15th December 2022
The purpose of this article is to cover the possible income tax issues of holding a rental property in a trust.
There are many reasons why an individual may wish to create a trust, such as, protecting younger beneficiaries from owning valuable assets outright, guaranteeing succession of assets, or inheritance tax planning. Using a trust allows a settlor to exercise an element of control about how assets are used to benefit the intended beneficiaries.
A trust is formed by a settlor who settles assets into a trust. The settlor appoints trustees to hold the assets. The legal ownership of the assets is then passed to the trustees, who must manage them for the benefit of the beneficiaries. A common asset settled into a trust is rental property, with the intention of generating income and paying this out to beneficiaries. However, the taxation of property income isn’t always straight forward and the tax treatment depends on many factors, including the terms of the trust. This article looks at the income tax issues of holding a rental property in a trust.
Generally, the trustees are liable to income tax on the income arising from the property they hold in their capacity as trustee. The trustees must complete a self-assessment tax return and pay the income tax out of the Trust’s income, before making distributions to the beneficiaries. The trust’s property business is taxed entirely separately from any property income received by the trustee in a different capacity, e.g. from property held personally or as trustee of another trust.
The trustees of a discretionary trust have the power to decide how and when the income of the trust is distributed. Typically, there will be a class of beneficiaries and the trustees can make distributions to anyone in this class as they see fit. The trustees are entitled to a Standard Rate Band which taxes the first £1,000 of income at the basic rate (currently 20%), and the balance of income is taxable at the rate applicable to trusts, which is the same as the additional rate (currently 45%).
The profits of a property business are calculated in the same way as for individuals. Like individuals, trusts are restricted from deducting interest costs from rental income. A discretionary trust will receive tax relief for the disallowed interest costs in the form of a tax reducer in the tax computation. The tax reducer is 20% of the lower of the disallowed interest costs, and the taxable profits for the property business in the year.
The trustees may incur expenses that are not directly related to the property business, e.g. a trustee may charge a fee for managing the trust as a whole. These expenses are not deductible from the property income, but the trustees will only be taxable at the basic rate of tax on income used to pay such expenses.
When income is distributed to beneficiaries, they will receive the income with a tax credit of 45%, which will be shown on a certificate provided by the trustees. If the beneficiary’s marginal tax rate is lower than 45%, they can claim a repayment of the difference. This makes discretionary trusts a tax efficient way to provide for beneficiaries who have little other income.
Interest in possessions trusts
An interest in possession trust (sometimes called a life interest trust) is taxed on rental profits at the basic rate of 20%. The beneficiary, sometimes known as a life tenant, is entitled to the net income and this must be paid out to them. The life tenant will receive a statement of income from the trust (R185) showing the income and the tax paid at the basic rate. If the life tenant is a higher or additional rate taxpayer, they will need to pay extra tax through their self-assessment tax return.
The rental profits are calculated in the same way as for individuals. The interest costs of the property business are not deductible by the trustees, nor is a tax reducer is available to them. However, the tax reducer can be claimed by the beneficiary and details of the restricted finance costs will be provided to the beneficiary on their R185 certificate.
Trusts where the settlor is also a beneficiary
If a settlor can benefit in any way from the trust, they will be personally taxable on all the income of the trust. The trustees still pay tax as detailed above, but will provide details of the income to the settlor who will also include it on their own self-assessment tax return. The settlor can claim credit for the tax that has already been paid by the trustees against their own tax liability.
Situations where the income is taxed on the beneficiary rather than the trustees
In certain situations, the beneficiary is taxable on the rental income rather than the trustees. This is the case if the trustees have mandated the income to be paid directly to the beneficiary, so that it does not pass through the hands of the trustees. A beneficiary of a ‘bare trust’ is also taxable personally on the net rental income. Less often, there is a strict settlement of land governed by the Settled Land Act 1925; for these the beneficiary is treated as the person carrying on the rental business rather than the trustees, so they are assessable directly on the rental income.
If losses are incurred by the trustees, they are carried forward to be deducted from future profits. Losses do not pass through to the beneficiary so cannot be offset against any rental profits the beneficiary may have personally. The above is not exhaustive but provides a broad overview of the taxation of property income on trustees.