Divorce Settlements and Inheritance Tax: The Mesher Order Explained
I was engaged by a client to discuss the inheritance tax implications of a Mesher order recently executed as part of the court's financial settlement in his divorce. While he understood the order's effect, he wanted to clarify its impact on his estate and his daughter's inheritance, especially in light of his recent diagnosis with a serious, but not life-threatening, illness
What is a Mesher Order?
A Mesher order is a type of court order used in family law related to the division of property following a divorce or separation. The concept originates from the case Mesher v. Mesher and Hall [1980], which set a precedent for how family courts handle the division of property, particularly the family home, after divorce or separation.
Although the Mesher order is based on common law (judges’ decisions) and does not derive its authority from a specific piece of legislation, section 24 of the Matrimonial Causes Act 1973 empowers courts to make property adjustment orders. A Mesher order is a type of property adjustment order.
How a Mesher Order Works
A Mesher order allows the sale of the family home to be postponed until a specified "triggering event" occurs. During this period, one party (often the parent with primary custody of the children) remains in the home with the children, while the other party retains a financial interest in the property.
The primary aim of a Mesher order is to provide stability for the children by allowing them to remain in the family home until they are older, while ensuring that both parties retain a financial interest in the property.
Once a triggering event occurs, the property is typically sold, and the proceeds are divided according to the terms set by the court.
Common Triggering Events
Triggering events that may prompt the sale of the home include:
The youngest child reaching a certain age (e.g., 18 or finishing full-time education).
The remarriage or cohabitation of the residing party.
The death of the residing party.
Does a Mesher Order Create a Trust?
Whether a Mesher order creates a formal trust depends on its specific wording and structure.
In some cases, the order may explicitly state that the property interest is to be held on trust for the benefit of the residing party. In such situations, the non-residing party would transfer legal title of their interest to trustees, often retaining a reversionary interest (i.e., the interest or proceeds revert to them after a sale). This arrangement constitutes a formal trust, triggering certain tax consequences.
However, not all Mesher orders create a formal trust. In many cases, the non-residing party retains ownership of their share of the property while granting the residing party the right to occupy the home until the triggering event. Although no legal title is transferred to trustees, this arrangement can function similarly to a "life interest." For inheritance tax purposes, the residing party is treated as having a qualifying interest in possession in the property during the period of the Mesher order and, therefore, deemed ownership of the property.
Inheritance Tax implications of a Mesher order
If the non-residing party’s interest is transferred into a trust, this is considered a chargeable lifetime transfer. Any value transferred above the available nil rate band (currently £325,000 as of 2024) is subject to an immediate inheritance tax charge of 25%. Additionally, ongoing inheritance tax obligations, such as 10-year anniversary charges and exit charges, may apply under the relevant property regime.
Where no formal trust is established, and the non-residing party retains a financial interest in the property, there is no immediate inheritance tax charge because no transfer of value has occurred – the non-residing party continues to own their interest, and the Mesher order merely delays the realisation of that interest.
When the trigger event in a Mesher order occurs and the qualifying interest in possession for the residing party ends, it does not create a potentially exempt transfer. A potentially exempt transfer occurs when an individual voluntarily makes a gift to during their lifetime to another individual, which becomes exempt if they survive seven years.
Capital Gains Tax implications of a Mesher order
Transferring an interest into a trust counts as a disposal for capital gains tax purposes. The non-residing party may face capital gains tax on the gain between the property's market value at the time of the Mesher order and the original acquisition cost. If they had lived in the property as their main residence, they may be able to claim principal private residence relief to exempt any gain.
If no trust is created, the non-residing party still holds their share of the property, so no disposal takes place. However, if they sell their interest later, they could be liable for capital gains tax on any increase in value, although principal private residence relief may apply to exempt some of the gain.
What Happens if the Non-Residing Party Dies Before the Trigger Event?
If the non-residing party’s interest is transferred into a trust, it no longer forms part of their estate for IHT purposes, provided they survive for seven years after the transfer. However, if they die within seven years, the value of the original chargeable lifetime transfer may be aggregated with their estate, although any IHT already paid can offset the liability.
If there is no trust because the non-residing party retains their financial interest in the property, this share will be included in their estate for inheritance purposes. The interest would typically be discounted by 5% to 15% to account for the fact that the property is encumbered by the residing party’s life interest and cannot be sold.
What Happens if the Residing Party Dies Before the Trigger Event?
Subject to the terms of the order, a trust will terminate if the residing party dies before the trigger event, with the trust property passing to the reversionary beneficiary (the remainderman). Trust termination will trigger an inheritance tax exit charge at a rate of not more than 6%. As with the chargeable lifetime transfer on the trust creation, the inheritance tax charge applies to the value of the property above the nil rate band only.
An inheritance tax exit charge will also apply if the residing party survives the order, and the trust terminates on the trigger event.
The trustees may be liable for capital gains tax on the trust’s termination. If the residing party had occupied the property as their main residence, principal private residence relief should exempt any gain accrued during the trust period.
Where no trust exists, their life interest will cease, and the full open-market value of the property will form part of their estate for inheritance tax purposes. This value includes both their ownership interest and their beneficial interest under the qualifying interest in possession.
if the residing party dies and their qualifying interest in possession is taxed in their estate, there is no probate uplift for the non-residing owner because they already own the asset and are not inheriting anything.
Double Taxation if the Residing Party Dies Before the Trigger Event?
Where a qualifying interest in possession subsists, the death of a residing party under a Mesher order can result in both the residing party and non-residing party’s interests being subject to inheritance tax in the residing party’s estate. Inheritance tax will also be levied on the non-residing party’s interest whether directly (property) or indirectly (proceeds of sale) when the non-residing party dies.
A single beneficiary inheriting the entirety of both estates, could contend that they have born the burden of two, separate inheritance tax charges on the same property interest— that owned by the non-residing party.
Would There Be Double Taxation Relief?
There is no double taxation relief because, legally, separate interests are taxed at separate events. While a single beneficiary might feel as though they are bearing a double IHT charge on the same property, this is not considered double taxation in the legal sense.
Conclusion
A Mesher order is not placed as a legal charge on a property like a mortgage but instead delays the sale or division of the property, specifying how it will be divided once the triggering event occurs. Both parties typically remain legal owners during the Mesher order period, and as such, there is no transfer of value by the non-residing party, meaning there is no immediate inheritance tax charge on the creation of the residing party’s life interest.
If the residing party dies during the Mesher order period, the value of the life interest would be included in their estate in addition to their own legal interest in the property—effectively subjecting 100% of the property to inheritance tax in their estate. If the non-residing spouse later dies with the value of the property (directly or indirectly) included in their estate, their interest in the property could effectively be taxed twice.
It is important to consider these potential tax consequences when structuring a Mesher order. Please note that this post is intended for general informational purposes only and should not be considered legal or tax advice. Always seek professional guidance tailored to your specific circumstances.