Using a Trust to Save Tax
and Protect Your Wealth
How to protect your property wealth
In previous articles we have seen the fabulous triple tax savings (Income Tax, Capital Gains Tax and Inheritance Tax) available to families investing in student accommodation for their young adult children. However, we also saw that these fabulous savings were generally only available when the parents were prepared to put a substantial part of the family’s wealth in their children’s hands.
Not everyone is comfortable with this and many parents prefer to keep the capital growth in their child’s student home for themselves, or at least defer the day that the child gains control of the underlying wealth until they are perhaps a little more mature. This is where a trust comes in handy.
Using a Trust
Where a property is occupied as a main residence by the beneficiary of a trust, the trust is entitled to the same amounts of principal private residence relief and private letting relief as that beneficiary would have been entitled to if they had owned the property themselves.
This exemption does not apply where a capital gain on a property has been held over on a transfer into the trust, but this is no problem where the property is purchased by the trust in the first place.
Diana sets up a trust with her daughter Emma as the beneficiary and transfers £150,000 into it which the trust uses to buy a three bedroom flat.
Emma occupies one of the bedrooms and the trust rents the others to two of her friends. The three friends have just started a three year course at Peel University. At the beginning of each new academic year, the friends change rooms so that, by the end of the course, Emma has used each room personally (we looked at the importance of this in last month’s Business Tax Saver).
After graduating, Emma moves to London and the trust rents the property out to other parties. Seven years later, the trust sells the flat for £250,000, realising a gain of £100,000.
The bedrooms take up 54% of the floorspace so, throughout her time at university, Emma personally occupied a total of 64% (46% + 1/3 x 54%). The trust is therefore entitled to principal private residence relief as follows:
Period of occupation by beneficiary: £100,000 x 3/10 x 64% = £19,200
Last three years of ownership: £100,000 x 3/10 = £30,000
The trust is also entitled to private letting relief of £40,000, giving total relief of £89,200 and bringing the taxable gain down to just £10,800.
This gain would then either be assessed on Diana or on the trust itself, depending on the exact nature of the trust. A trust is generally only entitled to an annual exemption equal to half the amount given to individuals. Nevertheless, although a small amount of Capital Gains Tax might arise, the family would still have saved at least £16,056 (£89,200 x 18%).
What happens next depends on exactly how the trust was set up in the first place.
Diana may have kept the ‘reversionary interest’ in the trust. This would mean that the sale proceeds are passed back to her. Her reversionary interest could even have started as soon as Emma left university if she preferred, although this would leave Diana fully exposed to Capital Gains Tax on any future growth in the value of the property thereafter.
Alternatively, the sale proceeds could continue to be held for Emma’s benefit until she reached a set age, or even for life. Some families prefer to keep wealth in trust as long as possible, as this protects the beneficiary from problems such as a bad marriage or bankruptcy.
Typically, the income arising in the trust is automatically passed to the beneficiary. This is known as an ‘interest in possession’ and is a good way to provide the beneficiary with income during their university years and perhaps later. In this way, the trust income is taxed at the beneficiary’s top Income Tax rate, as part of their income, rather than at the trust tax rate which is currently 40% and will increase to 50% from 6th April 2010.
Whether you give property directly to your child or use a trust, it is important to avoid any significant personal use of the property yourself (or by your spouse or civil partner), as this can lead to Income Tax charges. You can stay over for the occasional night or weekend when visiting your child but anything more is risky unless you start paying a full market rent.
If you use a trust where you retain the reversionary interest, you can use the property as you wish after it reverts back to you. You will even be able to claim principal private residence relief if you later adopt the property as your own private residence, provided that the trust did not hold over the gain arising on the transfer back to you.
Using a trust may have Inheritance Tax consequences and professional advice is essential. However, there is not generally a problem if the parent puts no more than an amount equal to the nil rate band (currently £325,000) into the trust and the trust holds the property for less than ten years. Couples can usually put up to £325,000 each into trust without any adverse Inheritance Tax consequences. Even when a trust does hold property for ten years or more, there are often little or no Inheritance Tax charges where the amount originally invested did not exceed the nil rate band.