Trusts and Main Residence Exemption

This podcast completes our look at the rather remarkable exemption for gains arising on the sale by taxpayers of a main residence – we started by examining the nature of the exemption and saw that in recent years a lot of investors have tried to claim the relief but failed to show that the property in question had ever been a residence.

In our last podcast we looked at the election that can be made by taxpayers who own more than one residence and we saw that with careful planning it is possible to use this election to maximise the exemptions available.  Remember though it is critical that that the election is made when available it is the key to allow the significant subsequent variations to be made.

The relief is contained in sections 222 and 223 of the Taxation of Chargeable Gains Act of 1992.  This month I’m going to look at the closely related relief that allows trustees to claim the relief where a beneficiary of the trust occupies a main residence owned by the trustees.  This also permits a considerable amount of tax planning.

First consider a practical example.  Alan bought the house, that he and his wife Anne live in, in 1986 and it has always been in his sole name.   He died in 2003 leaving his estate, including the house, to a trust established to hold the property during his wife’s lifetime which, when she dies, will be divided equally between their children.

In 2012 Anne needs to go into a care home and the trustees decide to sell the house to produce sufficient funds for this purpose.  As Anne does not own the property it is not possible to claim relief under s222 and if this further relief did not exist the gain would be chargeable and would reduce the amount available to buy Anne’s new accommodation.

Section 225 of the Act gives a relief to the trustees so that the gain arising on the sale of the house will be exempt just as if Anne had owned it directly.

The condition is that the dwelling-house has been the only or main residence of a person entitled to occupy it under the terms of the settlement.  The Trust must have been written in such a way to permit the beneficiary’s occupation but this can be a discretionary power – as was decided by the High Court in the case of Sansom & Or v Peay in 1976, sometimes called the Ridge Settlement Trustees case.

It is also possible for a s222(5) election to be made in respect of the property and this is important if the beneficiary has another residence which could also be their main residence – in fact it may be prudent for the trustees to ask the beneficiary to join in making the election in any event to guarantee the relief. Where made in respect of the trust property it must be signed both by the trustees and the beneficiary in question.

The relief is extended by s225A where a private residence is held by personal representatives of a deceased person who sell a house shortly after death to satisfy, for example, the requirements of a will or the payment of debts and the property is occupied by a legatee with a relevant interest accounting for more than 75% of the net proceeds after payment of liabilities, then the gain will also be exempt.

So far it all seems a very logical pair of reliefs but before 2003 many taxpayers had used these provisions to obtain a rather surprising relief.  Let’s suppose a house had been purchased as an investment many years previously and a very large gain had been made.  It was possible, until then, to set up at trust, transfer the property over into the trust and claim a relief called gift relief.  This relief was available to postpone the gain on transfer to the trust if there was a possibility of an Inheritance Tax Liability arising, provided that the value was within the IHT nil rate band, currently £325,000, the relief could be claimed but no tax would actually be payable.

Gift relief operated by reducing the value of the gift, the house,  by the amount of the gain arising at the date of the transfer into the trust and so if the trustees sold the property the final gain that they would make would be the same as if the property had not been put in the trust in the first place.  Here comes the twist – the trustees would then allow, under a discretionary power, one of the taxpayer’s children to occupy the property as THEIR main residence, they would then make the joint election and on sale the WHOLE of the gain would be exempted, not just the gain since the property was placed into the settlement!

From 10 December 2003 onwards trustees cannot claim main residence relief where gift relief had been claimed at any time in respect of the property – does this mean that trusts can no longer be used in main residence tax planning?

No – it doesn’t – the main residence relief is only lost if gift relief was also claimed.  If there is no need to claim gift relief there is then no problem with using a trust – let’s look at some practical examples:

Benny’s son Brad is about to enter his second year at university and must move out of halls of residence into privately rented property.  Benny decides to buy a house that Brad can live in and then, when he leaves university, can then be turned into a buy-to-let investment property.  Simply buying the house will not allow Benny to claim main residence relief as it is not his residence.  Suppose, on purchase, he transfers the property into a trust and allows Brad, under a discretionary power, to occupy it as his main residence, they jointly make the election.  Now on later sale the exemption will be available because gift relief had NOT claimed, and that will include the usual last three years of ownership in any event AND the letting exemption of £40,000 as well!  Provided that the cost of the house does not exceed the IHT threshold there will be no IHT to pay either.

Clearly interesting but here is another – until 1988 every taxpayer could claim a second exempt residence if it was occupied rent free by a dependent relative – today that relief only continues whilst the house is still being occupied by the same dependent relative who occupied in before 1988.

Charles’s mother is 88 and she needs to enter sheltered accommodation which Charles buys and allows her to live in it – on sale, after her death, the gain will be fully chargeable.  However Charles could, like Benny, transfer the property into a trust, allowing his mother to occupy it as a beneficiary and on sale the gain will be fully exempt.  Theoretically there is no limit to the number of dependent relatives that could be housed in this way – except for Inheritance Tax of course.  However if the intended beneficiary can be shown to be disabled the gift into the trust will not trigger a lifetime liability but it will be counted as part of the estate of the disabled person when they die.

Here is another practical example… Danielle obtained a divorce from her husband Dick and the court made an order that she be allowed to live in the property until their children reached the age of majority at which time it should be sold and the proceeds divided between them.  Danielle’s half of the gain will be exempt as it is her main residence but Dick’s share of the gain on sale is unlikely to be covered by the exemption.  There is an extra statutory concession which would allow him to claim the gain as exempt but only if he has no other main residence, and this is not very likely.  However, where the court orders this to be done it is called a Mesher Order and is treated as though a trust arose and as a result of that Dick’s gain will not be chargeable.

Suppose, seeking to avoid unnecessary legal expenses, Danielle and Dick do not obtain a court order?  The gain will be chargeable unless – and you guessed it, unless a trust is used.  Furthermore, as long as this is reasonable provision for Danielle it will not be chargeable when the trust is set up as there is an IHT exemption for settlements made between persons who are, or who have been married – the house here could be valued in the millions and the relief would still be available!

I think we can now see how trusts can be used in connection with property to further maximise our exempt gains but there is a ticking time-bomb here which the unwary may not realise could catch them out.

Suppose Ernie had purchased a property as an investment in 1990 and then in 1999 needed a property to house an elderly dependent relative, Aunt Ethel.  He set up a trust, made Ethel a beneficiary and claimed gift relief which, at the time, was perfectly normal tax planning as outlined above.  However – having claimed gift relief – the main residence relief stops on 10 December 2003 and if that house were to be sold now the gain from 2003 onwards would be chargeable with no last three years and no letting exemption either.  I wonder how many taxpayers realised in 2003 when the relief was taken away that they could lose it by having claimed another relief many, many years previously?

Another example – Fred, a single man in his 60’s lived with and looked after his elderly parents so that his two younger sisters did not have to.  After the death of the parents, who left their estates to be divided equally between the three children, the sisters allowed Fred to continue to live in the property for the next 5 years until he died.  The house was then sold and a substantial gain arose.  The valuer acting on behalf of the executors when Fred’s parents died negotiated a reduced value because Fred was living in it, although not as a tenant with rights of occupation.

Fred’s third of the gain on sale will be exempt and the sisters will be fully chargeable unless…

Unless they executed a deed of variation within two years of the death of the second spouse which altered that person’s will to create a trust for the benefit of the three allowing any one or more of them to occupy the property.  Now Fred’s occupation satisfies the condition and the whole of the gain will be exempt, not just the third that relates to him personally – it will also not alter the IHT payable which would be the same whether the estate was left directly or in trust.

This is a fantastically flexible relief which, if used properly, can save many, many thousands of pounds of CGT liabilities.  Equally if the appropriate conditions are not satisfied the revenue can, of course, deny the relief.  Anyone planning to use the relief should include, in their tax returns, a full explanation of what is being done and it’s commercial reasons to protect the taxpayer from the possibility of discovery assessments in later years if the revenue decide to disagree.

Bear in mind that there will be legal expenses, especially in setting up appropriately worded trusts as discussed here, you may also find that local family solicitors are reluctant to set up these devices.  Once established the running costs should be very low and a tax return only required when the property is sold unless other income arises to the trustees.

This podcast was presented, written and produced by Paul Soper who asserts copyright therein.  The full text of the podcast can be read at my site taxationpodcasts.com.

For further details of podcast production, particularly if you would like me to create them for you, contact me at Paulsoper, all one word, at mac dot com.