Islamic Finance In Residential Property Transactions

Faith groups across the globe have long tried, with varying degrees of success, to give legal weight to religious principles which apply to the daily lives of their followers.

Perhaps one of the best examples of this is the increasing prominence of Islamic finance. Shariah- compliant financial arrangements, which embody the overarching principle that a consumer must not be required to pay interest, but which still allow the banks to make a profit, are now very common, both in the Islamic world and elsewhere, including in England. Numerous products are now available for Muslim home buyers to purchase their property in line with their religious beliefs and are also often sought out by non-Muslims in the absence of other viable financing options.

The finance of English residential property using Shariah financial arrangements presents numerous legal risks and obstacles for both banks and consumers which can fortunately, with the right advice and approach, be overcome and mitigated.

The Basic Structure 

One type of Islamic compliant financial arrangements available in the UK market for the purchase of residential property is known as ‘Diminishing Musharaka’ product. This is effectively a partnership or a ‘joint venture’ between the bank and the customer.  

The property is purchased in the name of the bank, and then a lease of the property is granted to the customer, pursuant to which the customer can occupy the property. The leasehold interest owned by the customer will also usually be charged to the bank.

A separate deed (usually called the ‘Diminishing Musharaka Agreement’) sets out the percentage split of the beneficial interest in the property between the bank and the customer. This percentage split represents the Loan to Value Ratio (i.e. the LTV) as it is known in a conventional mortgage, which is essentially the equity which the bank has contributed towards purchasing the property (this being the loan to the customer) and the cash which the customer have themselves contributed towards the purchase.

The customer will then be required to pay rental payments to the bank pursuant to the terms of the lease, in return for occupying the proportion of the beneficial property which the bank owns. Additionally, the customer will also pay instalments to the bank to purchase the proportion of the beneficial interest which the bank owns, and over time, their beneficial interest in the property will increase and the bank’s interest will, commensurately decrease. Ultimately, assuming the customer keeps up with all payments, they will have purchased the entirety of the bank’s beneficial interest, as the payment of the rent and payment of the purchase instalments together result in a profit for the bank. It is at this stage that the financial arrangement comes to an end, so that the customer owns the property outright. This will involve removing the charge secured against the lease, surrendering the lease, and the bank transferring the property to the customer.

Property ownership in Sharia only marriages

Shariah compliance financial arrangements are just one of the many legal considerations to be made by Muslims living in England and Wales. One particular family law situation which gives rise to legal complexities is property ownership in absence of a legally recognised marriage.

Many Muslim couples will enter into a Shariah only based marriage, which does not meet the criteria for a legal marriage in the courts of England and Wales. The couple will then combine their assets and purchase often the most valuable asset they own: the family home. Often the family home will be registered in the name of one party to the marriage, and the parties will agree to this under the misunderstanding that their marriage is recognised legally and therefore the property will be considered a marital asset.

However, when a couple purchases a home and their marriage is not legally recognised in England and Wales, upon separation they are not afforded the same financial protections as legally married couples*, and are essentially considered to be cohabitating only. Therefore, only the legal owner of the property is recognised to have a share in the property. The non-legal owner is then limited to bringing any claims for the property under the Trusts of Land and Appointment of Trustees Act 1996 (TOLATA). 

Under this legislation, it is possible for a party to try to establish a financial interest in the property if it is not held in their name or if they are looking to claim a larger share in the property than is legally recorded. The legislation will enable the parties to go to court for a declaration as to the ownership of the property and take into account contributions made to the property which give rise to a financial interest. The court can make various orders, such as an order to force the sale of the property, to allow for a share of the capital to be distributed between the parties, and it can permit a party to remain in the property.

If a party is looking to then bring a claim under this legislation, attention needs to be given to number of considerations, included and not limited to:-

• These claims are notoriously difficulty to bring and the claim in this area of law is very complex;
  
  
• As the claims are brought under civil proceedings, adverse costs orders can be made. This means that the Applicant must bear in mind that the court may order for the Applicant to meet the Respondent’s reasonable legal fees in the proceedings if they are unsuccessful in their application;
  
  
• The cost of bringing the application may outweigh the interest of the Applicant in the property.

There are however alternative methods to court proceedings to settle these types of disputes, including negotiations outside of court and mediation. These can be very useful methods of alternative dispute resolution which can allow for cost effective results.

Contributions from family members

In the Islamic culture, couples will generally not cohabit prior to marriage and this will often be the first property that the married parties will purchase. It is therefore common for parents/grandparents of the couple to contribute financially to the purchase of the family home.

The legislation does not only allow for the non-legal owner of the home to make a claim for a share in the equity, but also third parties who have a financial interest. Again, this is a complicated legal area and is often more cost effective to be settled outside of court proceedings, however the legislation does allow for these third parties to apply for an order to allow for a recovery of a financial interest in the property. 

Tax considerations

Given the multiple dispositions of land interests in an Islamic mortgage transaction, both at the beginning of the life of the loan and at the time of redemption, transactional parties and their advisers can struggle to come to terms with the unforeseen and undesired tax consequences which can arise, both for the bank and the customer.  These tax consequences are complex and could relate to VAT, Stamp Duty Land Tax, Inheritance Tax and Capital Gains Tax. Issues such as these should be carefully discussed and negotiated in good time, so that any necessary redrafting of documents can be negotiated and finalised.

Final Thoughts

Irwin Mitchell’s team of experts have considerable experience in advising not only the transactional elements of Shariah-compliant financial arrangements but also some of the less commonly encountered peripheral issues, such as those relating to the inadvertent tax consequences  and wider inheritance planning matters. Under a Sharia financial arrangement, if a property or an asset is in the name of the  bank, the bank should discuss options with the client as to what will happen in the event of death of the clients, and as to whether the Sharia agreement will be transferred into the name of a person of the customer’s choice (for example, a spouse or child), or whether the property should be sold by the bank and the sale proceeds distributed in accordance with the will of the deceased. Such issues can often be overlooked by participants in Islamic financing transactions, but they should be addressed at the outset to avoid difficulties later on.

*With regards to financial provisions for children, non-married couples are afforded the same rights as married couples, to pursue proceedings under Schedule 1 Children 1989.