In the UK, inheritance tax is levied on the value of the estate above a certain threshold (currently £325,000, with an additional residence nil-rate band of up to £175,000, depending on the circumstances). If the value of your estate exceeds the threshold, IHT is charged at 40% on the value over the threshold.

One strategy to reduce or avoid inheritance tax is placing assets (like rental properties) into a trust. Here’s how it works:

– Setting Up a Trust: You can place your rental properties into a trust, with your children (or other beneficiaries) as the beneficiaries. A trust allows you to effectively pass ownership of the properties to your children without them being directly inherited as part of your estate.

– Gifting the Properties to the Trust: If you gift the properties to the trust during your lifetime, this is considered a gift for inheritance tax purposes. The gift is subject to the “seven-year rule,” which means that if you survive seven years after the gift, the properties will generally not be included in your estate for IHT purposes. However, if you pass away within seven years, the gift will be subject to IHT (with potential taper relief for gifts made after 3 years).

IHT Benefits:

– Potential IHT Mitigation: If the trust is structured correctly, and the properties are outside of your estate after seven years, the value of the rental properties may not be subject to inheritance tax when you pass away.

– Avoiding Probate: If the properties are held in a trust, they do not form part of your estate when you die, and therefore do not need to go through the probate process, which can be time-consuming.

Types of Trusts:

There are various types of trusts, and the structure you choose will have a significant impact on how inheritance tax is treated. Some of the most common trust structures for this purpose are:

– Discretionary Trusts: These allow the trustees to decide how and when to distribute the income or capital to the beneficiaries. However, gifts into discretionary trusts are subject to an immediate 20% IHT charge on amounts above the nil-rate band, and there may be ongoing tax charges as well.

– Bare Trusts: In a bare trust, the beneficiaries have an immediate right to the assets. This can be simpler for IHT purposes but may not offer the same level of control over how the properties are managed.

 

Other Considerations

While using a trust to pass rental properties on to your children can offer potential benefits, there are several important factors to consider:

– Capital Gains Tax (CGT): When you transfer rental properties to a trust, this may trigger a capital gains tax (CGT) liability, as the transfer is considered a disposal for tax purposes. The gain is calculated based on the difference between the market value of the property at the time of transfer and its original cost. This could result in a significant tax bill depending on the value of the properties.

– Income Tax: If the trust generates rental income from the properties, the trustees will need to pay income tax on that income. The tax rate will depend on the type of trust. In a discretionary trust, the income is taxed at the highest rate of income tax (currently 45%).

– Control: Once the rental properties are placed in a trust, you will lose some control over them, as the trustees will be responsible for managing the assets and making decisions about the income and distribution. You can choose to remain as a trustee, but you need to be aware of the potential loss of flexibility in decision-making.

– Tax on Trusts: Trusts are subject to specific tax rules in the UK, which can sometimes result in higher tax rates on both income and capital gains than individuals would pay. For example, discretionary trusts are taxed at higher rates of income tax and CGT.

Alternatives to Trusts

While trusts can help mitigate inheritance tax, there are other strategies you may want to consider:

– Gifting the Properties Directly to Your Children: If you gift rental properties directly to your children, and survive for seven years after the gift, they will generally be outside of your estate for IHT purposes. However, you would need to consider the CGT implications of such a gift and whether your children are in a position to manage the properties.

– Using Life Insurance: Some people take out a life insurance policy to cover any potential inheritance tax liability. This could provide the beneficiaries with funds to pay the tax, so they don’t need to sell the properties.

– Spending Down Your Estate: Another option is to spend down your estate or transfer wealth gradually over time, ensuring that you remain below the IHT threshold.

Conclusion

Using a trust can be an effective tool to reduce inheritance tax when passing rental properties to your children in the UK. However, it is important to be aware of the complexities involved, including potential capital gains tax liabilities, income tax on the rental income, and the costs associated with setting up and maintaining the trust. Consulting with a qualified tax advisor or estate planner is highly recommended to ensure that the trust is structured correctly and that all aspects of tax law are considered. This will help you achieve the best possible outcome for both you and your children.