Against a background of rapidly rising house prices over the last decade and more, average house prices for first time buyers are high – in spite of the current climate of economic uncertainty. As a result first time buyers often have to look to parents or other family members for a helping hand in funding the deposit or part of the equity.
How to structure these parental contributions has always been a dilemma. One the one hand, parents are often willing to make gifts of capital to their children. This is often seen as sensible inheritance tax planning for the parents as, provided they survive the gift by seven years, it will not be treated as part of their estate for inheritance tax purposes.
On the other hand, parents have sometimes been reluctant to make outright gifts to their children as they fear that if their children’s relationship subsequently breaks up, the original capital gifted will be shared with the child’s divorcing spouse. Furthermore, if the child is self-employed, any capital contribution is at risk from creditors should the business fail. In these circumstances the capital contribution has often been made by way of a loan, promissory note or even a second charge on a property – the downside of which is that the parent will still be treated as owning an asset which will form part of their estate and possibly subject to inheritance tax on their death. In addition, should the parent go into nursing care, the value of the loan will form part of their estate and be treated as capital available to pay for ongoing care. The children could then find themselves in a position where they have to re-mortgage or sell the property to fund their parent’s nursing care or face the prospect of having a second mortgage with the local authority social services department.
So how can the parental contribution be structured to prevent the contribution forming part of the estate for inheritance tax purposes, or as capital available to fund nursing care fees whilst trying to protect the capital from any subsequent divorce or business failure by their child?
The answer is to make the contribution via a discretionary trust arrangement. The parent can set up a discretionary trust in favour of their children and grandchildren. The parents themselves can act as trustees and effectively control where any monies are spent or used. Provided the parent is not a beneficiary of the trust, once seven years have elapsed from the contribution to the trust, the capital no longer forms part of their estate for inheritance tax purposes. In addition provided the parents are in reasonably good health at the time of the contribution and a reasonable period of time elapses before the parent enters into nursing care, it would be difficult for any local authority to claim the fund as “capital available” to fund any ongoing nursing care fees.
Once the funds have been introduced into the trust the parents, as trustees, can loan the trust fund to their child for purchasing their new property but this loan is repayable back to the trust. As a result, if the child subsequently becomes divorced repayment back to the trust will reduce the equity in the house and potentially protect it from the subsequent divorce settlement. If the child’s business was to fail and insolvency proceedings follow, the discretionary trust would be a creditor and take its place with other creditors. If the loan by the trust is secured by way of a legal charge, this would give priority over any unsecured creditors on any bankruptcy proceedings.
As can be seen, provided the parent survives by seven years the contribution to the trust is treated in a similar way to a gift, whilst the loan by the trust to the child carries the benefits of a loan in the event of marital breakdown and insolvency.
Depending on how the loan in structured, the administration of the trust need not be complicated and expensive. With careful drafting, with the right trustees and beneficiaries, and with the correct set up, it is possible to get the best of both worlds!
For more information or advice, please contact John Rouse or Charles McKenzie in the Wills, Trust and Tax department.
