DECLARATION OF TRUST (DoTs) – Smart Tax Planning
First off, a declaration of trust is not a trust, it’s more like a declaration of facts. Although it is a legal arrangement for tax planning purposes. Funnily enough, because it’s a legal arrangement, some accountants may not know about it and because it’s a tax planning tool, solicitors may also not be aware of it.
Here are some ways a DoT can be very useful:
1. Income tax mitigation on investment properties
Should you and your spouse own investment property, generally the solicitor would have structured it on a ‘tenants in common’ basis. This means the equity and thus the rental yield would need to be split on a 50:50 basis.
If you are a higher rate or top rate taxpayer, your portion of the rental income, which is 50%, would be taxed at 40-45%.
If your spouse is lower rate taxpayer, their share of the rental income benefits from a lower rate of income tax, and of course if they were a full-time homemaker it’s unlikely they would pay any tax on the rental income at all as they would have their personal allowances to set against any rental income.
A DoT can be used to declare that 99% (or any other percentage) of the rental income should be for the beneficial interest of the lower rate taxpayer. This now means 99% of the rent is taxed at the lower rate, which could save you thousands.
What to watch out for?
If you sell the property, while a DoT is in place, 99% of the equity in the property is also in the estate of your spouse.
If your spouse dies, 99% of the equity will be in their estate for probate purposes.
If you divorce, 99% of the equity in the property will also be in your ex-spouses estate.
Will a DoT work for non-spouse joint owners?
It may not be tax efficient as there is likely to be capital gains tax implications on giving up equity to the non-spouse.
2. Confirming real ownership of the property
If you are buying a property with a partner, then at outset especially if you are both unmarried to each other, you can put in place a DoT which will reflect the proportionate ownership of the property based on the contribution each of you has made to the property. This will be crucial if you ever separate.
3. Making a lifetime gift
Where one person owns a property in their own name. They can add the other spouse on a DoT stating they own the property equally. Both parties now gift the property (most likely to their children) and this allows two lots of annual allowances to be used for CGT purposes. As it’s considered a potentially exempt transfer for inheritance tax purposes they also benefit from both of their inheritance tax nil rate band.
What’s a potentially exempt transfer?
You’d think if you gifted something there’d be no tax to pay. It’s not so simple. In fact, it’s considered a potentially exempt transfer. A period of 7 years must pass before that gift is completely outside your estate. Should you die within this 7-year period that gift can be brought back into your estate for the calculation of any inheritance tax charge.