Buy a second home and pay no capital gains tax
02-10-2015
Here's how you can buy a second property completely free of CGT - and give your adult children a rent-free home
By Nicole Blackmore
Want to buy a second property that your children can live in rent-free, while also avoiding capital gains tax?
It sounds too good to be true. As regular readers of these pages know too well, the capital gains tax (CGT) net has been closing in on owners of more than one property, with successive changes in legislation.
But this little-known loophole remains a wholly legitimate way to buy another property and subsequently dispose of it without having to pay any CGT.
Plus, your full CGT exemption on your own home is unaffected.
As rising property prices put home ownership out of reach for many in their 20s and 30s, this can also be a fantastic way to help your child escape the costly rental market – and save for a deposit.
It involves the use of a trust, but one which should be relatively easy and cheap to arrange. The trust can also be used where you have owned the property for some time, according to Frank Nash, a tax partner at London-based accountancy firm Blick Rothenberg.
Here we take you through the process step by step.
Buying a property
The best way to do this is to set up a formal written trust, before you buy the property, with one or both parents named as the trustees. A solicitor can help you do this for a fee of a few hundred pounds.
Rather than purchase the property privately, you loan the trust the deposit and the trust takes out the mortgage. You will usually need to guarantee any mortgage in your own name because banks are otherwise reluctant to lend to trustees.
A “life interest trust” allows you to name a single child as a beneficiary, and that child also has a right to the income from the property.
A “discretionary trust” allows you to name any number of children, or other friends or family members for that matter, as beneficiaries. With a discretionary trust there is no automatic right to the income but you can structure it in this way if you choose.
With both types of trust, the named beneficiaries can become what are called life tenants, which gives them the right to live in the property rent-free.
A discretionary trust is a more flexible arrangement because one child could occupy the property for three years – while they are at university, for example – then a younger sibling could take over the property at a later date. There is no limit to the number of times the occupier can change, as long as they have the right to occupy the property rent-free under the terms of the trust.
By naming your children as beneficiaries they effectively trigger their own “principle private residence relief” when they move into the property. This is the relief that exempts a homeowner’s main property from CGT.
When you come to sell the property as trustees, you can claim the exemption for the whole period of ownership as long as it has been occupied by at least one of the named beneficiaries at all times.
Your own principle private residence relief on your home is not affected and there is no limit to the amount of gains you can take tax-free through this arrangement. There is also no income tax due on the sale.
If your children move out of the property, you have 18 months to sell it before a capital gains tax liability would start to accrue. Within this 18-month period you can let it out to any tenants you like and it will not affect the CGT exemption.
Outside of the 18-month period, if the property is not occupied by a named beneficiary, CGT may be due for that period.
If you’ve already bought the property
You haven’t necessarily missed out on this valuable tax advantage. There are occasions where a trust can be “implied”, even when a trust deed was not set up at the time the property was purchased. The capital gains tax relief can still apply in what is known as an “implied trust”.
If your children have been living in the property and benefiting from the arrangement, HMRC will want to see that the arrangement operated in practice in exactly the same way that a trust would have.
My child lives in the property with flatmates. Will income tax be due on their rent?
In short, yes, but there are ways to minimise the tax owed.
How this is treated will depend on the type of trust you have set up and where the rent is paid.
If the rent is paid to the trust: you should notify HMRC that you have set up a trust that will receive rental income, and register it for self-assessment. This is an important step even if you are already personally registered for self-assessment, as a trust is considered a separate legal entity.
A life interest trust, where there is just one named beneficiary, will have to pay 20pc on the rental income, after expenses and the mortgage interest have been claimed.
A discretionary trust on the other hand must pay 45pc tax on the rental income, after expenses.
In both cases, however, you as a trustee can pay the income to your child as the beneficiary. If they have no other earnings their personal tax allowance of £10,000 will be intact and they can claim the tax back from HMRC up to this limit.
If the rent is paid to the child: your child can receive the net income as the life tenant. It is essentially the same as if they had purchased the property in their own name, received the rent and paid the expenses and mortgage interest personally.
He will have to register for self-assessment, and can claim the same expenses as above to reduce his tax liability.
If you choose this option it is sensible to write to HMRC and explain that the income is being mandated to your child as the life tenant, and ask the taxman to agree that the trust does not therefore need to complete a tax return. This will help avoid any problems down the track.
What about inheritance tax?
If you loan the deposit for the property to the trust, as described above, there will be no upfront inheritance tax to pay.
You will only incur an upfront IHT charge if you gift the asset to the trust and it is worth more than the IHT limit of £325,000. In this case a 20pc IHT charge would apply to the excess.
But only settled assets – money you put into the trust – count. You need to put some money in when you set it up but this can be any amount you like, £100 is a good starting point, and this is what would count towards the limit. As it is unlikely that you would ever gift more than £325,000 to the trust, upfront IHT would very rarely apply.
Any trust that owns property must also pay inheritance tax every 10 years at 6pc on any value above the £325,000 threshold. But again, if the deposit is loaned rather than gifted to the trust, this will not usually trigger a charge.
If one or both parents as the trustees die, new trustees can be appointed and the trust can carry on as normal. Alternatively, if the trust is set up so the children inherit the property on death, the normal inheritance tax rules apply.