This article looks at some of the ways that letting property can provide a tax-efficient way to provide income to your children. It is about children because I am assuming you would not extend the necessary generosity to anyone else (except your spouse, for whom different arrangements can be made).
It is important to realise that by ‘children’ I mean adult children – that is, 18 years old at least. None of these arrangements work for minor children, because if you provide funds to produce income for your child under 18 years old, that income will be taxed on you under the tax legislation dealing with ‘settlements’.
Suppose your (adult) child is off to university, or moving to a new town for their first job. If you would like to give them a helping hand, a let property can be a good way to achieve this.
Rent a Room Relief
This tax relief applies where an individual lets a room in their ‘main residence’. Rental income of up to £4,250 per year is exempt from tax.
Using this relief, it is possible for your child to receive rental income of up to £13,690 a year free of any tax – assuming they have no other income, so their personal allowance of £9,440 is also available against the rent.
It works like this. You and the child buy a property as ‘tenants in common’. This enables you to own it in unequal shares, so perhaps you own 90% and the child owns 10%. Your child lives in the property and lets one or more rooms to their friends or fellow students.
As the owner of 90% of the property, you might think you would be taxable on 90% of the rent, but it is possible for joint owners of a property (unless they are married) to agree among themselves how the rent is to be divided, so you agree (in writing) that it will all go to the child. This is important, because if more than one person is entitled to the rental income, then the £4,250 rent a room exemption is reduced to £2,125 each.
If it is necessary to fund the purchase with a mortgage, then it may be more efficient not to claim rent a room relief, if the mortgage interest is greater than the rent – if you claim rent a room relief, you cannot claim any other expenses.
If the property is sold, the 10% of the capital gain that applies to the child will be exempt from capital gains tax (CGT), provided the property has been used as the child’s main residence – and this relief is not affected by renting out a room to one lodger, but it may be if there is more than one. If so, another tax relief may apply, but this is a complex area and good tax advice is needed.
Your 90% of the gain, however, will be chargeable to CGT, as the property was not your main residence, and (unlike the rental income) CGT is charged in proportion to your ownership.
There is a way to have the best of both worlds – rent a room relief and full CGT exemption. Instead of owning the property directly, you set up a trust and name the child as the beneficiary, giving them a right to occupy the property, and specifically giving them the right to let rooms if they wish.
The child claims rent a room relief as before, and when the property is sold, the gain is exempt from CGT because the main residence exemption also applies to trusts where a beneficiary is entitled to occupy the property as their main residence.
The proceeds of sale belong to the trustees, not to the child and not to you. If this arrangement is to work, you (and your spouse and any minor children you may have) must not be allowed to benefit from the trust. The cash from the sale can be used to help the adult child with their expenses, or to buy another property for them to live in.
Practical Tip :
Setting up an arrangement involving a trust in this way is a complicated matter and there are many traps for the unwary. Make sure you get expert advice from a good tax adviser, and don’t try to do it yourself!