Inheritance Tax planning and your home: Options to consider

Following on from our first article in this series on looking at your main residence and inheritance tax (IHT) planning, the purpose of this article is to bring to your attention some strategies that could be considered as part of an overall IHT plan.  

This article is for general information purposes only and does not constitute personal financial advice. Individual tax treatment depends on personal circumstances and may be subject to change. Appropriate professional advice should be sought before acting on any of the information contained here.

To make an IHT effective gift of the main residence, it is necessary to ensure that the arrangement does not come within Gift with Reservation (GWR) rules or the Pre-Owned Asset Tax (POAT) provisions. Please read our first article to learn more on GWR and POAT rules. Consideration should also be given to the impact of the planning on the availability of the Residence Nil Rate Band (RNRB) following any gift. However, we will consider this in each of the following typical scenarios.

Selling the home, buying a less expensive house and giving away the money released is a straightforward approach to IHT planning. However, this would not be acceptable to someone who wanted to remain in their current home. Some of the other pros and cons are listed below.

Pros:

• This is a relatively simple concept to understand and can be desirable if parents or grandparents etc are starting to struggle to maintain their current home.
• The money released could be used for several different purposes, including boosting income in retirement and improving an IHT position.
• Buying a smaller home should be less expensive to run, and you can choose to relocate nearer to family.

Cons:

• Selling your home, especially one where your children have grown up in, can be quite a difficult and uncomfortable thing to do.
• Moving to a smaller home means that usually there is simply less space than in your previous home.
• Once a suitable alternative home is found, and the costs of moving etc are factored in, the sum of money actually released can be a lot less than hoped.
• Should the sum released be gifted away, then the amount in excess of the annual exemption will usually be considered a Potentially Exempt transfer (PET) and so will form part of the donor’s estate for seven years should the donor die within seven years of making the gift.
• You may end up losing your Residential Nil Rate Band (RNRB). Whilst there is legislation  designed to compensate those who have downsized to a smaller property or gifted their home prior to death, where the sum released is gifted or invested in an IHT planning arrangement, such as a Discounted Gift Trust or Loan Trust, the clients may not recover the full RNRB lost unless other assets of sufficient value are also closely inherited on death. The downsizing addition is calculated as the lower of the RNRB lost and the value of the other estate assets closely inherited, Of course, if both properties were valued in excess of the RNRB (or two RNRBs in the case of married clients or those in a civil partnership) no RNRB will be lost.

Those clients who wish to remain in their current property without the complications inherent in ‘giving it away but remaining in occupation’ (see below); may wish to consider equity release to allow them to undertake IHT planning with the released funds.

Typically, the method of equity release chosen is a lifetime mortgage with interest rolled up, or a Retirement Interest Only (RIO) mortgage. This will constitute a debt on the property which reduces the taxable value of the property on death (thereby reducing IHT). There will usually be a provision that the total outstanding debt cannot cause ‘negative equity’ to arise.

RIO mortgages are similar in structure to interest-only mortgages, with the borrowers paying just the interest on the loan every month. In a similar manner to a lifetime mortgage, the loan is repaid on the sale of the property or on death. However, this type of mortgage has no set end date.

Estate planning options for the released funds will range from an outright gift to a gift into an IHT planning arrangement such as a Discounted Gift Trust or a Loan Trust, depending on the client’s requirements for control and access. 

Pros:

• Easier to plan with cash: possible to retain access or control or generate an ‘income’ stream.
• House remains in ownership of donor.
• Debt diminishes value of property (and so overall taxable estate on death) provided that the loan is not retained in the estate or invested in property (such as business property) that qualifies for relief from IHT.

Cons:

• Debt (increased by interest) diminishes amount available to recipients on homeowner’s death (although hopefully compensated by growth on the property investment).
• The debt could result in the property being sold on death and not left to family.
• Need to carefully weigh up costs or benefits dependent on strategy adopted.
• With the lifetime mortgage scheme, the estate would continue to include a ‘qualifying residential interest’ (reduced by the value of the mortgage), and the release of equity would not therefore affect the availability of the RNRB even if the equity released was subsequently gifted.

For many, downsizing and equity release are not attractive options and staying in their own home remains their favoured choice. 

One approach we often see discussed is to gift the property to your children, for example, whilst paying them rent to continue to live in it. 

Please note a full market rent must be paid to ensure GWR is avoided. 

Pros:

• Rent paid out of capital diminishes the donor’s estate without it being a gift for IHT purposes, while rent paid out of income which would otherwise be accumulating in the estate prevents the IHT position from worsening.
• The IHT eventually saved will be 40% of the value of the property gifted plus a further 40% on the rent, while the income tax cost to the recipient will be on the rent alone and will be determined by the rate of tax paid by the recipient, although this calculation assumes the full seven-year period is survived and that the planning remains effective throughout.

Cons:

• The donor has effectively lost control of their home. This could be problematic in the event of family disputes, particularly where one of the children, in this example, wishes to sell the property for their own purposes, e.g. as part of a divorce settlement etc. Remember, it is an asset of the children now and will form part of their estate for IHT purposes too.
• Where the donor pays the rent out of after-tax income, there is an element of double taxation as the rent is then taxable again in the hands of the recipient.
• It is essential that a regular rent review is carried out and documented so that the market rent continues to be paid. Failure to do so would render the planning ineffective under the GWR rules.
• The donor will usually need to have sufficient surplus income to make the payments.
• Capital Gains Tax (CGT) principal private residence relief will not be available to the new owner when the property is eventually sold, as this exemption is generally only applicable to your main residence. It should also be noted that the gift itself is a disposal for CGT purposes, treated as taking place at market value. The donor may benefit from Private Residence Relief on their gain if the property has been their only or main residence throughout ownership, but any period of non-occupation (other than permitted absences) could restrict the relief available. Specialist CGT advice should be sought.
• The gift of the property will be classed as a Potentially Exempt Transfer (PET), as mentioned above and cannot qualify for the RNRB as this can only apply to the estate on death. However, Finance Act 2016 compensates those who have disposed of their only residence prior to death (and so lost out on RNRB) with an ‘additional’ RNRB in certain cases. Generally speaking, the downsizing addition will be available where other assets of sufficient value are closely inherited on death. The addition is capped at the lower of the RNRB lost and the value of those other closely inherited assets.
• Even if you have successfully navigated the GWR rules you must be mindful not to fall into the POAT rules which are generally designed to stop ‘gift and stay’ strategies.   

This would typically involve a gift of, say, a 50% interest in a property to a person (such as a son or daughter) with subsequent joint occupation by donor and donee, with each paying their proportionate share of the outgoings. 

Pros:

• It is a ‘natural’ arrangement for close families who live together and plan to continue doing so in the future.
• No rent will be required from the recipient.

Cons:

• It is important that the donor does not enjoy a benefit by paying less than their proportionate share of the outgoings.
• A GWR will arise if the donee, such as children, ceases to occupy unless a commercial rent is paid from that point on.
• Provided that the retained share is of sufficient value to utilise the RNRB, there will be no adverse consequences for such planning. Where the value of the retained share is significantly below the RNRB then the same considerations as outlined above will apply.

Where property which has been gifted during lifetime remains in the donor’s estate as property subject to a reservation, that property is capable of qualifying for the RNRB. The RNRB will be available in such cases where the original gift was an outright gift made to lineal descendants (or their spouses or civil partners) as in such cases the property is deemed to be inherited by the donee(s). A gift to a Trust would not qualify for this treatment.

For those who are concerned about the loss of control of the property as outlined above, a Trust can help to prevent “sideways disinheritance” (e.g. children losing the house to a new spouse), potentially protect against beneficiaries’ divorce or bankruptcy and ring-fence the property for vulnerable beneficiaries. Appropriate advice from a qualified Trust advisor should be sought before taking this further.