Interest in Possession Trust Guide

07 March 2025

Planning for the future of your estate is a huge consideration for most people, ensuring the right beneficiaries inherit the correct assets and avoid certain tax implications after you’ve passed away. However, without proper planning, your assets could become a source of contention or may not be distributed as you intended.

An Interest in Possession (IIP) Trust offers an effective solution to this common challenge, allowing an individual to receive income generated from the trust’s assets whilst preserving your property for the right beneficiaries. This article will guide you through the essentials of IIP Trusts, including:

When an IIP Trust is the best choice for your estate planning needs.
Tax implications, such as inheritance tax (IHT), capital gains tax (CGT), and income tax considerations.
The advantages and disadvantages of using an IIP Trust.
How to set up an IIP Trust through HMRC’s Trust Registration Service (TRS).
Whether assets can be transferred out of an IIP Trust, and the related tax implications of doing this.

What Is an Interest in Possession Trust?
Impact of the Finance Act 2006 on IIP Trusts
How Does an Interest in Possession Trust Work?
Tax Implications of an Interest in Possession Trust
What Are the Benefits of an Interest in Possession Trust?
What Are the Challenges of an Interest in Possession Trust?
How to Register an Interest in Possession Trust
Can You Transfer Out of an IIP Trust?

What Is an Interest in Possession Trust?

An Interest in Possession (IIP) Trust is a legal arrangement where you wish to give someone the benefit of an asset during their lifetime, but then subsequently pass it onto additional beneficiaries after their death.

The initial beneficiary (or beneficiaries), referred to as the life tenant, has the right to receive the income generated by the trust's assets during their lifetime. However, the life tenant does not own, have access to, or have control over the trust’s capital. This is preserved for the benefit of other beneficiaries, known as the remaindermen, who will benefit from the capital or assets after the life tenant has passed away.

The assets within the trust are managed by the trustees, who are legally obligated to act in the best interests of all beneficiaries, ensuring the terms of the trust are properly followed.

Typical assets included in an IIP Trust include:

Property: Residential or commercial properties that generate rental income.
Investments: Shares, bonds, or investment funds that produce dividends or interest.
Cash Deposits: Used to generate interest income for the life tenant.

Impact of the Finance Act 2006 on IIP Trusts

The Finance Act 2006 significantly changed the taxation of IIP Trusts in the UK. Before March 22, 2006, any lifetime transfers into an IIP Trust were classed as “Potentially Exempt Transfers” (PETs), meaning there was no immediate IHT charge - as long as the settlor (the creator of the trust) survived 7 years from the trust creation date. IIP Trusts were generally not subject to the relevant property regime, meaning they avoided periodic charges every ten years, as well as the exit charge associated with Discretionary Trusts.

Post-March 2006, transfers into new IIP Trusts are no longer treated as PETs - meaning they are immediately subject to IHT - unless the trust is classed as a Bare Trust, or the value of the transfer is within the IHT nil-rate band (currently at £325,000).

If an IIP Trust, created before 22 March 2006, ended before 6 October 2008 while the life tenant was still alive, and a new life tenant had been appointed, this new beneficiary would be subject to the previous tax rules (before the Finance Act 2006). This meant that there was a period between 22 March 2006 and 5 October 2008 when an IIP Trust beneficiary could pass their interest to someone else, such as their children.

Transitional Serial Interest

A Transitional Serial Interest (TSI) is a specific type of interest in possession that was introduced following changes to IHT rules under the Finance Act 2006. Through a TSI, IIP Trusts are not taxed under the relevant property regime, and instead, for IHT purposes, the assets are treated as being owned by the life tenant.

However, the window for creating a TSI was limited; the new interest in possession must have been granted between 22 March 2006 and 5 October 2008. Therefore, TSIs are now only relevant for historic trusts and estate planning arrangements during that window.

IIP Trusts Created By a Will

IIP Trusts created by a Will are typically qualifying IIPs, meaning they are treated differently from lifetime trusts for tax purposes. Instead of falling under the relevant property regime, which subjects trusts to periodic and exit charges, these trusts are considered part of the life tenant's estate. This means that when the life tenant dies, the value of the trust assets is included in their estate for IHT purposes.

How Does an Interest in Possession Trust Work?

Income Rights of the Life Tenant

The life tenant has an absolute right to receive all income generated by the trust’s assets after the deduction of any necessary expenses. For example:

If the trust holds a rental property, the life tenant is entitled to the net rental income.
If the trust holds dividend-paying investments, the life tenant receives the dividends.

However, the life tenant cannot access the capital or demand that the trustees sell or alter the assets to increase income, unless such powers are expressly granted in the trust deed.

Management of Capital for the Remaindermen

The trustees are responsible for managing the trust’s capital to preserve its value for the remaindermen. This often involves:

Maintaining properties to ensure their value does not depreciate.
Making investment decisions to balance income generation for the life tenant with capital growth for the remaindermen.
Ensuring that the trust complies with relevant tax laws to reduce liabilities.

In terms of who bears the cost of managing the trust’s capital, this will depend on how the trust has been drafted. Often there will be terms in the trust that state the life tenant is responsible for ongoing maintenance of a property as well as responsibility for utilities, insurance etc.

Example of How an IIP Trust Works

A parent may, through a Will, establish an IIP Trust to ensure their surviving spouse has a steady income from investments while protecting the capital for their children. This ensures that the spouse is financially secure while preserving the family’s assets for future generations.

Tax Implications of an Interest in Possession Trust

Income Tax

Income tax applies to the income generated by the trust’s assets, which is passed to the life tenant. The life tenant is responsible for paying income tax on the income they receive from the trust. The tax rate depends on the type of income, such as:

Rental Income: Taxed as property income.
Dividend Income: Taxed at dividend tax rates, the basic rate of which is 8.75%.
Savings Interest: Taxed as savings income.

The trustees usually deduct basic rate income tax (20%) before distributing the income. If the life tenant is a higher or additional rate taxpayer, they must pay any additional tax due through their self-assessment tax return. If the life tenant is a non-taxpayer, they can reclaim the tax deducted by the trustees.

Trustees are responsible for managing the income generated by the trust’s assets and ensuring that tax is properly deducted before distribution. Trusts with a total income of less than £500 pay no income tax.

Inheritance Tax (IHT)

As outlined earlier, the IHT of IIP Trusts depends on whether the trust was created before or after 22 March 2006. As a recap, here’s how they change before and after this date:

Pre-22 March 2006 trusts generally fall outside the relevant property regime, meaning they do not incur periodic or exit IHT charges. However, the value of the trust’s assets is included in the life tenant’s estate for IHT purposes upon their death.
Post-22 March 2006 trusts are usually subject to the relevant property regime, incurring periodic IHT charges every 10 years at a maximum rate of 6% on the value of the trust’s assets. Exit charges are applied when the capital is distributed from the trust. Exceptions include trusts created under a Will, which are treated like pre-March 2006 trusts, or for vulnerable beneficiaries, which may be subject to more favourable tax treatment.

For example, Mr Smith sets up an IIP Trust, transferring £500,000 in assets. His daughter, Emily, is the life tenant, entitled to the income.

After her death, the assets pass to Mr Smith’s grandchildren. The £500,000 transfer is a Chargeable Lifetime Transfer (CLT). The excess over the £325,000 nil-rate band (£175,000) incurs a 20% IHT charge (£35,000).

When the assets pass to the grandchildren, they may face further IHT, depending on the estate’s value, and the trust may also face periodic (every 10 years) and exit charges when assets leave the trust.

Capital Gains Tax (CGT)

Capital gains tax is relevant when trust assets are sold or transferred, resulting in a gain. Trustees are responsible for paying CGT on any gains made when trust assets are disposed of. The applicable rate is:

24% for capital gains realised on the sale of residential property not eligible for Private Residence Relief (PPR), and from April 2025, it 24% will also apply for all other assets.
20% for capital gains realised on the sale of other assets, following the trust’s annual exemption deduction.

The life tenant is not directly liable for CGT because they have no entitlement to the trust’s capital. If assets are transferred to the remaindermen (e.g. children) instead of being sold, the trust may be eligible for holdover relief, which allows CGT to be deferred until the remaindermen sell the assets.

Example:

Using Mr Smith as an example again, the transfer of assets into the trust is classed as a “disposal” for CGT purposes. Mr Smith may need to pay CGT on any gain since the assets’ acquisition, calculated based on the market value at the time of the transfer.

His daughter, Emily, does not pay CGT on the trust’s income, but if she sells any trust assets during her lifetime, the trust will pay CGT on the gain.

When the assets pass to the grandchildren, there’s a deemed disposal at market value. This triggers CGT on any increase in value since Mr Smith’s initial transfer.

If the asset being disposed of is a property that a life tenant has been living within, the trust can in certain circumstances benefit from principal private residence relief from CGT. This relief prevents CGT being paid on the disposal of someone's main home.

What Are the Benefits of an Interest in Possession Trust?

An IIP Trust offers many advantages to the settlor, life tenant, and remaindermen, most notably:

Financial Security: Provides reliable income for the life tenant while preserving capital for remaindermen.
Asset Protection: Safeguards assets from being depleted or mismanaged; particularly useful for high net-worth individuals (HNWIs).
Estate Planning Flexibility: Balances the needs of multiple beneficiaries, making them particularly ideal for blended families.
Professional Oversight: Trustees ensure impartial management in line with the trust’s terms.
Tax Efficiency: Offers potential inheritance tax advantages, notably for pre-22 March 2006 trusts.

What Are the Challenges of an Interest in Possession Trust?

While IIP Trusts offer benefits, they also have a few considerations that should be carefully evaluated. These include:

Complex Administration: Trustees must manage records, taxes, and legal obligations. Neglecting this could result in fines.
Tax Liabilities: Trusts created after the Finance Act 2006 are usually subject to IHT and CGT.
Beneficiary Conflicts: Balancing life tenant and remaindermen interests can sometimes cause disputes.
Limited Flexibility: IIP trusts may not adapt well to changing circumstances or tax laws, and may require expertise to monitor any changes.
Rights to Trust Fund: The life tenant is entitled only to trust income, not capital. Trustees may control capital distribution or it may pass to named beneficiaries after the life interest ends.

The easiest way to overcome these potential challenges is to use professional advice throughout the trust’s use. Legal expertise, especially from those who specialise in trust law such as our team of friendly solicitors at Culver Law, is recommended to ensure legal compliance and avoid any unwanted tax implications or disputes along the way.

How to Register an Interest in Possession Trust

Setting up and registering an Interest in Possession Trust involves several steps to ensure it is legally sound. As a brief overview, here’s what you need to do:

Check if Registration Is Required: IIP trusts must be entered on the HMRC trust register if they generate income that is not directly mandated to the life tenant or incur capital gains from asset disposals.
Gather Necessary Information: Document details about the trust, and collect information about the trustees, settlor, life tenant, and remaindermen. You will also need to describe the trust’s assets and approximate valuations.
Complete the Registration Process: To register the trust, you will need an Organisation Government Gateway ID and password. Provide the required information through the Trust Registration Service (TRS), ensuring it is accurate and up to date.
Meet Deadlines: Non-taxable trusts created after 6 October 2020 must be registered within 90 days of: a) their creation, or, b) becoming liable for tax. Taxable trusts must be registered within 9- days of the trust becoming liable for tax.
Update Records: Trustees must update the TRS whenever changes occur, such as a new trustee or beneficiary. You may be subject to a £5,000 penalty if you fail to keep the register up to date.

Trust Administration Support

Creating and administering an IIP Trust can be complex, requiring detailed record-keeping, compliance with tax laws, and balancing the interests of beneficiaries. Engaging legal professionals for trust administration support can help trustees manage their responsibilities effectively, in the following ways:

Ensuring trust deeds, tax returns, and other paperwork comply with legal requirements.
Navigating income tax, CGT, and IHT obligations to minimise liabilities.
Managing the process through HMRC's Trust Registration Service.
Addressing conflicts between trustees or beneficiaries impartially and legally.
Guiding trustees through changes to tax laws and the trust’s overall administration.

Can You Transfer Out of an IIP Trust?

Whilst assets can be transferred out of an IIP Trust, there are certain tax implications to be aware of, particularly regarding CGT. Let’s take a closer look at these:

Capital Gains Tax

A CGT disposal occurs when trustees transfer chargeable assets to a beneficiary. This may happen either because the trustees have discretionary authority to distribute capital or when a beneficiary becomes entitled to the trust’s capital, such as upon reaching a specified age or event.
Trustees and beneficiaries can jointly elect for holdover relief to defer the CGT liability. This is possible if the asset is a “qualifying business asset” or if the trust qualifies, which primarily applies to lifetime IIP trusts created after 21 March 2006. The deferred gain is taxed only when the beneficiary disposes of the asset.
Holdover relief is particularly advantageous because the beneficiary benefits from their full CGT annual exemption and may pay a lower CGT rate.

Inheritance Tax

For an IIP Trust created on or before 22 March 2006, or if the IIP Trust was created by a will, when the IIP trust comes to an end, this is a deemed gift by the life tenant of the trust and so the seven year gifting rule for Inheritance Tax is also applicable.

Timing Considerations for Holdover Relief

Trustees must avoid transferring assets within the first three months of the trust’s creation or within three months following a ten-yearly IHT charge. Transfers during these periods do not qualify as chargeable lifetime transfers for IHT, and holdover relief will not apply unless the assets are business-related.

Tax-Free Uplift on Life Tenant’s Death

For IIP trusts created on or before 22 March 2006, the death of the life tenant triggers a tax-free uplift in asset values. The trust assets are treated as part of the life tenant’s estate for IHT purposes, wiping out any capital gains up to the date of death. The acquisition cost for CGT is then reset to the asset’s market value at that time.
However, if gains were held over when the trust was created - only possible for business assets - then these gains become taxable upon the life tenant’s death.

Special Trusts for Minors

Trusts created upon the death of a parent for minor children, such as 18–25 trusts or bereaved minors’ trusts, are eligible for holdover relief when the beneficiary reaches the relevant age.

Contact Our Trust Law Experts Today

If you’re considering the creation of an IIP Trust, don’t delay. Our friendly team of solicitors at our London and Cambridge offices will help guide you through the process to ensure your wealth is protected in the most efficient ways possible. To get started with us, simply get in touch today for a FREE consultation, where we can discuss the best trust options for your needs.

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