Case Study - Getting onto the housing ladder
This article was published in CITY AM on 9 November 2016
With rising house prices and tighter commercial lending criteria it can be increasingly difficult for young people to buy a first property and get on to the housing ladder. Often the Bank of Mum and Dad will be called upon.
Parents who want to help their children are often uncertain about the best way to provide the funds, the tax consequences and the legal position of boyfriends, girlfriends, sons-in-law and daughters-in-law. For example, many parents are concerned about what would happen to the funds if their children were to divorce, or if the funds are used unwisely.
An outright gift of cash for a deposit is straightforward and relatively tax efficient. So long as the person making the gift survives seven years, the gift will be outside of their estate for Inheritance Tax (IHT) purposes on death. IHT is otherwise charged at 40% on the value of the estate above £325,000. However, an outright gift provides no means to protect this family money on divorce or bankruptcy.
An alternative approach would be for the parents to buy a property for a child to occupy. This arrangement provides asset protection but is not tax efficient. When the property is sold (assuming it has gone up in value) the gain will be subject to Capital Gains Tax (CGT) as for tax purposes it is treated as a second property. For the same reason from 1 April 2016 the higher Stamp Duty Land Tax (SDLT) rate (3% above the standard rate) applies to purchases of second properties.
For IHT purposes there is no gift so the value of the property at the time will remain within the parents' estates for IHT purposes. If the parent dies and the value of the estate is above the IHT threshold, there will be more IHT to pay. Additionally, where there is insufficient liquid cash in the estate to pay the IHT due, the personal representatives who administer the estate might have to consider selling or mortgaging the property to raise the funds to pay that IHT.
A middle ground between these two possibilities would be for parents to lend the funds, ideally securing the money against the property by placing a charge on the Land Registry title in the same way that a commercial lender would. Usually, a family loan will be interest free. This approach offers asset protection and tax efficiency for CGT and SDLT but not for IHT as the value of the loan will remain in the parents' estates.
An approach which can combine the best of both worlds – the asset protection of a loan with the tax efficiency of a gift - is for the parents to gift cash to a trust. The trustees can then lend the money to the children. A gift to trust can be more tax efficient than an outright gift as not only will the funds not form part of the parents' estates after seven years, but they will also not form part of the child's estate.
We recently acted for a couple whose daughter was looking to buy a property with her boyfriend. Both were in their early 20s and they had saved a small deposit between them. However, they were struggling to find a mortgage large enough to purchase a property of the size they wanted.
The daughter's parents were happy to provide £250,000 towards the purchase but were conscious that this was a significant amount of money and that their daughter's relationship with her boyfriend was still at a relatively early stage. They were also open to ways to reduce the size of their combined estate from IHT.
Rather than gift the funds to their daughter outright or lend the funds to her directly, the parents gave the cash to a lifetime trust of which the parents were the trustees. From there, the funds were lent to the daughter interest free to allow her to buy the property of her choice with her boyfriend. The trustees took a second charge over the property to secure the loan.
The gift to trust was made by the mother in this case as the mother was statistically more likely to survive seven years. So long as she does indeed survive seven years from the date of the gift, the funds will not form part of the parents' combined estates for IHT, nor the daughter's. This could save up to £100,000 of IHT. The trust can exist for up to 125 years and so the funds can potentially be used for future generations of the family as well without being subject to IHT. Trusts of this nature are subject to IHT charges every ten years but so long as the value of the loan is less than the IHT Nil Rate Band threshold at the time, there will be no IHT to pay.
The trust structure is also tax efficient for buying and selling the property. As the house was purchased in the names of the daughter and her boyfriend, the higher rate of SDLT for second properties did not apply.
If the daughter and her boyfriend wish to move in the future, the sale will be free of CGT in the normal way for a principal private residence. The funds will be repaid to the trust and the charge removed at that point. If the parents (in their capacity as trustees) agree, the funds can be lent again on agreed terms to help fund the purchase of a replacement property.
Crucially, the strategy was discussed at a meeting with the parents, daughter and boyfriend at an early stage so that all could agree on what was proposed. The daughter and boyfriend were encouraged to draw up a Declaration of Trust between them to set out their beneficial ownership of the equity. The daughter's share of equity was larger to reflect the loan made to her from trust. The Declaration of Trust also set out how the property would be divided were the relationship to end, including provision for each party to have the option to buy out the equitable share of the other.
Regardless of how the funds are provided, where the property is to be co-owned by a partner or spouse it is important to put in a place a Declaration of Trust to ensure the division of the equity of the property, including any provision from parents, is clearly documented at the start. Similarly, if a child purchases a property in their sole name but occupies with a partner or spouse, a formal waiver of any rights created by virtue of their occupation may be appropriate. In every case it is best to consider the rights of all involved as early as possible to avoid acrimony in future.
The Private Wealth team dealt with advising the family. The boyfriend was included at family meetings but encouraged to take independent legal advice on his position. Once the strategy was agreed, the Residential Conveyancing team dealt with the purchase of the property on behalf of the daughter and her boyfriend.
The terms of the Declaration of Trust can be reviewed in the fullness of time as circumstances change. If the relationship continues and, for instance, the couple were to marry we would suggest that they also consider drawing up a pre-nuptial agreement with the assistance of the Family Team.