Focus on the family home in Inheritance Tax planning

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.

To summarise what follows. There are a number of reasons why the family home is not a suitable vehicle for Inheritance Tax planning and if it is to be used it should only be so as a last resort when all other options have been explored.

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.

History of financial planning and the family home

There will be many situations, however, where the introduction of the residence nil rate band (RNRB) is not enough to remove a person’s estate from Inheritance Tax. This is where other solutions are sought. There have been many schemes in the past, some simple and others ingenious, to remove the family home from Inheritance Tax. All too often those using complex schemes for this purpose have not always understood the legal effects and tax consequences of all the transactions involved.

In each case HMRC Capital Taxes has subsequently brought in legislation to make such schemes no longer a practical proposition. Tax planning opportunities involving the family home are therefore limited and continuous close attention is being paid by HMRC Capital Taxes to this area of planning. It is therefore extremely important that professional legal advice is sought by anyone setting up any Inheritance Tax planning strategy involving the family home.

One factor that can easily be overlooked but is clear from some of the previous schemes is that they have relied on the family being ‘happy and united’. In practice, sadly, the relationship between parents and children may sour and sorting out conflicting desires has proved to be expensive in terms of legal fees.

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 be 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 to you 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 as we will see under the next heading future capital growth on the property will be potentially subject to Capital Gains Tax on your death.

Capital Gains Tax

There is no Capital Gains Tax (CGT) when you sell your family home because of the principal private residence relief. This relief also applies if you give your home (or a portion of your home) to your children or grandchildren. However, if during your lifetime you give your family home to children or grandchildren but continue to live there then you need to be aware of what will happen on your death when you children or grandchildren sell your former family home.

When they sell the property which has not been their main residence then CGT will arise based on any capital growth on the property after since the gift was made.

Impact on the Residence Nil Rate Band (RNRB)

We have seen under an earlier heading that to qualify for the residence nil rate band (RNRB) your property must be left on death to direct descendants (or their spouses/civil partners). Any arrangement that involves a lifetime gift of the family home or part of it will result in the RNRB not being available.

Of course, for those with estates well in excess of the £2m threshold will be ineligible for RNRB in any event.

Downsizing

There comes a time when many older people living in a large home, perhaps with an equally large garden, decide that life would be simpler in a smaller property, perhaps a new build with a modern kitchen and bathroom. This is an ideal time to release equity to pass to the children or grandchildren without trying to do something complicated with the family home. If you are able to live a further seven years then that gift is outside of your estate for Inheritance Tax purposes.

Equity Release

Where you don’t want to downsize but still want to make some inroads into the likely Inheritance Tax bill then you might want to consider using equity release. As it’s name suggests this is a way of releasing some of the capital value of your home into a cash sum which can then be passed to children or grandchildren. After seven years the gift will be outside of your estate for Inheritance Tax purposes and the mortgage on the family home will reduce its value for Inheritance Tax purposes.

Children who live at home

If an adult child (or children) is still living at home with his or her parent(s) then the parent(s) could give part of the property to their child (or children). If the child (or children) occupying the family home were to pay an appropriate proportion of the outgoings on the property then this is likely to avoid the gift with reservation and pre-owned assets tax rules.

As a general rule it is recommended that ownership and the payment of household expenses in these situations should be on a 50/50 basis to minimise the risk of investigation by HMRC.

There are, of course, potential problems with joint ownership that need to be considered. The biggest of these being if the child (or children) want to sell for any number of reasons.

If the child (or children) decides to move out of the family home at some stage then the parents will need to start paying a full commercial rent for the part of the property that they have given to the child (or children) or they will fall within the gift with reservation rules.

One advantage of a live-in child (or children) owning part of the family home is that on their parents’ death the value of the remaining share of the property being left to the child (or children) is likely to be reduced to reflect the joint ownership.

Second properties

Rather than trying to give the family home to children or grandchildren it is generally easier, where available, to give a second property such as a holiday home without infringing the gift with reservation provisions. As far as GWR is concerned there should be no problem with continuing to make use of the property occasionally.

However, it is also necessary to take into account the pre-owned assets tax rules as ‘occupation’ is construed widely for these purposes. Avoiding these provisions can be achieved using the co-ownership route in the same way as explained under Children living at home or by the previous owner paying a commercial rent for the time spent there.

Giving a second property will involve a possible liability for Capital Gains Tax. Second properties do not qualify for the residence nil rate band.

Using a Trust

The issues raised in these notes 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.

Other thoughts

You could move out of the family home at the same time as you give it to your children or grandchildren. This would escape the gift with reservation (GWR)  provisions and start the clock running for the seven year period to get it out of your estate for Inheritance Tax purposes. Of course, you are left with the need to find somewhere to live!

You could also sell the family home and make an unconditional gift of the cash proceeds to your children or grandchildren. You are then left with the same problem of needing somewhere to live. Your children or grandchildren could use the cash to buy a property for the purpose of giving you somewhere to live. It would seem that there would be no GWR issue here simply because it is not possible to trace a GWR through a cash transaction. It would be essential for each part of this planning to be unconditional on each other part. This would still be caught by the pre-owned assets tax.

Joint ownership of the family home

The majority of homes owned by married couples/civil partners will be owned in joint names. It is therefore worth spending a moment identifying the two forms of property co-ownership recognised in English law. These are:

  • Joint tenancy – As joint tenants you have equal rights to the whole property; the property automatically goes to the other joint tenant(s) if you die; and you cannot pass on your ownership of the property in your will
  • Tenancy in common – As tenants in common you can own different shares of the property; the property does not automatically go to the other tenant(s) if you die; and you can pass on your share of the property in your will

For married couples/civil partnerships, joint tenancy is often preferable since, in the event of the death of one of them, no probate or other formalities are required in respect of the property. However, for tax planning purposes, particularly where gifts or legacies of the property are intended, a tenancy in common will be the most useful and most flexible form of joint ownership.

For Inheritance Tax and Capital Gains Tax purposes, there is no distinction between the two types of ownership as, in each case, each tenant will be treated as absolute beneficial owner of their share.

Links to more information

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.