The problem: I have heard that the legislation around the deductibility of debts has changed. Should I still be writing mortgage protection plans under trust?
The solution: The Finance Act 2013 introduced a change which limits the deductibility of debts in certain circumstances.
The change in legislation is primarily aimed at tackling tax avoidance schemes. This is when money is borrowed by an individual but then used to buy property, which then is either excluded property or benefits from a relief such as business property or agricultural property relief.
But it can also catch the ordinary person who has done the sensible thing and put their mortgage protection plan in trust.
Previously, when calculating the value of an estate, debts such as a mortgage could be deducted from the value of the property.
This meant that many people did not have an estate above the nil rate band, even though the property itself may be worth more.
But this change means that the mortgage can only be deducted if the loan is actually repaid from the estate of the deceased.
As a result, those who want to pass on the family home and have put in place a life policy written in trust, to ensure there is enough to repay the mortgage, could now have an inheritance tax bill.
That is because the policy is no longer part of the estate, if it is written in trust.
If the property passes to the next generation and it is still encumbered by the mortgage, should the beneficiary subsequently repay that mortgage using the proceeds from the policy, the debt would not have been repaid from the estate and is not therefore deductible.
The full value of the house would then be included in calculating their inheritance tax liability. This does not just affect new arrangements. It affects anyone who dies on or after 17 July 2013.
But all is not lost. HMRC has very kindly given a solution to the problem it has created.
You will find this in the draft guidance to be added to their Inheritance Tax Manual.
This states that if the executors borrow money to repay the original mortgage and this new loan is secured on the property, so that the beneficiary receives the property charged with the new debt, it can be accepted that the original mortgage has been repaid from the estate.
The guidance goes on to say that the beneficiary may even make a loan to the executors from the proceeds of an insurance policy held in trust, outside the estate, for the purposes of repaying the mortgage.
The source of the funds does not matter.
So, provided the correct steps are followed, it still makes sense to write a mortgage protection policy in trust from a tax perspective, as the mortgage can still be deducted from the value of the house.
Remember that if the policy is not in trust it will form part of the estate and would effectively cancel out the debt.
This would mean the full value of the house would be used in calculating the inheritance tax liability.
And it should not be forgotten that there are reasons other than avoiding inheritance tax to write policies in trust. Even those clients who still would not have an inheritance tax liability following this change can benefit, if only in avoiding the delays that probate can cause.
I have heard that the legislation around the deductibility of debts has changed. Should I still be writing mortgage protection plans under trust?
Ian Smart is head of product development & technical support at Bright Grey