Thousands of families need to review their wills if they want to benefit from the Government’s new inheritance tax allowance.
Thousands of families who set up “discretionary trusts” so they could leave property to children in a tax-efficient manner will miss out on the Government’s valuable new inheritance tax allowance unless they make significant changes to their will, accountants have warned.
Homesleft to children through a discretionary trust will not benefit from the “family home allowance”, worth up to £350,000 per couple from 2020, because assets do not pass directly to children.
Discretionary trusts – the most common form of trust – were widely used in the past to minimise inheritance tax (IHT).
Why were discretionary trusts so popular?
Prior to October 2007, the first of a couple to die could leave all their assets to their surviving spouse completely free of IHT. But when the surviving spouse died they could only use their own tax-free allowance, or “nil-rate band”, for the total estate. This meant that when assets were passed to children or other beneficiaries, on the second death, many faced a tax charge.
To avoid this, people created discretionary trusts so that the first spouse’s assets were taken out of the estate for inheritance tax purposes on their death. Thus, each spouse’s allowance was utilised.
What has changed?
Since October 2007, married couples and civil partners could transfer any of their unused nil-rate band to their surviving spouse, creating a tax-free allowance of up to £650,000 on the second death.
This made discretionary trusts less attractive, but some people still use them to ensure assets are left to their intended beneficiaries, such as children from a first marriage, for example.
If you set up a discretionary trust. Why should you review it?
The new family home allowance will be available to people who own a home from April 2017. It will eventually be worth an additional £175,000 per person in 2020. Added to the £325,000 allowance that everyone gets now, this means a new allowance for property owners of £500,000 – or £1m for couples.
Crucially, to qualify for the family home allowance the property must be “directly inherited” by direct descendants. This includes children, stepchildren, adopted and foster children, and grandchildren.
Discretionary trusts will not qualify because the trustees take on legal ownership of the asset in the trust and have discretion around which of the beneficiaries receive which assets, how much each will get and when. The beneficiaries only have the right to be considered by the trustees, who are not legally bound to follow the wishes of the deceased.
Which trusts will qualify?
Under the trusts below, any property (and other assets) are deemed to pass directly to the beneficiaries, who are fully entitled to use the property or take any income from it. The existence of the trust is effectively ignored for tax purposes.
Interest in possession (IIP) trusts
The most common qualifying trust will be an IIP created by will – this is often seen where the first spouse dies and wants to ensure that the surviving spouse can occupy the property for the duration of their lifetime, before the property passes to children or grandchildren.
Disabled persons trust and IIP
Similar to the above, this is where an IIP is created for the benefit of a disabled beneficiary.
Bereaved minor’s trust
This trust is created for the benefit of a child under the age of 18 who has already suffered the death of one parent.
While the child is under 18, he or she should be able to live in the property or, if it is let, should benefit from any income.
When the child reaches 18 years of age, legal ownership of the property passes to them.
Age 18 to 25 trusts
This operates in a similar way to the trust above, but the child takes on legal ownership of the property at age 25.