Inheritance tax planning and rental properties
Official statistics show that more than 2.5million individuals own a rental property in the UK.
The freezing of the inheritance tax (IHT) nil rate band since 2009, coupled with house price growth over the same period, means that many of these landlords’ estates will be liable to IHT when they die. Landlords might wish to reduce the IHT burden on their children but due to various factors, including the cost-of-living crisis, they may feel that they do not wish to give up the rent generated by the property.
Avoiding a reservation of benefit
IHT is not payable on assets that you give away more than seven years before your death provided there are “no strings” attached to the gift. If you reserve a benefit from the gift, its value will still be deemed to be in your estate, even if the gift was made more than seven years before your death. An example of a reservation of benefit is when an individual gives away their family home but continues to live there rent free.
There are, however, some statutory exceptions within the relevant legislation. If the gift of the family home is to a person who shares occupation of the house with the person making the gift (the donor) there will be no reservation of benefit provided the donor does not receive a collateral benefit, such as the donee paying more than their share of the property expenses.
Rental properties and the reservation of benefit legislation
S102B of the Finance Act 1986 provides that if an individual gives away a part share in a property the gift will be a reservation of benefit with two exceptions. The first exception applies when the donor either does not occupy the property or does so excluding the donee and paying a full market rental. In the case of a rental property the donor does not occupy the property, it is occupied by the tenant. The view is therefore taken by some commentators that a landlord can give away a part share in a rental property and the gift will be effective for IHT purposes even if they continue to receive the rent, provided they never occupy the property. The property must be mortgage free and it is better if the donor intends to retain the property permanently.
Use of a trust
The gift of a share in the rental property can be an outright gift. For example, Jennifer gives 50% of her interest in a rental property to her son Alex. Alex will be entitled to 50% of the rent and taxed on that amount but gives all the net rental income to his mother.
This arrangement will satisfy the statutory exception if Jennifer does not occupy the house. She will, however, be dependent on her son’s goodwill to pay over the rental income to her, and the arrangement could be threatened by events outside their control.
By comparison if Jennifer made the gift to a trust under which she was entitled to a life interest with the capital passing to Alex there will be an added layer of protection. In addition, Jennifer would be entitled as of right to the trust income.
The gift should be IHT free if Jennifer survives it by seven years. No IHT will be immediately payable provided that the value of the share given away does not exceed £325,000, but IHT at the lifetime rate of 20% will be payable if a share valued at more than this is given to the trust.
Capital gains tax (CGT)
CGT will be payable by Jennifer on the gift which will be assessed on the difference between her acquisition cost and the value of the property at the time of the gift. However, if Jennifer invests in tax favoured investments, she may be able to defer the payment of CGT.
There would be no CGT uplift on the share of the property held in the trust on Jennifer’s death so if Alex decides to sell it at that point CGT will be due on the difference between the value at the time of the gift and the value it realises on sale. It should of course be remembered that CGT is currently payable at a maximum rate of 28%, and only on the gain, while IHT is payable at a flat rate of 40% on the entire value of the property.