Estate planning during lifetime with the main residence

Tony Wickenden, Managing Director at Technical Connection, discusses estate planning during lifetime with the main residence.

Estate planning with the main residence is notoriously difficult mainly due to the existence of anti-avoidance legislation that has evolved over the years, designed to prevent those who give their property away from enjoying a benefit in it without adverse inheritance tax consequences.  Even if an estate planning strategy with the family home is not caught by the gift with reservation rules (which continue to treat the gifted property as part of the estate for IHT purposes), they will almost inevitably be caught by the pre-owned asset tax legislation which imposes an income tax charge on formerly owned property which is occupied by the previous owner but for some reason is not caught by the gift with reservation rules. To be effective, any estate planning with the main residence will need to legitimately avoid each of these anti-avoidance provisions.

IHT-effective gifts of the main residence

Despite the aforesaid difficulties, there are some limited exceptions from both the gift with reservation (GWR) and the pre-owned asset tax rules that may offer solutions. The first of these is continued occupation by the donor for full consideration which provides that a gift of the main residence with continued occupation will be IHT effective if the donor pays a commercial rent to the donee. This option might suit clients with surplus income that would otherwise be building up in the estate, adding further to the IHT challenge. However, it is important to note that if the payment of rent ceases, a reservation of benefit will re-surface and care therefore should to be taken where there is a possibility that income levels will reduce in the future which could impair the continued payment of rent.  The potential tax consequences of this “rental based” solution for the recipient should also be borne in mind – the rental income will be subject to income tax and any gain in the value of the property between the date of gift and date of sale will be subject to CGT (currently at 18 or 28% but could be more if rates increase) on disposal. Self-evidently, the opportunity for a tax-free uplift of the value of the property for CGT on the death of the original property owner is lost.

The other exception is where a gift of a share of the property is made to someone who shares occupation with the donor – for example, an adult child who is still living at home. Such a gift will not be a GWR, even though the donor continues to occupy the property without paying rent. Again, for the arrangement to be fully IHT effective, the shared occupation must last until the date of death of the donor. So, this idea will only really be viable where co-occupation is likely to be a permanent arrangement. It is also important that the donor does not benefit in any way from the arrangement – so the donee cannot pay more than their fair share of the property outgoings.

Equity release or downsizing

Those clients over 55 who wish to remain in their current property without the complications inherent in ‘giving it away but remaining in occupation’ may wish to consider equity release to allow them to undertake IHT planning with the released funds.

Typically, the method of equity release chosen is a lifetime mortgage with interest rolled-up. This will constitute a debt on the property which reduces the taxable value of the property on death (thereby reducing IHT- to the extent that the residence nil-rate band is not available for the property). Importantly, there will usually be a provision that the total outstanding debt cannot cause negative equity to arise, and in some cases the interest rate may be fixed.

Estate planning options using the released funds will range from an outright gift to a gift into an IHT planning arrangement such as a discounted gift trust and/or a loan trust depending on the client’s requirements for control and access.

There are of course advantages and disadvantages with this approach:

·         On the plus side, the house remains in the ownership of donor so there are no adverse CGT implications; and the debt diminishes value of property (and so the overall taxable estate on death) provided that the loan is not retained in the estate or invested in property – such as business property – that qualifies for relief from IHT

·         However, the increasing debt also diminishes the amount available to recipients on homeowner’s death and could ultimately result in the property having to be sold on death. The residence nil-rate band amount may also be restricted if the net value of the home is less than the residence nil-rate band (RNRB) amount that would otherwise have been available, which effectively negates the IHT advantage that the arrangement aims to deliver.

Selling the home, buying a less expensive house and giving away the cash released is an alternative method of IHT planning that can be implemented (and will not necessarily lead to any restriction in the overall RNRB amount available if either the new home is at least equal in value to the RNRB or other assets equal to the amount of RNRB ‘lost’ as a result of the downsize are gifted outright to qualifying beneficiaries on death. However, downsizing would not, of course, be appropriate for someone who wanted to remain in their current home.

In all strategies founded on releasing equity to donate and creating an IHT-deductible debt, especially given the many “moving parts” in the decision making it is essential that really careful consideration is given to any planning before any steps are taken.

Residence Nil-Rate Band Planning

Broadly speaking, the residence nil-rate band (RNRB) is available to estates where a home or former home (or an interest in a home or former home) is left to children or grandchildren or to the spouses, civil partners, widows, widowers or surviving civil partners of children or grandchildren. An extended definition of children, which includes stepchildren and fostered children applies for these purposes.

A further condition is that the property must usually pass to the qualifying beneficiary outright – although as explained below there are some limited exceptions to this rule; and additionally, the RNRB will be restricted by £1 for every £2 by which the estate exceeds £2m. In practical terms, this means that on current values, no RNRB will be available to a single person whose estate is equal to or greater than £2.35m, or to a married couple with an estate on second death of £2.7m or higher.

Given that a full RNRB is worth an IHT saving of £140,000 to a married couple, those with estates or joint estates above the nil-rate band available to them will want to do what they can to ensure that they receive the benefit of this generous allowance. There are a number of options here:

·         Those whose estates are just below the £2m threshold may wish to consider loan trust arrangements or making gifts out of surplus income to stop the estate from getting any larger

·         Those with estates in excess of £2m may wish to consider making outright gifts or gifts to trusts during lifetime to reduce the estate. Although such gifts will remain assessable to IHT unless survived by 7 years, they will reduce the estate immediately for the purposes of the £2m threshold test

·         For couples who have joint estates in excess of the £2m threshold, consideration could be given to making gifts on first death to reduce the amount passing to spouse. This could be a first death gift of a share of the home or of a former home to use the RNRB of the first to die; or of other assets to use the standard nil rate band. Where access is required by the surviving spouse, a first death gift of the nil-rate band could be made to a trust

·         As business assets qualifying for relief will be nonetheless included for the purposes of determining whether or not an estate exceeds the £2m RNRB threshold, consideration could also be given to leaving these to a discretionary trust, or to children, on first death where this is viable. This will ensure that the busines assets, or the proceeds of sale thereof, will not be aggregated with the estate of the surviving spouse – further facilitating the goal of getting the estate down to below £2m by second death

·         Where clients are married or in a civil partnership and one or both of them has previously been widowed, it may be possible to make use of multiple RNRBs (and NRBs) with planning. There are a number of ways that this can be achieved, and the most suitable approach will depend on estate values and composition

·         Wills should be reviewed to make sure that they are RNRB-friendly and that when the home is ultimately inherited, the home will be deemed to pass to qualifying beneficiaries outright.

The role of life insurance

For many, none of shared occupation, occupation for full consideration or equity release through lifetime mortgage will be viable solutions to the IHT problem and an IHT liability will arise in relation to the main home even where full use is made of any residence nil-rate band that’s available. In such cases, the relatively straightforward route of funding for the liability using life insurance should not be overlooked.

A joint lives last survivor life insurance held in trust (or assigned to children) to meet any prospective IHT liability offers a number of benefits:

·         Guaranteed tax-free sum assured payable on death once first premium paid (subject to any review clauses) - ensuring there is no need to sell the home to meet the tax

·         Speed of payment provided there is a surviving trustee to make the claim

·         Premium payments are gifts and represent an excellent way of using the annual exemption and/or normal expenditure out of income exemption

·         Use of a discretionary trust means that changing circumstances can be catered for

·         “Virtually” immune from HMRC challenge

·         Where the plan is assigned to adult children, they can take over premium payments if the premiums cause an unacceptable reduction in the net spendable income of the house owners.

Giving away a property or share in it in a way that is acceptable to both donor/done, and is effective for IHT, is likely to be difficult during the owner’s lifetime, and planning to ensure that the full benefit of the residence nil-rate band can be obtained will therefore be the priority for many. However, in cases where the residence nil- rate band is not available and/or IHT is still an issue, house owners should consider other assets for planning and, to the extent that this is not possible, make provision for the liability through life assurance in trust to provide the funds to those whose inheritance will be diminished by the tax.

Related content

Equity release and inheritance tax - Post death planning

Bare trusts for minors - taxation of life policy gains

Nil rate band planning

Discounted gift trust underwriting