Lifetime Mortgages and IHT Planning

Inheritance tax, including gift with reservation provisions, was introduced in 1986 to replace capital transfer tax. These provisions have made it difficult to gift an asset while keeping immediate or possible future access to that asset. There are some well-known exceptions for those with cash who can use loan trusts, discounted gift trusts and variations of both. But it’s harder to do when it comes to your main residence. You can give your home away but for the gift to be inheritance tax effective, and if you want to continue living in it, you only have two options –  pay a full market rent or make a partial gift and live in your home with the donee. Both solutions could work for some but will be impractical or too expensive for most.

So, making a lifetime gift of your main residence (or even a share in it) in an inheritance tax effective way is pretty difficult for most. The main residence will, for many families, represent an important and material part of the main estate and it will leave many with a high IHT liability on death. This is not so much of a problem when the first spouse/partner dies, as in most cases the deceased’s share of the property will pass automatically to the survivor and will be free of inheritance tax where the couple are married or civil partners. However, depending on the value of the house, it could be more problematic when the surviving spouse/partner dies. 

The introduction of the residence nil rate band (RNRB) in April 2017 was a definite help. When a spouse/partner dies the RNRB, combined with the ordinary nil rate band, means up to £1m of the survivor’s estate can pass to the next generation, as any unused nil rate band and RNRB on first death is effectively transferrable to the survivor. In practice though, the RNRB has done little more than counter the freezing of the nil rate band (NRB) since 2009. Following last year’s budget, this nil rate band “freeze” (which extends to the RNRB too) continues until April 2026.

The problem the RNRB was meant to address is that so much personal wealth is locked in bricks and mortar. The most recent HMRC statistics for 2018-2019 show that UK residential property represented 51.6%[1] of gross estate assets. IHT planning with the family home has traditionally been fraught with difficulties, because of issues around gifts with reservation (GWR) and pre-owned assets tax (POAT). Ironically, one of the reasons for the reluctance to gift capital – ultra low (albeit increasing) interest rates – is becoming an alternative way to plan using residential property in estate planning.

Many lifetime mortgage (LTM) interest rates are fixed, and although they have crept upwards they are still relatively low. This  means that the LTM has become a viable option to providing capital for tax-efficient lifetime gifting. LTMs are not the only solution for those wanting to carry out IHT, but in the right circumstances they can offer a useful way to accelerate an inheritance and save tax. Whether they will be suitable or not will depend on a range of factors, effectively “moving parts”. These will change over time and their movement can have an impact on whether, on pure financial grounds, an LTM and lifetime gift-based strategy will deliver a favourable outcome. It will also be important to factor in the non-financial benefit, for both the donee and the donor, of an “early gift” .

Here are some of the key variables that will need to be factored into the decision-making process:

  • If the person contemplating the LTM is married or in a civil partnership. For those who are married or in a civil partnership there would be £1,000,000 of NRB and RNRB to use between them. That number would be halved for others. For married couples or civil partners with children, IHT problems therefore start further up the wealth scale and are exacerbated once an estate threshold of £2m is reached, when RNRB taper starts to apply. For childless couples, RNRB generally does not enter the IHT calculations as it only applies if the property is “closely inherited”.
  • Whether or not (and if so the extent to which) the property value falls within available nil rate bands. The estate of the deceased, net of mortgage debt at death, needs to be more than the sum of NRB and RNRB for a lifetime mortgage to have maximum benefit. The benefit provided by a lifetime mortgage is eroded if it ultimately means that all or part of the RNRB is wasted. Remember that it can only be set against a home, subject to the complex downsizing rules.
  • The lifetime mortgage interest rate related to the assumed property value growth rate. To a degree this is related to point 2 above. The greater the gap between the mortgage rate and the rate of property growth, the faster net equity is eroded and the more likely it is that the RNRB is not fully useable.
  • The time at which the donor dies. Any lifetime gift will fall back into the donor’s estate for IHT purposes unless they survive seven years after making it. Within that timeframe there is no IHT-saving and the donor will have paid the expenses of arranging the mortgage. Whether that leaves the donee(s) “net worse off” depends on what is viewed as the financial and non- financial benefit to the donee (and donor) of the early gift.

A lifetime mortgage may or may not be a useful approach to IHT planning. For example, if the donor were in poor health and unlikely to survive seven years, then the lifetime gift would not give an IHT advantage. So, too, the lifetime mortgage option is unlikely to make sense if the property value were much lower and the accumulating mortgage might not leave enough equity to cover the available RNRB. However, if the property value was materially above the available nil rate bands and the donor had a high probability of surviving the gift by more than seven years, this would be more likely to create a positive financial outcome.

The points made above highlight how the various “moving parts” interreact, making any decision to use a lifetime mortgage in estate planning very much an individual one. However, given the right general circumstances, an adviser committed to taking a genuine “all asset” holistic approach to estate planning should at least consider and investigate whether (and if so to what extent) a lifetime mortgage could facilitate estate planning to deliver tax , financial and non-financial benefits.

[1] https://www.gov.uk/government/statistics/inheritance-tax-statistics-table-124-assets-in-estates-by-range-of-net-estate-and-tax-due

Example:

Sharon  is 67 and is seriously considering what she can do about what could be a meaningful IHT issue. She would also desperately like to help her daughter. She was  divorced from her husband of 33 years shortly before she retired and the result was that (having been the main earner) she has felt the economic impact of the divorce through the diminishment of her pension share and her investments, in part because she chose to keep the family home. She now has a property worth £750,000 and fixed interest investments of £200,000 which she needs to supplement her pension.

Her only child, Flora, has just had her first child, Sharon’s first grandchild, and Sharon is keen to do all she can to help Flora move to a larger home more appropriate for a family.

The “gap” in what is available to Flora through a combination of equity and mortgage is around £200,000.

Sharon would like to help and understands the tax benefits of making lifetime gifts, but she cannot afford to give away any of her capital. That’s where the lifetime mortgage could come in. Let’s assume Sharon could raise £200,000 through a lifetime mortgage at an interest rate of 2.82% AER. If Sharon dies 18 years later, at age 85, then Flora’s inheritance would be as illustrated below ...based on the assumptions made:

  No Mortgage (£) Lifetime Mortgage (£)
Value of property

1,071,185

  1,071,185

Outstanding loan

-

 332,100

Net property value

1,071,185

739,085

Investments

  200,000

 200,000

Taxable estate

1,271,185

939,085

IHT

 (222,825)

(89,985)

Net estate

1,048,360

849,100

Lifetime Gift in 2021

-

 200,000

Total benefit

1,048,360

1,049,100

So in principle, this example does not appear to be producing any great benefit, but that ignores the timing of the £200,000 gift. In theory it will save Flora 17 years of mortgage interest on £200,000 (assuming she could even borrow that much based on her income) and probably win her a lower rate on the mortgage she does take. And there would be the  materially important but non-financial benefit of living in and enjoying her new home.

The lifetime mortgage works in this case because:

  • Sharon is single. If she were married or in a civil partnership, IHT would not be an immediate issue because there would be £1,000,000 of NRB and RNRB. For couples with children, IHT problems start further up the wealth scale and are exacerbated once an estate threshold of £2m is reached, at which point RNRB taper starts to apply. For childless couples, RNRB generally does not enter the IHT calculations as it only applies if the property is “closely inherited”.
  • The RNRB is not lost. The RNRB, while frozen until April 2026, may become CPI-linked from April 2026 .The benefit provided by a lifetime mortgage is eroded if it ultimately means that all or part of the RNRB is wasted (it can only be set against a home, subject to the complex downsizing rules).
  • The NRB is fully useable. This is a similar point to 2. The estate net of mortgage debt at death needs to be more than the sum of NRB and RNRB for a lifetime mortgage to have maximum benefit. It helps that Sharon has £200,000 assets in addition to her home.
  • The lifetime mortgage interest rate is close to the assumed property value growth rate. To a degree this is a consequence of 2 and 3. The greater the gap between the mortgage rate and property growth, the faster net equity is eroded and the more likely it is that the RNRB is not fully useable.
  • Sharon dies at the right time. The £200,000 lifetime gift will fall back into Sharon’s estate for IHT purposes unless she survives seven years after making it. Within that timeframe there is no IHT-saving and Sharon will have paid the expenses of arranging the mortgage. Whether that leaves Flora worse off comes down to the earlier points about mortgage interest savings and giving Flora the ability to buy.

Over time, a mortgage rate higher than the property growth rate will eventually mean the point at which net equity drops below the RNRB (plus NRB, if appropriate) is reached.

Similarly, some of the opposite of factors 5-9 in the list above would suggest that a lifetime mortgage may not be a useful approach to IHT planning. For example, if Sharon were in poor health and unlikely to survive seven years, then there would be no benefit from the lifetime gift. So, too, the lifetime mortgage option is unlikely to make sense if her property value were much lower and the accumulating mortgage was expected to leave too little equity to cover her single RNRB. 

The five points immediately above highlight how the various “moving parts” interreact, making any decision to use a lifetime mortgage in estate planning very much an individual one. However, given the right general circumstances, an adviser committed to taking a genuine “all asset” holistic approach to estate planning should at least consider and investigate whether (and if so to what extent) a lifetime mortgage could facilitate estate planning to deliver tax, financial and non-financial benefits.

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