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Transferring Rental Income: Beware Of Tax Traps!

Lee Sharpe looks at how rental income can be shared out – and the traps to beware of. 

Is it possible to give away your income in a property but still to retain the capital? Is it possible to transfer some or all of the rental income to another family member – for instance, one who is subject to a lower rate of income tax?

Transfer of income streams
Trying to transfer only the income, such that the original owner retains the beneficial ownership of the property, is likely to fall foul of specific anti-avoidance legislation that will effectively tax the income donor as if the transfer had never taken place. This is complex legislation primarily aimed at businesses trying to convert income into capital (so that it is taxed at lower rates), but it can potentially cover the re-allocation of income between two individuals, thanks to ITA 2007, s 809AZA et seq. However, these anti-avoidance provisions basically apply only where a capital interest in the underlying income-producing interest is not also transferred. 

Of course, transferring an interest in the underlying asset will usually trigger a capital gains tax (CGT) charge, basically on the increase in value of the interest, over and above the corresponding cost. This rule applies even where the property interest is gifted or sold at a discount (transfers between spouses and civil partners are generally ‘CGT-free’, but other family members are not protected in this way). So, is it possible to transfer only a relatively small proportion of the capital interest, but comparatively much more of the income?

Joint property
Jointly-held property is potentially much more flexible. As regards joint property generally, HMRC’s Property Income manual says (at PIM1030):

‘...the share of any profit or loss arising from jointly owned property will normally be the same as the share owned in the property being let. But joint owners can agree a different division of profits and losses and so occasionally the share of the profits or losses will be different from the share in the property. The share for tax purposes must be the same as the share actually agreed’ (emphasis added).

So, in theory, it should be fairly straightforward: give away a small proportion of the capital interest in the property so as to avoid any large CGT bill, but transfer a large proportion of the income so that it is taxed at lower rates. However, it is often not that simple. 

Spouses and civil partners
Transfers of capital wealth between spouses usually avoid a CGT charge, but there are special rules about the sharing of income. 

The default position is that if spouses/civil partners share the underlying beneficial interest in the property in any proportion, then the income is halved equally between them (ITA 2007, s 836). In order to displace this approach, the spouses must generally either:
  1. actually own the underlying asset in an other-than 50:50 split and make a joint declaration to that effect to HMRC; or
  2. be operating in a partnership – this is generally considered to be quite rare for jointly-owned investment property, but there may be increased interest in the distinction in years to come. 
Note that, in (1), spouses can change their income split only according to the actual split of underlying capital interest in the asset itself; (2) is more flexible. 

There are, however, further complications. 

Settlements anti-avoidance legislation
The ‘settlements legislation’ are anti-avoidance provisions that attack arrangements where the person giving the income away – the ‘settlor’ – will (or may) still benefit. Such income ‘settled’ on another party will be treated as the income of the settlor, effectively undoing any potential benefit in the transfer. 

The settlements legislation specifically targets spouses and minor children (ITTOIA 2005, s 625). If, say, a parent wanted to transfer 50% of a property’s income to his or her minor children, then it would automatically be treated as still being his or her income for income tax purposes. A similar approach applies for spouses, although there is a specific exception (ITTOIA 2005, s 836) where there is an outright gift of the underlying asset between spouses (rather than a gift that is essentially only of the income from the asset). In effect, this will tie back to the rules mentioned above about the treatment of jointly-owned assets between spouses (and civil partners) and moving interests in assets between them. 

However, it should be noted that the settlements legislation does not apply only to relationships between spouses and civil partners, and between parents and their minor children; in theory, it can apply wherever the original settlor gives away a right to income, but nevertheless stands to benefit from the income given away. 

Example: Gift of property interest to adult son
Jack and Jill give away a 20% stake in one of their buy-to-let properties to their adult son, Jeremy. Let’s say that the capital gain on the relatively small share of the property is covered by their CGT annual exemptions (£11,300 each in the 2017/18 tax year). 

As an aside, if the property is subject to a mortgage and Jeremy is deemed to take on some responsibility for the finance, then this can count as ‘consideration’ by Jeremy for the purposes of stamp duty land tax, even if he got the 20% stake in the property as an outright gift.

Taking HMRC’s guidance in PIM1030, Jeremy is entitled to 20% of the rental income. But Jack and Jill want to give Jeremy 50% of the income because they do not need all of the rental income and Jeremy pays tax at only 20%, while Jack and Jill pay tax at 40%.

On basic principles, Jack and Jill have ‘settled’ their right to receive 30% of the rental income on Jeremy. However, Jeremy is over the age of 18, so he is not a minor child, and the settlements legislation will not trigger automatically; in order for the settlements legislation to bite, Jack and Jill must benefit somehow from the settled income, or be able to do so. But there are no such arrangements; the income is paid over to Jeremy, who uses the additional funds to help pay for his own residential mortgage, and Jack and Jill never see a penny of the income they have made over to Jeremy. 

We have seen that there are numerous pitfalls to transferring property income to someone else. Generally, some interest in the property must be transferred to the individual intended to benefit, in order for the income ‘transfer’ to be effective for tax purposes. There must be no circularity in the arrangements so that the ‘donor’ or ‘settlor’ can still benefit from the funds given away – for example, Jack and Jill should not hold a joint rental bank account with Jeremy, otherwise it could be argued that they are still free to withdraw funds that they were supposed to have given away. 

Practical Tip:
Nevertheless, it is often possible to arrange a tax-efficient distribution of income without necessarily having to precipitate a significant CGT charge in the process. It is always recommended that professional advice be sought beforehand, to ensure that all taxes (e.g. inheritance tax) are properly considered and catered for in the planning. 

This is a sample article from the monthly Property Tax Insider magazine. Go here to get your first free issue of Property Tax Insider.