For most people, the family home is their most valuable asset. Unfortunately, it is also often the asset that admits them to what was once a very exclusive club – the Inheritance Tax club.
Inheritance Tax (“IHT”) is charged on a person’s “estate” (broadly, assets less liabilities) when they die. The first £275,000 is free of charge (the “nil rate bend”) and all the rest is charged at 40%. The nil rate band will rise to £285,000 in April 2006, and to £300,000 in April 2007.
Because the nil rate band has not kept pace with house prices, more and more people find themselves in line for what used to be a tax on the rich. Transfers between married couples (or civil partners) are exempt from IHT, so if the home is left to the surviving spouse there is no IHT cost on the first death, but when the survivor dies, the house may well have to be sold to pay the IHT.
Much ingenuity has therefore gone into schemes to avoid IHT on the family home, and these have been countered with much legislation. There was a time when the ageing parent could simply “put the house in the children’s names” and continue to live there – this has not been effective for many years, though sadly I still come across situations where people have thought it was, and get an unpleasant surprise when the parent dies and is still taxed on the value of the house.
The three biggest obstacles to IHT planning for the family home are:
- “Reservation of benefit” – If you give the house away, but carry on living there, you will be treated as if you still owned it for IHT purposes
- “Life interests” – If you do not own the property, but have the right to live there for the rest of your life, you are treated as if you owned it for IHT purposes
- “Pre-owned Assets Tax” – This is an annual charge to income tax on the “benefit” of using assets that you once owned in the past, or assets that you have never owned but which were bought by their owners with money that you gave them.
The tax on pre-owned assets began in 2005, but it catches arrangements made as long ago as 1986. Any future IHT planning might be similarly attacked with retrospective effect, so this is not a planning area for the faint-hearted!
Any IHT planning involving the family home needs expert advice, both to ensure that it works for tax purposes, and also that other vital factors are considered:
- Security for the person living in the house – some schemes rely on the generosity of the children in letting the parent occupy “their” house, but what happens if the children go bankrupt?
- The ability to move house in the future
- The potential problems if nursing home care becomes necessary (the rules on “deliberate deprivation” can deny local authority funding to those who have given assets away)
There are two sorts of planning to consider – lifetime planning, and “first death” planning.
The scope here is very limited – but the following can be considered:
- Give away the home, then pay a full market rent to live there - but the rent will be taxable income for the new owners of the home
- Give a share in the home to (say) a child, who then lives there with you and shares the running costs – but if the child moves out, the value of their share will be included in your estate again
- Give cash to the children, wait seven years, then sell the house and move into one they buy with the cash – this works, but only if you have that kind of cash available in the first place
- Mortgage the house, and invest the money in assets that do not attract IHT, such as shares in unlisted trading companies (perhaps the children run such a company?), or agricultural land which is let out – after two years, the investments described will qualify for 100% relief from IHT, and the mortgage will reduce the value of the house for IHT purposes – but you have to pay the mortgage interest. I have seen this work, but only because the parent concerned wanted to invest in the children’s company anyway.
“First death” planning
If you are a married couple (or a civil partnership), there is some opportunity to pass the home down to the children when the first of you dies – a dead person cannot “reserve a benefit”.
The first essential step is to ensure that you own the home as “tenants in common” rather than as “joint tenants”. This is because a joint tenant inherits the other joint tenant’s share automatically on their death, whereas a tenant in common can leave their share to whomever they wish. If you are joint tenants, it is a simple legal procedure to convert to being tenants in common.
Some planning possibilities on the first death are:
- Leave your share of the house to the children – this is the “low-tech” form of planning, and crucially, it relies on the children’s generosity in allowing the surviving partner to live there undisturbed (they cannot evict him/her, but they could put a tenant in or force a sale of the property), and on them not going bankrupt. If the survivor wants to sell up and move, there will be capital gains tax to pay on the sale of the house.
- Leave your share of the house to a “discretionary trust” with your partner and your children as beneficiaries – assuming that your half of the property is worth less than the “nil rate band” there is no IHT to pay, and when your partner dies they can leave their share to the children as well. If, however, your partner wants to move, there may be CGT to pay when the house is sold, and there is a danger that the Revenue will say that your partner has a “life interest” in the other half of the house. A more sophisticated scheme is:
- Leave a cash legacy equal to the “nil rate band” to a discretionary trust, and empower that trust to take an index-linked charge over the house instead of cash – this needs careful drafting to ensure that your partner does not have a “life interest” as before, and it is essential that the trustees of the trust know how to manage things to avoid this problem. The main advantage of this arrangement is that if the survivor wants to move house, they can do so without any CGT being payable on the sale of the old property.
It may be possible to deal with this planning after the first death, by using a “deed of variation” within two years of the death. This effectively rewrites the will, providing that the beneficiaries agree.
IHT planning is a complicated business, and it is essential to get proper professional help. I will leave you with two pieces of advice:
- MAKE A WILL
- If someone tells you they know a “simple” way to avoid IHT, they do not understand how IHT works!