Using a deed of trust to mitigate the impact of Section 24 and save tax
First Published: November 2016 | Available in: Property Articles Your Property NetworkThe forthcoming mortgage interest relief restrictions – starting in tax year 2018 – mean that for many landlords there is a substantial benefit in re-structuring the beneficial ownership of their portfolio, through the judicious use of a ‘deed of trust’ (DOT), in order to make full use of spousal and family Basic Rate tax bands. But what is a deed of trust exactly, why are they beneficial, and how are they properly put into practice?
What is a deed of trust (DOT) exactly – I’ve heard the term, but never really understand what a deed of trust actually is!
A deed of trust is a legal document that enables the ‘beneficial’ interest in a property to be assigned to a different person than the underlying legal owner.
Putting a DOT in place has the effect of ‘diverting’ the income on a property from the legal owner to the person named on the DOT – this can be very beneficial where there is a tax advantage to be gained by such a transfer of interest.
From a tax perspective, there is a distinction between legal and beneficial ownership. The legal ownership of a property is whoever the Land Registry owner is, and if the property is mortgaged, who the mortgagee is. However, it is the ‘beneficial’ owner of a property that is taxed on the property income. Crucially, the DOT enables the legal and beneficial ownership to be detached from one another.
Does this mean that I need to re-mortgage my property if I put a DOT in place?
Normally, there is no need to notify a lender of a DOT, as the DOT simply transfers the rights to the mortgaged property’s income from one person to another. However, care should be taken to review any lender’s terms and conditions regarding any DOT, as lenders have differing approaches to the concept of a DOT.
OK – so how could a DOT help me save tax?
‘Section 24’ refers to the forthcoming mortgage interest relief restrictions, which apply to mortgaged residential property investors as of tax year 2018. These changes mean that mortgage interest will be restricted to the Basic Rate of income tax, from tax year 2018, gradually phasing in over tax years 2018 – 2021.
The effect of these restrictions will be to push many current Basic Rate taxpayers into the Higher Rate of income tax – essentially, such landlords will pay Higher Rate income tax on their pre-interest property profits, while only receiving Basic Rate tax relief on mortgage costs, which for some will result in effective tax rates on cash profits of 60-100% (in some cases a tax results from an actual cash loss).
By putting a DOT in place, a landlord could ‘transfer’ the income in a property from themselves to another person who may not be in such a position – namely, a person for who, even considering the effect of Section 24, is not subject to Higher Rate income tax on rental profits.
A key objective of using a DOT is to achieve the tax benefits of transferring income to another person who is unaffected by Section 24 – the financial impact can be substantially beneficial.
Ok – sounds promising – who should I transfer property income to via a DOT?
Obviously, this is a landlord’s prerogative! Generally, a spouse would be the preferred recipient of property income via a DOT, since capital gains tax (CGT) is not payable on spousal transfers of property. Otherwise, trusted siblings, family members and friends or business partners are alternatives – generally, the objective is to channel property income into the name of a person who is unaffected by Section 24.
What are the tax implications of a DOT?
This is the part of dealing with a DOT that some landlords misunderstand – a DOT is a ‘real’ legal document, and not trivial paperwork that has no tax consequence. There are two key taxes to consider when looking at the initial tax impact of using a DOT:
Capital Gains Tax (CGT)
CGT is payable whenever a person makes a ‘capital disposal’ i.e. either sells a property or transfers a property to another legal person (note that a ‘legal person’ includes another individual or a company). Note that spousal transfers are treated as being on a ‘nil gain nil loss’ basis, and so there is no CGT due on transfers of capital assets between spouses, whether this is a legal or a beneficial transfer.
However, transfers of capital assets between individuals, or between individuals / companies, and companies / companies are fully chargeable to CGT. This is the most significant reason that, for example, parents cannot simply transfer properties standing at a significant capital gain to their children (note: CGT is payable on such a transfer based on the market value of the relevant property at the time of transfer – even if the transfer is an outright gift).
Stamp Duty Land Tax (SDLT)
When a property is transferred from one legal person to another, not only is the property itself transferred at market value, but also the value of any mortgage at the time of transfer is deemed to also transfer along with the property itself.
The value of the mortgage deemed to transfer is chargeable to SDLT – even for spousal transfers – at the SDLT rate in force at the time (currently any transfer >£40k).
For example:
Mr Husband and Mrs Wife own a property as tenants in common, valued at £125k, purchased for £110k, and mortgaged at £96k. Mrs Wife is a Higher Rate taxpayer, while Mr Husband is Basic Rate taxpayer, and would remain so if the property were to be transferred beneficially to him via a DOT.
Prior to 1.4.16, Mrs Wife could transfer the property to Mr Husband for nil CGT (due to the ‘nil gain nil loss spousal transfer’ rules) and nil SDLT (due to the £96k mortgage, and the pre-1.4.16 SDLT 0% band of £125k).
After 1.4.16, Mr Husband would incur an SDLT charge of £1,440 (3% of half of £96k mortgage) in order to receive Mrs Wife’s half-share of the property.
Therefore, the optimum solution is often to either transfer only a fraction of a property from one person to another such that only a <£40k mortgage balance is deemed to transfer, or to repay any mortgage prior to a beneficial transfer.
OK – a DOT could provide a substantial tax saving to me – who could deal with the DOT for me?
There are several options:
1. The ‘DIY’ approach
Your property accountant may be able to provide a template DOT for completion, although you as the client would be responsible for the correct completion of the DOT, since your property accountant is not a legal adviser. There are also various internet-sourced DOT templates available. This is the cheapest option, but of course there is the risk that the DOT hasn’t been completed property, and consequently is invalid.
2. Your solicitor
Solicitors are able to prepare DOTs, and often there is a benefit immediately prior to the sale of a property in having the ‘selling’ solicitor deal with a DOT which might provide a CGT benefit (since there can be no doubt that the selling solicitor prepared the DOT correctly, of course). This is often the most expensive option (rates of £250-450 are routinely quoted).
3. Use a specialist DOT service provider
Using any service provider whose specialises in the service that you require, is more likely to result in a satisfactory outcome. The following company has provided a good service to many clients of ours, and charges a typical fee of £150 for a professionally-produced DOT:
Please note that we have no affiliation or commission arrangement with the above company, and there are other companies that are able to provide a similar service).
And, do I need to inform HMRC of a DOT?
Married couples need to inform HMRC of a change in the beneficial ownership of a property jointly owned on a tenants in common basis. All other property ownership scenarios do not need to be notified to HMRC (though HMRC are of course entitled to check any DOT, should HMRC enquire into anyone’s tax return).
Summary…
Using a DOT to transfer beneficial interest in a property from one legal person to another can be an effective way to mitigate the impact of Section 24, or indeed to mitigate the expiration of any rental losses and impact of Higher Rate income tax on rental profits.
However, there are CGT & SDLT considerations as part of such a decision, and documentation needs to be validly drawn up, and where appropriate filed with HMRC. As always, professional advice should be sought, as mistakes can be costly (especially after 31.3.16 regarding SDLT!).