Individuals with residential property investments have traditionally used discretionary trusts to pass them on to future generations. Increasingly, family investment companies (FICs) are being used as an alternative succession route. This article considers the two different routes and the advantages and disadvantages of both.
Individual circumstances will be paramount when deciding the best route to take.
Route One – Family investment company
Investment property portfolios can be held within a Family Investment Company (‘FIC’) and family members of different generations can be shareholders of the company.
Advantages of FICs
- There is flexibility in the rights of family members. As such, parents can, if they wish, retain control of the company and have a controlling shareholding with voting rights. They can also appoint themselves as directors so they can manage the company.
- By assigning different classes of shares to family members, there is flexibility to distribute company profits as desired. A trust can be set up as a shareholder to hold shares for future offspring or younger children.
- There are no immediate inheritance tax charges on the creation of FICs.
- If parents wish to retain access to capital, instead of gifting property to the company, they can sell it to the company for debt, giving rise to a loan owed back to them. If they need access to capital, they can request loan repayments. They can also benefit from the company profits.
- Companies benefit from low rates of corporation tax (currently 19% and due to rise to 25% from April 2023) and this low tax environment has been a major driver in the popularity of FICs. The profits can be reduced by management expenses, salaries, benefits and pension contributions. Additionally, companies are not subject to the restrictions of mortgage interest relief and so they can claim the full relief unlike individuals.
Disadvantages of FICs
- If property is transferred to the company, capital gains tax arises on any gains arising between the date of original acquisition and transfer to the company. For residential property disposals, the individual will need to report and pay the CGT due to HMRC by competing a UK land return within 60 days of disposal.
- Stamp duty is payable on the transfer of property to the FIC and there would be an additional 3% surcharge applied to residential properties. There is also an additional 15% charge if the property value is in excess of £500,000 and is not being used for a qualifying purpose (e.g. for rental). For property portfolios, Multiple Dwellings Relief and the application of commercial rates for holdings of six or more properties can reduce exposure to SDLT on residential properties.
- Double taxation can arise as, in addition to corporation tax, individuals are subject to income tax on any company distributions. This can be minimised by accumulating income or directing income streams to family members with limited other personal income. Distributions can be made by dividend payments and so individuals can use their tax-free dividend allowances and lower income tax rate.
- There would also be an annual tax on enveloped dwellings for companies holding one or more residential properties with values exceeding £500,000. Relief is available for rental properties.
- Shareholders place the value of their shareholdings in their estates and these are chargeable to inheritance tax (IHT) on their death. IHT relief is not available for holdings in a property investment company as Business Property Relief is not available for companies not wholly or mainly trading. Similarly, any loan created on the set up on the FIC remains in the lender’s estate and is chargeable to IHT.
- IHT can be mitigated by parents giving away their shareholdings and assigning their loans to other family members. These are potentially exempt transfers and so are not chargeable to IHT if the parents survive for seven years. If an individual does not give away their shareholding, providing they do not have a controlling shareholding, it is discounted as a minority shareholding on their death. Even if a deceased parent still had any loan outstanding, any appreciation in property values since the setup of the FIC is excluded from the estate. A charge to CGT would however arise on any gifting of the shares.
Route two – Trusts
Trusts are the more traditional tax planning tool for transferring property to future generations and may still be more appropriate depending on the circumstances.
Advantages of trusts
- Putting property assets into trust removes the assets from the original owner’s estate for IHT purposes as there is no interest retained in the asset. No IHT would be payable on the original owners’ death unless they died within seven years of making the transfer to trust.
- When assets are put into a trust, they are not given to beneficiaries but are under the control of the trustees. The settlors can appoint trustees to manage the funds and they can appoint themselves.
- Trusts can be established for the benefit of classes of beneficiaries and so there can be enormous flexibility regarding income and capital distributions depending on future needs and trust deed specifications.
- Trusts can last for 125 years and so potentially several generations of IHT charges can be mitigated.
- There are no stamp duty charges arising on the gifting of property to trusts.
- If the property activities benefit from Business Property Relief then IHT liabilities can be reduced or eliminated.
Disadvantages of trusts
- The major disadvantage to creating a trust is the immediate inheritance tax charge on any transfers in excess of the nil rate band of £325,000 (£650,000 per couple).
- If property is transferred to the trust, capital gains tax would arise on any gains arising between the date of original acquisition and transfer to the trust, as with FICs. However, as IHT is chargeable on the assets, holdover relief can be claimed which means no tax is immediately payable and the trust takes on the original base cost of the property.
- Throughout the lifetime of a trust, there are IHT exit charges on any capital distributions and ten yearly periodic charges, both chargeable at a rate of up to 6%.
- Trusts are subject to much higher tax rates than FICs. 39.35% is due on dividend income, 45% on other income and 20% on capital gains (28% if residential properties). However, distributions to beneficiaries carry tax credits at 45% allowing low-income beneficiaries to claim back tax to the extent that 45% exceeds their marginal rate of tax.
- Settlers must be excluded from future interest in the properties for the transfer to be an effective disposal, and so they are not able to access the assets or receive any future income. This can be prohibitive if property owners wish to retain access to capital or benefit from income.
Other options and next steps
In some circumstances, it might be possible to look at more “left field” options. For example, could a simple rental portfolio be converted into a portfolio that is not merely renting properties but buying and developing properties and then selling them on? For some, this will still sit within their comfort area and will open up the possibility of claiming Business Property Relief in respect of the development portfolio, meaning that the assets would not be subject to IHT at all.
There is no particular advantage in one structure over the other and the choice ultimately comes down to personal circumstances and preferences after discussion with your adviser. For some, the familiarity of a company and the lack of an immediate IHT charge will win the day. For others, the “clean break” for IHT purposes, together with the ability to retain a degree of control through retaining trusteeship will mean the trust is favoured. As alluded to above, a combination of the two can often give a satisfactory result.