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Using a trust to mitigate capital gains tax on property.

A trust is purely an arrangement where an individual (the settlor) transfers an asset into a trust run by other persons (the trustees) for the benefit of someone else (the beneficiary).

The trust has an independent existence from the trustees, who can retire or join with no implications except if a non-resident trustee is appointed.

Why a trust?

In addition to being a very useful succession planning tool, a trust generally keeps assets safe from the clutches of creditors or estranged spouses and provides a safe conduit for assets destined for younger children or other vulnerable beneficiaries.

A trust is also a mechanism to dissociate the benefit of an asset's use for a defined period from its eventual long-term ownership.

Type of trust

The legally binding trust deed (which must be drafted by a qualified professional) will dictate whether the trust is:

- a discretionary trust, which offers welcome flexibility as the trustees can choose how and when any income or capital is transferred to individuals within the defined class of beneficiaries; or

- an interest in possession trust, when the named beneficiary (life tenant) has an automatic right to the trust income during their lifetime (typically, a spouse) while future ownership will pass to someone else (often the couple's children) on death.

When does CGT arise?

Capital gains tax (CGT) is charged at the following points:

- when property is transferred into the trust;

- on the property's exit from the trust; or

- if the trust becomes non-resident.

As an aside, the above often have inheritance tax (IHT) consequences, although the interaction of CGT with IHT can be beneficial. Any transfer of a mortgaged property will require the lender's permission and may also result in a stamp duty land tax charge (or the equivalent in Wales or Scotland).

Property transferred into trust

When the settlor gifts property to a trust, this is a deemed market value transfer between connected parties. Any resulting gain will be automatically reduced by capital losses on other assets owned by the settlor arising in the same tax year. Further, any available current tax year trading losses or brought forward capital losses can also reduce the gain. Unless a holdover relief claim is made (see below), any remaining amount (after deduction of the immaterial annual exemption) will crystallise a CGT charge for the settlor, subject to rates of 18% for gains falling within the basic-rate band and 24% otherwise.

For property owned by a married couple (or civil partners), it is possible to change the relevant proportions (at nil gain, nil loss) so that, on transfer to the trust, full use is made of both individual's losses, annual exemptions and lower tax rate bands. Care is required, however, to avoid triggering anti-avoidance provisions.

Any CGT arising on residential property disposals must also be reported and paid within 60 days of the transfer using HMRC's CGT on UK property service, and in most cases, reported on the settlor's self-assessment tax return as well.

Property exiting the trust

The transfer of property out of the trust is treated as a disposal, whether by sale or appointment to a beneficiary (which is a deemed market value transfer under TCGA 1992, s 71, although holdover relief could be available). After deducting any available losses, the trustees will be liable to CGT on the gain at a rate of 24%. The tax is payable and reportable within 60 days (for residential property), which requires the trust to have already registered with the trust registration service according to HMRC's Agent Update 140 (hopefully most trusts will have already registered to avoid penalties).

If an appointment results in a loss which cannot be set against gains realised by the trust in the same tax year, it can instead be transferred to the recipient beneficiary for use against future gains arising from the same property (under TCGA 1992, s 71(2)).

Deferral of gains

While not eliminating any gain, holdover relief at least offers a deferral opportunity. It is only available on transfer into the trust, however, where the settlor, their spouse or dependent children cannot (or could not) benefit from the trust, under TCGA 1992, s 169B. On a future transfer to a beneficiary, another holdover claim is often possible, which can encompass the original relief already embedded within the asset's value.

Holdover relief requires a joint claim on form HS295, except for the initial transfer to a trust when it is just the settlor who elects for relief.

Example: Holdover relief on gifted property

Logan owns a buy-to-let property which he acquired for £100,000 but is now worth £400,000. On gifting the property to a discretionary trust, the gain is £300,000. To avoid a 'dry' CGT charge of £72,000, he claims holdover relief, which defers the gain, meaning that the property's base cost for the purposes of any future disposal by the trust is £100,000 (rather than £400,000).

A few years later, the trustees appoint the property to a beneficiary when the property is worth £500,000. The resulting gain of £400,000 (calculated by deducting the base cost of £100,000) can be deferred again so that the beneficiary's base cost is £100,000 with respect to any future disposal. The CGT has successfully been deferred twice.

Restrictions

Holdover relief is only available in respect of:

- business and agricultural assets, including plant, machinery, and trading company shares, under TCGA 1992, s 165; and

- any type of asset where an IHT charge arises, under TCGA 1992, s 260, including transfers covered by the nil rate band of £325,000, exemptions or reliefs, but not merely potentially exempt transfers. For a jointly-owned property, the nil rate band will cover a property value of £650,000 (as reduced by any previous transfers to trusts or companies in the seven years preceding the gift).

When appointing property out of the trust to a beneficiary, timing is important as an IHT charge arises only after three months have elapsed from either the creation of the trust or its most recent tenth anniversary. There is also a clawback period of six years from the end of the tax year of the transfer, where the held over gain will come into charge should the trust become settlor-interested or emigrate (although, as non-residents remain liable to UK CGT on UK land, any clawed back gain can itself be deferred under TCGA 1992, s 168A).

Occupying residential property

A word of caution in relation to residential property is that principal private residence (PPR) relief, which normally exempts the gain relating to the period when the property was occupied as an individual's main residence, may not be available. Any holdover relief (whether claimed on the property entering or exiting a trust) precludes any subsequent PPR relief claim in respect of a beneficiary who occupies the property (under TCGA 1992, s 226A).

This is true no matter whether it is the trust or beneficiary who makes the eventual disposal. A choice therefore has to be made between:

- incurring a CGT charge when property enters the trust, retaining the possibility of a future PPR claim; or

- deferring the gain, which prevents any possible future PPR relief claim, and paying CGT on any appreciation in value in the future at whichever rate then applies.

Practical tip

When transferring residential property into a trust, the long-term effects of any available holdover relief claim must be weighed up against the loss of PPR relief, particularly if the settlor has losses to offset. Specific professional advice should always be sought to ensure the (often irreversible) tax consequences of using a trust are fully anticipated.