Tax and estate planning for unmarried couples
Rejecting the traditional route of marriage in favour of cohabitation has become increasingly commonplace over the last two decades with the number of cohabiting couples doubling to 3.3 million between 1997 and 2017 (ONS November 2017). However, while many may not see any non-financial /emotional benefits to formalising their relationship in law, cohabiting couples can still find themselves at a financial disadvantage when compared to their married counterparts. Unlike married couples and those in a registered civil partnerships, cohabiting couples will not so readily benefit from each other’s estate on intestacy nor will they benefit from tax breaks such as the ability to transfer any unused nil rate band or residence nil rate band to the survivor of them or the ability to transfer chargeable assets between them without making a disposal for capital gains tax (CGT) purposes.
It is clear , even from these few examples, that cohabiting couples must be treated differently from married couples when considering tax and financial planning matters. Below, we outline some of the key areas that will need particular consideration when advising cohabitees. In many cases of course , the tax and legal detail may be dealt with by another professional such as a solicitor or accountant but having a solid understanding of the rules is , we think, essential for the financial planner giving advice to their co-habiting, unmarried clients .
As cohabiting couples, unlike spouses or registered civil partners, will not benefit from each other’s estates on intestacy, Wills are vitally important where there is a desire to make financial provision for a surviving cohabitee. Because there is no applicable “relationship based” inheritance tax (IHT) exemption , any gift to the cohabiting partner will utilise some or all of the available nil rate band and where the amount passed to the surviving cohabitee is in excess of the available nil rate band, there is potential for an IHT charge to apply to the same funds on both first and second death (subject to the availability of quick succession relief where both deaths occur within the same five year period). To avoid this position – and ensure that maximum benefit is obtained from both nil rate bands - it may be prudent for the first to die to leave an amount up to the nil rate band to a discretionary trust, that includes the survivor as a possible beneficiary, on first death This will ensure that the surviving cohabitee has access to the estate of the first to die but without it forming part of their estate and being potentially subject to IHT twice.
Using a nil rate band trust on first death to limit the amount passing outright to the survivor can also help to keep the estate on second death down to below the £2m threshold for residence nil rate band which will be an important consideration if a home will ultimately be passed to the couple’s children and the joint estate is hovering around the £2m mark.
Nil rate band and residence nil rate band considerations
Even if clients are not married (or in a civil partnership), one or more residence nil rate bands may be available to offset against the estate on death if the couple have children who will inherit their home.
It is, however, important to remember that the survivor of a cohabiting couple will not benefit from any nil rate band or residence nil rate band that has not been used by the first of the cohabiting couple to die. There are a number of actions that cohabiting clients may therefore want to consider to ensure that these valuable allowances are fully utilised:
· Where one party holds the majority of the couple’s wealth, it may therefore be worth considering the viability of equalising estates (by potentially exempt transfers) to ensure that two nil rate bands can be fully utilised. This will be particularly relevant where the cohabiting couple have children to whom they are happy to leave assets on first death. Care will however need to be taken to avoid capital gains tax and stamp duty land tax implications which could arise in connection with lifetime transfers of chargeable assets or property that is subject to a mortgage;
· Where estates are already largely equalised (or each couple at least owns sufficient wealth to be able to make use of a full nil rate band on first death), two nil rate bands will be utilised regardless of whom the estate is left to on first death. However, the same cannot be said of the residence nil rate band (RNRB) which will only be available to an estate where a share of a home or former home is left to children or grandchildren. The inability to transfer any unused RNRB to a surviving cohabitee means that unless each party leaves their share of their home outright to their children (or grandchildren) on first death, the RNRB of the first to die will be wasted. Of course, leaving a share of the home of the survivor to a third party is not without risk. In particular, the new owners may seek to enforce the sale of the home thereby jeopardising the survivor’s security of tenure. This is unlikely where the deceased’s share of the home has been left to common children but could be a real issue where each party has their own children from an earlier relationship;
· Where the cohabiting couple do not have children, the residence nil rate band will not be in point. Cohabitees who are in this position and own their home on a tenancy in common may wish to consider leaving their share of their home to a life interest trust to protect the occupation rights of the survivor while retaining control over the ultimate destination of their property share. It will however be important to have regard to the IHT implications of such an arrangement for the estate of the survivor. In such cases, the nil rate band of the survivor will effectively be shared between the trust interest and his or her free estate which could result in perceived inequity if the beneficiaries of the survivors estate and the remaindermen of the trust are different people. It may be possible to address this with life insurance (see below). Of course where any couple (co habiting or not) do not have children, then IHT planning can often assume less importance as part of overall financial planning.
Where one of a cohabiting couple has business assets that qualify for relief from IHT (through Business Relief) , these can be left to the surviving cohabitee effectively IHT-free. Unlike a widow, widower or surviving civil partner though, a surviving cohabitee will not inherit the ownership period of the first to die and so will need to own the business assets for a further two years for them to qualify for IHT relief on second death.
There may alternatively be merit in leaving the qualifying business assets to a trust that includes the survivor as a beneficiary. This can be particularly effective if the business assets are likely to be sold after death as the survivor will have continued access to the sale proceeds (albeit at the discretion of the trustees and possibly even by way of interest free loan that would then form a debt on the borrowing survivor’s estate) without them forming part of their estate.
Where cohabiting parents each own a residence that they have at some point occupied as their home, it will be easier to make use of two residence nil rate bands as one of the residences can be left outright to children (common or otherwise) on first death. Although this may not be viable if the survivor requires an income from or continued use of the property owned by the first to die.
In addition, where each of an unmarried couple owns a residential property and both properties are used by the couple as residences, it may be possible for two main residence elections to be made so that neither property will be subject to CGT on eventual sale. This is not an opportunity that is available to married couples who may only elect for one single residence to be their joint main residence.
Rental/buy-to-let property income
Where a married couple (or civil partners) jointly own a rental property, they are deemed to own the property 50:50 for income tax purposes regardless of the actual ownership. This position may be income tax-inefficient if one party earns significantly more than the other and can only be overcome by making a Form 17 election to have the rental income taxed according to the actual beneficial ownership split. By contrast where the couple are not married (and are not in partnership), the share of any profit or loss arising from jointly owned property will normally be the same as the share owned in the property being let. However, unmarried joint owners can agree to share the profits or losses in a way that does not reflect their share in the property. Provided that the share declared for tax purposes is the same as the share actually agreed, HMRC appear to have no issue with this (see PIM1030). This is good news for unmarried couples who have purchased buy-to-let property jointly without giving due consideration to the impact of taxation on rental income (or whose income positions have changed significantly since the purchase) and who would otherwise incur capital gains tax (and potential stamp duty land tax) costs in readjusting the beneficial ownership proportions.
Capital gains tax
As mentioned above, while married couples (and registered civil partners) can transfer chargeable assets between them on a no loss/no gain basis, a transfer between unmarried partners will give rise to a CGT disposal potentially giving rise to a gain. This limits the potential to transfer chargeable assets, such as shares or property, into joint names pre-disposal to make use of two CGT exemptions. Unmarried couples should therefore be encouraged to make investments in joint names from outset in cases where a future lifetime disposal is envisaged. A joint investment will not of course be advisable if each party plans to leave their share of their investments to someone other than their surviving partner. In such cases, the opportunity to utilise two CGT exemptions on future disposal can be similarly secured by splitting the total investment equally between the parties.
A gift of a shared home (or a share of it) to an unmarried partner who is not in a civil partnership with the deceased on death will not qualify for any spouse exemption. This means that if the value of the home (or share) is greater than the available nil rate band, an IHT liability will arise on first death. A suitable life insurance policy that pays out a sum equivalent to the likely tax on the first death can offer a cost-effective solution, particularly if the couple are in good health, and will ensure that there is no need for the survivor to sell the home in order to pay the tax.
In most other respects, the difference between advising married couples and unmarried couples is negligible. For business owners, for example, planning income flow to enable each of a couple to use their personal allowance, lower rates of tax and dividend allowance will all still be worthwhile . As indicated above though, any share transfers to facilitate dividend payment could come with IHT and CGT consequences.
Making lifetime gifts or creating trusts will be the default option for IHT mitigation (but remember to include the cohabiting partner as a possible beneficiary as most ‘off-the-shelf’ trusts will not include cohabitees as a class as standard).
Where IHT efficient arrangements are not possible without jeopardising either the security of the surviving cohabitee or the smooth transition to beneficiaries of their full anticipated inheritance, the solution may be to favour practicality and use life insurance either to fund the IHT bill that will arise on first death; or to compensate beneficiaries who are losing out on the benefit of a full nil rate band as a result of arrangements set up to control the destination of assets comprised in the estate of the first to die. If established at a time when both parties are in good health, the premium cost will often be a small price to pay for of retaining control and ensuring that intended beneficiaries are not compromised.