A fairly common question that I have been asked over the years is “How can we avoid Inheritance Tax being paid on our home.” This is often, of course, because the family home is one of the largest assets in a person’s estate and in many cases the single largest asset. This is usually followed by something along the lines of “Can’t we simply transfer our home to our children now and then after seven years it will be free of Inheritance tax?” The assumption is that those asking the questions will continue to live in the family home for the rest of their lives.
There are a number of reasons why the family home is not a suitable vehicle for Inheritance Tax planning and I have produced a new section of my website dealing with these in some detail. I can summarise the main points as follows.
Residence Nil Rate Band
The introduction of the residence nil rate band (RNRB) which applies to the estates of people who die after 6 April 2017 has meant that many people need no longer worry about their home causing an Inheritance Tax charge.
The RNRB is £175,000 per person and, if the proposals in the recent Budget become law, will continue at that level until April 2026. The standard nil rate band is £325,000, and on the same basis, will again continue at that level until April 2026. We can therefore calculate the maximum that a widow/widower, who leaves a residence to children or grandchildren, can leave free of Inheritance Tax. This is £1 million, i.e. £325,000 (nil rate band) + £325,000 (deceased spouse’s unused nil rate band) + £175,000 (RNRB) + £175,000 (deceased spouse’s RBRB).
The RNRB only applies if you plan on leaving a residence to ‘direct descendants’ such as your children or grandchildren and their spouses. Step-children, adopted children and fostered children are all ‘children’ for this purpose. For larger estates the RNRB will be reduced by a rate of £1 for every £2 by which their estate exceeds £2 million.
The RNRB can be offset against a part ownership in the family home as well as a property that is left to children or grandchildren in its entirety.
Gifts with Reservation (GWR)
This is one of the key tax issues relevant to a lifetime gift of the family home. To summarise the gifts with reservation (GWR) of benefits provision introduced in the Finance Act 1986, the donor should not enjoy any benefit from the gift or the value of the property.
In essence, therefore, the gift of a family home to children or grandchildren would be ineffective for Inheritance Tax purposes if the donor, after having made the gift, continued to enjoy a benefit from it. Since, in most cases, the potential donor will wish to continue to occupy the family home, after it (or part of it) is given to children or grandchildren or other family members, it will frequently be impossible to do this and achieve a saving in Inheritance Tax.
Pre-owned assets tax (POAT)
This is another key tax issue relevant to a lifetime gift of the family home. In the Finance act 2004 the Government introduced legislation to combat certain Inheritance Tax avoidance schemes where assets were disposed of, but the previous owner continued to enjoy benefit from the asset without making a commercial payment.
The pre-owned assets tax (POAT) charge is an income tax charge which is based on any benefit (or deemed benefit) received by a former owner of property that he has disposed of by way of gift. To put it simply, if you give your family home to your children or grandchildren and continue to live in it then you will be liable for a POAT income tax charge based on the rent that you should be paying. This is a similar idea to the additional income tax that employees can be charged as a benefit in kind charge for being provided with private medical insurance, for example.
Overcoming GWR and POAT
A gift with reservation (GWR) will not apply if full consideration is given for the gift. In terms of the gift of the family home then the GWR will be overcome with a lease back granted by your children or grandchildren at a full market rent. By paying a full market rent you would also avoid any liability under the pre-owned assets tax (POAT) provisions.
It is important to note that to avoid the GWR provisions, full consideration is required throughout the whole of the seven-year period before death. Furthermore there should be periodic rent reviews to make sure that the rent keeps pace with market changes.
Of course, paying a market rent to your children or grandchildren to remain in your family home will not have a great deal of appeal to most people. In effect you will be suffering a loss of net spendable income in attempting to reduce your children’s Inheritance Tax bill. The rent received by your children or grandchildren will be subject to income tax in their hands and future capital growth on the property will be potentially subject to Capital Gains Tax on your death.
Using a Trust
The issues I have raised will generally apply whether you make a gift of your home or part of your home directly to your children or grandchildren or place it into a trust for them.
We have seen that the residence nil rate band (RNRB) applies where the family home is left to direct descendants. Where the family home or part of it is placed in a trust this will not be seen as being to direct descendants unless the trust is a bare trust which has a specific named beneficiary or the gift creates an immediate post-death interest.
For a married couple/civil partners with children the RNRB on the death of the surviving partner could be worth £350,000 (i.e. £175,000 x 2) which at 40% Inheritance Tax is a tax saving of £140,000. It is therefore important to be aware of the availability of the RNRB or not when considering any proposed Inheritance Tax planning.