Want to limit IHT? Always consider the family home when estate planning

For a lot of people, their family home is the most valuable asset they’ll ever own. It’s therefore essential to take this into consideration early when conducting estate planning, in order to minimise inheritance tax liabilities. Yet very often, people seem to leave this most valuable asset to last, possibly for practical and emotional reasons. But by this time, it can be too late to mitigate any IHT liabilities. This article explains why, when conducting estate planning, it is always prudent to consider the family home.

What strategies can families take to protect their family home from inheritance tax?

There are a number of ways that families can protect their homes from the impact of IHT. Firstly, there’s the extended nil rate band (ENRB) to be aware of. The current rules state that each taxpayer has a £325,000 nil rate band for inheritance tax purposes, plus provided they are transferring the family home to direct descendants on death, they are currently eligible for an additional £100,000 in main residence tax relief (through the ENRB), creating an effective £425,000 exemption.

A direct descendant for this purpose is a child (including a step-child, adopted child or foster child) of the deceased and their lineal descendants.

How does the enhanced nil rate band (ENRB) work?

For a couple for whom the only asset is a family home in joint names valued at £1.2m, their ‘estate’ for IHT purposes will currently attract inheritance tax on the second death at 40% of £350,000; providing the property is bequeathed to direct descendants on the second death, the transfer of £850,000 of the property’s value (i.e. £325,000 x 2 plus £100,000 x2) will be tax free.

Over time, the amount of additional tax payable will decrease gradually, as the full ENRB becomes effective. By the 2020/2021 tax year, ENRB of £175,000 per person, reducing the chargeable assets in the above example to £200,000.

This extended exemption is available provided that the family home is bequeathed on death to direct descendants, giving families the chance to protect some of the wealth created in the family home during their lifetime from inheritance tax. Any ENRB which is not used on the first death is carried forward to be added to the spouse’s residential nil rate band on the second death.

Note however two important additional conditions for the ENRB to be available. Firstly, it is not available to set against lifetime gifts, even where made to qualifying direct descendants. Secondly, the ENRB is withdrawn at a rate of £1 for every £2 by which an estate has a total net value of more than £2m, meaning larger estate will not qualify for any ENRB at all.

These rules became effective on 6 April 2017 and they will remain applicable for the foreseeable future unless the Chancellor revokes the policy in a future budget. The table below outlines how the new ENRB relief will apply in coming years:

What other tax planning options exist?

Caution over existing Home Loan Double Trust schemes

Some taxpayers may still have IHT tax planning in place that was based on historical advice and which is currently regarded by HMRC as tax avoidance. This would include instances where a Home Loan Double Trust (HLDT) was created. If this situation applies to you, our advice is to seek specialist advice because depending on the circumstances, it may be worth looking at how to unwind the structure rather than risk HMRC ruling that it is invalid at a later date. However, doing this might mean liabilities arising for IHT, CGT and stamp duty – so calculations based on your individual scenario would need to be performed. Another option would be to wait and see if any cases involving HLDTs go to Tribunal, but this could also be risky. Overall, the government has been very clear about its attitude towards aggressive IHT planning, so our advice is always to err on the side of caution to avoid unexpected and unpleasant costs in the future.

Gifting your home but continuing to live in it

It’s sadly not effective for IHT purposes to simply give away your home under the lifetime gift rules but carry on living there as normal. This is classed as having your cake and eating it, or in HMRC’s terminology, a gift with reservation of benefits (GROB). However acceptable alternatives do exist that are variations on this basic tax planning idea. For example:

Gift and leaseback your property

Here the current owners gift their house to adult children or grandchildren. The gift is classed as a PET (potentially exempt transfer) and provided that the former owners (a.k.a. donors) survive for seven years and the house (value and potential increase in value) is removed from their estate.

If the donors decide to remain living in the property, they will have a GROB, but if they pay full market rent to the new owners, there is no reservation of benefit, meaning the GROB rules should not apply. This must however be approached with great caution, ensuring full market rate rental is always paid and ensuring contracts either for a tenancy or a fixed term lease are established in the same way as if the property was being rented to external tenants. Clearly, the donors must also have the funds available to meet their financial obligations in the future.

This strategy has the added benefit of reducing the value of the owner’s estate, but consideration must be given to whether a capital gain arises on the gift of the property, and the fact that because the donee is receiving the rental or lease payments at market value, it will mean additional income for them, which will be taxed accordingly. It will also mean the property will not qualify for the ENRB in the future. Overall, this can be a useful strategy but probably best considered in instances where the donee is a lower rate tax payer and donors can comfortably afford the rental payments in the future.

Gift a share of the property and jointly occupy the home

Here just a share in the property is gifted and the donor can continue living in the property, sharing it with the donee. This approach is most suitable in situations where the individuals involved already live together anyway, or plan to live together for caring reasons, e.g. an adult child moves into the house to care for their elderly parent.

Provided the seven-year rule can be applied, this strategy can potentially be classified as a PET. However, to ensure there are no grounds for GROB to apply, it will be important for the donor to demonstrate that they share in the costs of running the house in proportion with their total ownership of the property. In addition, donor and donee need to be clear about what ‘occupation’ means and the proportion of their time that will be spent living together, for the planning to be applicable.

It often pays to keep things simple, and this is certainly the case where the ENRB can be used. If an estate is too large to qualify, then potentially downsizing and the making of lifetime gifts can be considered in order to reduce the value of an estate.

Other alternatives are more aggressive and must be very carefully managed.  IHT is a complex area and we recommend talking through your individual circumstances with a tax specialist.

If you would like advice in this area please contact Lesley Stalker by emailing partners@rjp.co.uk