In last week’s article, we examined how lifetime trusts over the family home operate in practice and the risks associated with care fee assessments. This follow-up article considers lifetime trusts and inheritance tax. These arrangements are often promoted as a way of reducing or avoiding inheritance tax, but the position is complex and the tax rules can produce unfavourable and unexpected outcomes.
A brief reminder: what is a lifetime home trust?
A lifetime trust over the home typically involves the owner transferring all or part of their interest in the property into a trust during their lifetime.
The settlor will usually retain the right to live in the property, either through a right of income, right to occupy or by being included as a discretionary beneficiary.
Lifetime trusts and inheritance tax: gifts with reservation of benefit
The central inheritance tax issue with lifetime trusts is the gift with reservation of benefit regime. These rules are designed to prevent a person giving away an asset for inheritance tax purposes while continuing to enjoy it in practice.
The main rule is found in S102 of the Finance Act 1986. In short, a gift with reservation arises where a person gives away property and continues to benefit from the property in some form.
In practice, this means the expected benefit of lifetime trusts and inheritance tax planning does not arise in the majority of cases.
Effect of a Gift With Reservation
If the gift with reservation rules apply, and the reservation continues until death, the property is treated as forming part of the donor’s estate for inheritance tax purposes.
This means that the intended inheritance tax saving is usually defeated.
This can produce an outcome that clients often find surprising. The property may have been transferred into trust many years earlier, but if the settlor continued to live there, it may still be taxed as part of the estate.
This highlights an important distinction. The seven-year rule can apply to genuine lifetime gifts where the donor has given up benefit. It does not remove property from the estate where a benefit has been retained.
Paying Full Market Rent
One possible way to avoid, or bring to an end, a reservation of benefit is for the donor to pay a full open market rent for continued occupation.
A nominal rent will not be sufficient. The rent must be genuinely commercial.
In practice, this is often unattractive and the majority of trusts over a main residence are not set up in this way.
The relevant property regime
Most lifetime trusts created after 22 March 2006 fall within the relevant property regime.
This can lead to inheritance tax charges:
- when assets enter the trust;
- on ten-year anniversaries; and
- when assets leave the trust.
How relevant property regime charges are calculated are complex and will only apply to assets over the available nil rate band.
Even if no immediate charge arises, these ongoing charges can become relevant over time and are an important part of understanding lifetime trusts and inheritance tax.
Lifetime trusts and inheritance tax: the residence nil-rate band
Lifetime home trusts can also affect the residence nil-rate band (RNRB). The RNRB, in short, is an additional allowance where a person’s main residence or other qualifying property passes to direct descendants on their death. It is currently £175,000 per person and the allowance is transferable between spouses/civil partners. This means that a married couple or civil partners can potentially leave up to £1 million inheritance tax free on death.
However, RNRB is not available simply because the ultimate beneficiaries of a trust are the settlor’s children or grandchildren. The property must be “closely inherited”. In broad terms, this requires that the residence passes to direct descendants, or into certain forms of qualifying trust for their benefit.
This is often the key issue in cases involving lifetime trusts and inheritance tax.
Interaction With Gift With Reservation Rules
Where a client transfers their home into a lifetime trust but continues to live there rent-free, the gift with reservation of benefit rules will apply.
The property will be treated as forming part of the settlor’s estate immediately before death for inheritance tax purposes, even though it is legally owned by the trustees.
At first sight, it is easy to assume that if the home is still treated as part of the estate for inheritance tax, RNRB should also be available. That is not necessarily the case.
Section 8J of the Inheritance Tax Act 1984 contains specific rules dealing with gifts with reservation and RNRB. Where property forms part of the deceased’s estate immediately before death because of the gift with reservation rules, a beneficiary is treated as inheriting the property only if the property originally gifted became comprised in that beneficiary’s estate at the time the gift was made.
If, at the time of the lifetime transfer, the home became comprised in a relevant property trust, rather than in the estate of a direct descendant, the property has passed into the trust, not to the descendant personally.
RNRB is therefore not available, which can lead to a higher inheritance tax liability for the settlor.
Can this be corrected?
Where the property has been transferred into a lifetime trust, the usual solution is to:
- end the trust; and
- return the property to the settlor’s personal ownership.
This will allow the property to pass via their will on death in a way that secures the RNRB. However this may itself have tax implications to consider and the trust terms will need to be checked to ensure a transfer is possible.
Conclusion
Lifetime trusts are often promoted as a way of reducing inheritance tax, but the outcome complex.
When considering lifetime trusts and inheritance tax, it is essential to recognise that:
- the gift with reservation rules may apply;
- the relevant property regime may introduce additional charges; and
- RNRB will be lost.
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