%) on the asset at the date of the landlord’s death. Even if the full seven years do not pass before their death, as long as they survive for more than three years, taper relief is potentially available, such that the tax charge will reduce by 20% in the three to seven years after the death.
After seven years, the gift is completely exempt. Not only does gifting the asset potentially reduce the eventual death estate, but should the potentially exempt transfer become chargeable, the IHT charge is based on the value at the time of the gift; so in rising prices, gifting has a double IHT benefit.
By gifting the property into a trust (rather than directly), the landlord has the benefit of being able to ensure that the beneficiaries are only entitled to as much income as the trustees agree that they can have. The property itself can also be sold or mortgaged only by the trustees. The landlord is thus guaranteed that immature or spendthrift beneficiaries are limited in the level of income they can receive. In addition, they do not have the power to dispose of the property. The landlord could also appoint themselves as the trustee (or one of the trustees) and therefore retain effective control of the let property and the income generated from it, all while having legally given it away.
Another advantage of transferring the property into a trust is that more than one person can obtain an ongoing benefit from the income of the let property. A discretionary trust can be set up such that there is a ‘pool’ of beneficiaries to choose from when distributing income. Alternatively, an interest in possession trust can be set up such that there is more than one life tenant or more than one ‘remainderman’. In addition to being able to spread the asset between several beneficiaries, the creation of a trust can also spread the eventual tax burden by the beneficiaries that receive benefit from the trust.
Depending on the type of trust and the tax band of the landlord, the income tax payable on the income from the rental property may also be lower. If there is an interest in possession trust, the income will initially be taxable in the trust at the basic rate. This may be significantly lower than the income taxed in the hands of the landlord if they are a higher or additional-rate taxpayer. Once the income is paid out to the specific beneficiaries by the trustees, if they are not taxpayers (such as children), they will be entitled to a refund from the tax paid on their behalf by the trustees.
Disadvantages of gifting the property into trust
The main disadvantage is the impact of CGT on the initial settling of the trust. This is a disposal for CGT purposes and if the property has enjoyed an increase in value since the landlord acquired the property, the tax on any gain payable will be a ‘dry tax charge’ such that there are no proceeds received with which to pay any CGT charge. In addition, if the property is (say) a residential let property in London, any tax on the gain and the return itself need to be paid and filed respectively with HMRC within 60 days of the completion. If there is a mortgage on the property, stamp duty land tax may also become payable on the transfer.
There are two situations where this gain can be transferred (held over) to the trustees, payable only when the trustees eventually dispose of the property. These are the relief for gifts of business assets and the relief for gifts where there is both a CGT and an IHT charge.
As a normal rental property business is not defined as a ‘business’ for CGT purposes, the business asset method of holdover relief is not possible. However, if the landlord is transferring a property that satisfies the requirements of the furnished holiday let legislation, this is considered a business for CGT purposes, so any gain on this transfer could be held over.
The other situation where holdover is possible is when there has been both a CGT and an IHT charge levied on the asset as a result of the transfer to the trust. As all additions to trusts are chargeable lifetime transfers, holdover relief due to an IHT charge will be possible. This is because even if the value of the asset added to the trust is below the nil-rate band (NRB), because the NRB is a nil-rate band (i.e., not an exemption) it is still an IHT tax charge, albeit charged at a nil rate or zero per cent.
A further benefit of this is that the trustees can also use holdover relief should they wish to appoint the asset out to the beneficiaries once it is in the trust. If the let property, being a chargeable asset for CGT purposes, has risen in value during the period the trustees have held it, this would result in a capital gain. As the trust will be in the relevant property regime, an IHT exit charge will be incurred after the first quarter of the asset being in the trust. A trust for this purpose, notwithstanding the other advantages, allows a donor to pass on the CGT to the recipient through a two-stage process, even when it is not a business asset.
The other major disadvantage of the rental property being in a trust is the income tax charge. Unless the trust is an interest in possession (see above), it will be a discretionary trust and due to pay the ‘rate according to trusts’ (RAT). This is equal to the highest individual band and is charged at 45% for non-savings and interest and 39.35% for dividends. Only those landlords already in the additional band will not incur higher income tax rates by putting the property in a trust. A refund may arise, however, if payments are made to a beneficiary in a lower tax band.
Another disadvantage of holding the property in trust in cases where holdover relief is not possible (e.g., because the trustees sell the asset rather than gift it), the annual CGT exempt amount available to a trustee to offset any gain is only half of an individual taxpayer, so currently only £1,500.
Practical matters to consider are the obligation of the trustees to adhere to the requirements of the trust deed. If the trustee is the prior landlord, they need to appreciate that they no longer own the property, which can be a challenge in itself.
Practical tip
Beware of a settlor-interested trust. If the landlord, their spouse or minor child can benefit from the trust, all the income is chargeable to income tax on the landlord and the property will remain in their death estate.
