Only the wealthiest individuals used to worry about the implications of Inheritance Tax (IHT) on their estate. However, with thresholds frozen for more than a decade, and as the value of assets continue to rise, it is now affecting a far greater number of families who may enjoy more modest levels of wealth.
Whilst property is typically the most valuable asset in a deceased person’s estate, there are certain tax complexities tied to property which need to be carefully considered.
This guide covers the main IHT implications of owning property.
Inheritance tax: A brief summary
To understand how property fits into your estate plan, firstly, we need to consider the basics of IHT. This works as follows:
- UK individuals have a nil rate band (NRB) of £325,000. Estates below this level are not subject to IHT.
- Assets can pass to a spouse free of IHT. Should one spouse leave their entire estate to the other, the deceased spouse’s NRB will be transferred to the survivor.
- On second death, both NRBs are available to set against the estate; a total of £650,000 (minus the value of any assets passed to any other beneficiaries on first death).
- Gifts made in the seven years before death are normally added back into the estate. There are some exceptions to this, for example charitable donations are fully exempt and there are no tax implications if the gifts in one tax year do not exceed £3,000 (or £6,000 if no gifts were made in the previous tax year either).
- The estate over and above the NRB is taxed at a flat rate of 40%. The rate may be lower than this if the estate includes business assets. Likewise, if 10% of the estate is left to charity, the tax payable is reduced to 36%.
The residence nil rate band
The residence nil rate band (RNRB) was introduced in 2017 to reduce the impact of IHT where a main residence forms a significant part of the estate.
This can extend the NRB by up to £175,000 per individual. For a couple, this amounts to £350,000 if the property is owned jointly. However, there are a few conditions:
- The RNRB is capped at the value of the property. If it is worth less than £350,000, the full relief cannot be claimed.
- The property must be passed to direct descendants only. This means that you cannot claim RNRB relief if, for example, your property passed to your siblings or their children.
- For estates valued at over £2 million, the relief is gradually revoked at a rate of £1 for every £2 over the threshold. This means that estates valued at over £2.35 million (£2.7 million for a couple) do not receive the RNRB relief. However, making gifts shortly before death can be effective for restoring eligibility.
The situation becomes more complex if you have downsized your home, moved into residential care, or if your will includes provision for assets to pass into trust. Seeking advice is strongly recommended in these scenarios.
Gifting property
Thanks to the NRB and RNRB, a married couple with a joint estate valued at less than £2 million can effectively pass £1 million to the next generation free of IHT. However, where the property does not meet the conditions, or is worth significantly more than this, additional planning should be considered.
Making gifts is an important part of a holistic estate plan. Gifts of up to £3,000 per year, or gifts from surplus income, are immediately exempt. Similarly, larger gifts normally drop out of the estate after seven years.
However, gifting property is more complex than gifting other assets, partly because the value is usually in excess of the regular gifting exemptions.
A gift of property to an individual is a potentially exempt transfer (PET). This means that it attracts no immediate IHT and will drop out of the donor’s estate, free of IHT, if the donor survives for seven years. However, if gifts in the seven years before death exceed £325,000, the resulting tax will be reduced by 20% per year from the end of year 3 to year 7.
On the other hand, gifting the property to a trust (other than a bare or disabled trust) is a chargeable lifetime transfer (CLT). This means that the gift could incur an immediate tax charge of 20% if the gift exceeds £325,000. Additionally, trusts pay a higher rate of tax than individuals which can complicate matters if there is rental income, or if the property is later sold at a profit.
To be effective for IHT planning, the gift must be absolute, and you cannot continue to enjoy the asset as if it were still your own. This means that, if the gift were property, you cannot live in the property, receive rental income, or use the property as a holiday home.
If you continue to use the property, one of three scenarios may apply:
- The property could be considered a ‘gift with reservation’ and will be added back into your estate.
- An annual pre-owned asset tax (POAT) charge may apply.
- Alternatively, you will need to pay a commercial rate of rent. Should you pay rent to the new owner, the property may be viewed as an outright gift and thus could become a PET or CLT.
Additionally, if you need to pay for care, the value of the property may be taken into account for means testing purposes.
It’s a good idea to seek tax and legal advice if you are considering giving away a property, especially if it is your main residence.
Property as a business
If you own rental properties, the options to reduce tax are limited. Buy-to-let properties are treated less favourably from a tax perspective than other business assets in general.
Property companies are considered to be investments rather than trading businesses, which means that your estate cannot claim business relief.
However, if your property is held within a company, it may in fact be easier to gradually pass ownership to your beneficiaries. This is because you can transfer a certain number of shares rather than full ownership of a property. These transfers will still be treated as PETs; however, in some situations the shares (i.e. the loss to your estate, and therefore the value of the gift) may actually be worth less than the value of the properties. This is a highly complex area and you should seek tax advice before considering this option.
When gifting assets, including property and shares, there will be a disposal for capital gains tax purposes. This could give rise to a gain, resulting in tax being payable by you. Given the complexity involved, we would recommend seeking professional advice.
Paying the tax
In many cases, it is not possible or practical to avoid IHT on property. However, if your main residency is also your main asset, the beneficiaries may need to sell it in order to pay the tax, which may not be convenient.
A different option entirely is to set up an insurance policy to cover the tax payable from IHT. If the pay-out is directed into a suitable trust, it could bypass your estate, thus avoiding additional IHT. The regular premiums into the policy will be treated in the same way as other gifts, which will reduce your estate further if you remain within the annual allowances.
There are a number of options for passing on property tax-efficiently, however there are an equal number of pitfalls that could result in paying even more tax.
Please do not hesitate to contact Andy Hogarth, Financial Planning Director, to find out more about estate planning.