Buy-to-let properties and inheritance tax planning
Many clients own a Buy-to-let (BTL) property or a portfolio of such properties. Clients often rely on the income produced by the properties, particularly if they are retired. For this reason, they may be reluctant to enter into any tax planning in relation to their properties, especially if it involves outright gifts to the younger generation. However, retaining the properties throughout the owner’s lifetime can result in a hefty Inheritance tax bill on death.
There are many options available to mitigate this tax bill including Business Property Relief, various gift options, incorporation and estate planning. The following three case studies help to illustrate these options.
Case Study 1 – Alex
Alex has a number of BTL properties in Somerset and Dorset. Due to decreasing returns because of tax changes and mortgage rate rises he has decided to move into holiday letting. He wishes to differentiate his properties from other holiday lets and so provides activities such as shooting, water sports and exercise classes. He organises access to baby sitters and provides chefs on request. His properties have games rooms and tuition in tennis and football can be provided. A daily maid service is provided and travel arrangements can be made for guests visiting from abroad.
Case Study 2 – Philip
Philip is aged 56 and married with two adult children. He is the owner of a mortgage free buy-to-let property with a value of £600,000. His main residence owned jointly with his wife is valued at £1.5m and he has investments owned jointly with his wife, Julie, worth £850,000. He has retired early and the rental income from his BTL property is a staple part of his income.
Philip is concerned about inheritance tax (IHT). He takes the view that the next government will be a Labour one and that IHT is here to stay for the foreseeable future. He would like to consider his options and reduce his and Julie’s current IHT liability of £920,000 payable on the death of the second of them.
Case Study 3 – Harriet
Harriet owns a portfolio of five buy-to-let properties. She is divorced with three children. Harriet wishes to manage the income flow from her properties and to set up a structure that will help her pass value over to her children. The total value of the portfolio is £1.5 million.
Business Property Relief (BPR) and investment activities (Alex)
For a married couple or a couple in a civil partnership, IHT is payable on the value of assets in their estates exceeding £1 million, provided the couple have owned a property at any time, which they occupied, and it is left on death to lineal descendants (broadly children, grandchildren and their spouses). Other reliefs may apply to assets in excess of £1 million, such as spouse relief on the first death. BPR can provide up to 100% relief from Inheritance tax (IHT) on business property while Agricultural Property Relief applies to agricultural property used for agricultural purposes.
However, under s105(3) Inheritance Tax Act 1984 a business will not qualify for any BPR if it is regarded by HMRC as consisting, wholly or mainly, of making or holding investments. For example, a property let on a residential lease is an investment activity and will not qualify for BPR. Furnished holiday lets and commercial properties may qualify, however, depending on the nature of the business.
A long line of recent cases has set out how it should be determined whether a business is an investment business and the issue has generated more cases than any other IHT provision.
The most recent case on this issue is Butler which concerned a wedding barn. It was held that, “at no point did [the] Barn provide amenities and services that went significantly beyond the amenities that are provided in a property held predominantly for investment purposes….such of the amenities and services that were provided …..were not exceptional in their nature.”
BPR was denied which is unfortunate in this case as the owner’s diminishing engagement with business activities was caused by ill health.
- Aim for an 80:20 split in trading v investment activities
- Keep a close eye on activity levels in each sphere
- Keep minutes of meetings to show that the owner is making decisions and has not delegated this
- Keep records showing the time spent on each activity
Will Alex’s PRs be able to claim BPR on his properties?
This is a question of fact but the services listed are quite extensive, and are similar to those that might be provided by a holiday park, so it would appear possible that BPR will be available, subject to further information.
Properties let on residential leases will not qualify for BPR which can result in significant IHT bills. A gift of an entire property or properties to the owner’s children might be contemplated, as a potentially exempt transfer will be free from IHT after seven years. However, the owner must be prepared to give up the entitlement to the rental income to avoid the gift being a gift with reservation of benefit.
Options for Philip and Julie
1 Give Philip’s BTL property to their children
Advantages: IHT free after 7 years
Disadvantages: Capital Gains Tax (CGT) due on gift as no holdover relief is available as the property is not business property; Philip loses his entitlement to the income from property if the gift is to be effective due to the reservation of benefit rules; no protection of the gift from third party claims and if the property is subject to a mortgage there may be a Stamp Duty Land Tax bill on the transfer.
2 Property discount gift in Philip’s Will
How this works – If a property is owned jointly then the valuation of a share of the property will be discounted compared to the valuation of the whole property to reflect the difficulty in realising a part share on the open market. This valuation discount is typically between 10% and 15% and does not apply when ownership is split between spouses.
If Philip left 10% of his share in the property to a discretionary trust set up in his Will this will result in a reduction in value of the remaining share owned by Julie of £54,000-£81,000 on her death after Philip, depending on the agreed amount of the discount.
Advantages: No loss of income or control during Philip’s lifetime; no CGT; trust protects the 10% share owned by the trustees.
Disadvantages: Small reduction in IHT compared to overall liability; needs further planning to achieve greater saving.
3 Rental property income protection plan
How this works: The gift must be of an undivided share of the property (50% is suggested); s102B (3) Finance Act 1986 provides that if a person makes a gift of a share in a property and he/she does not occupy the property the gift will not be a gift with reservation for IHT purposes. This enables the income to be retained from the share gifted without a reservation of benefit. The property must be mortgage free and ideally the intention will be to retain the property. The gift should be to a trust both for protection purposes and to ensure that Philip is entitled to all the income owing to the 50% interest retained by him and his life interest under the trust which holds the other 50% share.
Advantages: Philip retains all the income; no Reservation of Benefit; gift IHT free after 7 years; no immediate charge to IHT as gift within the IHT nil rate band in this case; trust provides protection.
Disadvantages: CGT payable on the transfer as there is no holdover relief as the trust is settlor interested. This could be mitigated by suitable investments. There is also a possibility of a HMRC challenge to the planning as commentators do not have an unanimous view, although we have Counsel’s opinion which supports the efficacy of the planning.
Incorporation and IHT planning (Harriet)
Options for Harriet
- Corporate structure provides protection
- No Chargeable Lifetime Transfers if outright gift of shares (unlike a gift to a trust)
- Ability to share income and defer higher and additional rate tax
- Mortgage interest relief fully available (unlike personal ownership by Harriet)
- Administrative burden
- Increasing Corporation tax rates and reduction in dividend allowance-Corporation Tax 19%-25% (2023); dividend tax allowance halved to £1000 (2023/24) and due to halve again next year
- Element of double taxation: company profits subject to Corporation Tax and dividends taxable in shareholders’ hands
- Possible Capital Gains Tax bill but s162 TCGA 1992 provides incorporation relief
- For s162 to apply the business and all its assets must be transferred to the Company as a going concern in return for shares but the business must be seriously pursued by Harriet-this means significant activity by her-case law suggests at least 20 hours per week
- SDLT payable based on the market value of the properties transferred
HT planning via corporate structure
- Gifts of shares over time could be made to the younger generation
- Acquisition of new properties by the company could be funded via Director’s Loans ensuring that future growth in property value accrues to the company rather than to Harriet personally
- Value of Harriet’s shares could be frozen by creating two classes of shares
New B shares are issued to Harriet and the original ordinary shares are re-designated as A shares. The company’s Articles of Association are amended to provide that the B shares are only entitled to dividends and capital on winding up only to the extent that the A shares have already received £1.5 million (the current value of the shares). Harriet gives the B shares to her children. By the time Harriet dies five years later the total value of the company has increased to £2 million. £1 million (£1.5 million less dividends paid of £500,000) is within Harriet’s estate and subject to inheritance tax but the remaining £1 million belongs to her family leading to a substantial IHT saving.