There are several types of trusts, and each has its own structure, rules, and tax implications. The right choice depends on your goals, the nature of the assets, and who you want to benefit.
In this post, we’ll focus on mainly on ‘discretionary’ trusts. Discretionary trusts can be a powerful estate planning tool, especially when it comes to managing your property assets, both residential and commercial.
Whether you're looking to protect assets, provide for future generations, or manage tax exposure, placing property into a trust offers flexibility - but it also comes with complexity.
Before diving into discretionary trusts, let’s take a moment to understand what a trust actually is and how it works.
What is a Trust?
A trust is a legal arrangement where someone (called the settlor) gives assets such as property, cash, or investments to a group of people (the trustees) to look after for the benefit of others (the beneficiaries). In many ways, it’s like giving a structured gift: once the asset is placed into the trust, the settlor no longer owns it, and the trustees take legal control.
Often the settlors also choose to act as trustees, which allows them to stay involved in managing the trust and making decisions - though they cannot personally benefit from the trust assets if the trust is to be effective for tax purposes. This setup is common in family trusts, where the settlor wants to retain oversight while passing on value to others.
The trust is governed by a legal document called a trust deed, which sets out the rules, powers, and responsibilities. It’s designed to protect the assets, control how and when they’re used, and ensure they’re passed on according to the settlor’s wishes.
What Is a Discretionary Trust?
Now that we understand how a trust works in principle, lets look specifically at a discretionary trust:
A discretionary trust is a legal arrangement where trustees hold and manage assets (like property) for a group of beneficiaries. Unlike some trusts, the trustees have full discretion over:
Who receives income or capital
When distributions are made
How much each beneficiary receives
This flexibility makes discretionary trusts ideal for families with changing circumstances or where future beneficiaries (e.g. grandchildren) are not yet known.
Transferring Residential Property into a Trust
When you settle residential property into a discretionary trust, you're legally transferring ownership to the trustees. This triggers several tax implications:
1. Inheritance Tax (IHT)
· The transfer is a chargeable lifetime transfer.
· If the value is within the nil rate band (£325,000 per settlor), no immediate IHT is payable.
· If the settlor dies within 7 years, the gift may become chargeable at the death rate (up to 40%).
· The nil rate band refreshes every 7 years, meaning £325,000 can be moved out of the estate every 7 years with no tax charge.
2. Capital Gains Tax (CGT)
· The transfer is a disposal for CGT purposes.
· Gift holdover relief may be claimed to defer the gain, allowing the trust to inherit the original base cost.
· Without relief, CGT is payable on the difference between market value and original cost.
3. Stamp Duty Land Tax (SDLT)
· If the property is mortgaged, SDLT may be due on the outstanding loan amount.
· Legal advice is essential when transferring mortgaged property.
Ongoing Trust Management
Once the property is in the trust, trustees must:
· File annual self-assessment tax returns to report any income.
· Pay income tax on rental income at 45% (though see beneficiary tax position)
· Manage capital gains on future disposals.
· Consider 10-year anniversary charges (up to 6% on value above the nil rate band)
· Monitor exit charges if assets are distributed to beneficiaries
Beneficiary Tax Position
Beneficiaries only pay tax when they receive distributions. They:
· Must report income received via self-assessment
· Receive a tax credit for tax already paid by the trust
· May be entitled to a refund if their personal tax rate is lower than the trust rate
To demonstrate this last point, we can consider the position where a discretionary trust earns £10,000 in rental income, it pays tax at 45%, leaving £5,500 to distribute. The beneficiary, even though they receive £5,500, is treated as having received £10,000 and reports this on their tax return.
As a basic rate taxpayer (20%), they owe £2,000 in tax - but since the trust already paid £4,500, the beneficiary can reclaim the £2,500 difference from HMRC. This effectively means that the tax rate payable depends other income of the beneficiaries.
Key Considerations Before You Proceed
· Loss of control: Once the property is in trust, you no longer own it.
· No benefit for settlor: You (and your spouse/civil partner or minor children) cannot benefit from the trust.
· Legal and tax advice: Professional guidance is essential to navigate the complexities of trust arrangements and avoid unintended consequences. It's also important to be aware that there are ongoing costs associated with managing the trust and meeting its annual compliance obligations.
Final Thoughts
Putting residential property into a discretionary trust can offer long-term benefits for asset protection and estate planning - but it’s not a one-size-fits-all solution.
Understanding the tax implications and legal responsibilities is crucial before making the leap. Acting ‘early’ gives the best chance of maximising the amount of value removed from an individual’s estate.
It is noted that some tax is payable now, for example IHT at 20%, however, paying some tax now may actually be the best result and provide a far lower overall tax liability than if no action is taken and the value of the properties are subject to IHT at 40% on death.
Trusts can be an important tool in inheritance tax planning so contact us today to discuss the best approach for your estate planning needs.