April 2021
Inheritance Tax and The Family Home
This briefing should be read in conjunction with our general Inheritance Tax Guide which explains the operation of Inheritance Tax.
The family home is often the main asset in an estate, and while it is usually preferable to use other assets for Inheritance Tax (IHT) planning, this is not always possible.
Over the years many arrangements have been designed around the family home in attempts to reduce IHT, the common thread behind these schemes involving you making a gift of your property while continuing to live in your home, usually rent free. These schemes have been combated by HMRC in a number of ways: through the courts, via new legislation to close specific loopholes, the introduction of pre-owned asset tax and the general anti-abuse rule (GAAR), so such schemes are no longer successful.
Care is needed in understanding how IHT works. Too often, people think that if you give away your home whilst you are still alive but continue to live there, then you are saving potential Inheritance Tax. This is certainly not the case, and as some suggestions can involve considerable cost you should tread very carefully.
The following are considered in this briefing:-
- The IHT issues surrounding the transfer of the family home, either during lifetime or on death.
- The Residence Nil Rate Band (RNRB) introduced from April 2017. Any planning with the family home should take into account the potential impact on the main residence nil rate band which is available on transfers on death on or after 6 April 2017.
- IHT Planning options.
Can A Transfer Of Your Family Home During Your Lifetime Be Effective For IHT If You Continue To Live There?
In general, if you give away your home but continue to live there, the gift will NOT normally be effective for IHT purposes as it will be treated as a “gift with reservation”. In other words, if you give away your home (eg to your children) but still live there, then for IHT purposes the value of your home will still be treated as part of your estate and so potentially subject to IHT.
There may be some exceptions:
- If you pay rent at the full market rate for continued occupation of the whole property.
- If you gift part of the property to someone (a donee) and both parties reside at the property. To avoid a gift with reservation, the donee should pay no more than their share of the household running costs. You can however pay more than your appropriate share or all of the running costs. If the donee subsequently moves out of the property, a gift with reservation could arise at this time unless you pay the market rent for the share that you no longer own.
- You gift the whole property to a relative and move out, but later move back in due to unforeseen circumstances such as illness or infirmity.
It is important to note that these exceptions cannot be “cosmetic”. For example, if you pay rent it will have to be done under a formal commercial rental agreement, with the rent actually paid. In addition, if you gift to say a relative (donee) and both you and the relative reside at the property, the relative cannot simply claim “I was residing there”. The relative would need to demonstrate that he/she was actually living there (formal change of address with banks, HMRC, etc) and if the relative already owns a property then there could be taxation ramifications.
Adopting the above exceptions may be effective for IHT purposes but they unlikely to be popular with you if:
- You have repaid your mortgage and do not wish to pay rent to stay in "your" house. It may suit some as rent paid will further erode your estate for IHT purposes whilst not being regarded as ‘gifts' because they are part of a commercial agreement.
- You do not wish to share your home, either for personal reasons or because it may undermine your security of tenure.
In addition, you:-
- May lose the benefit of Capital Gains Tax main residence relief on the property.
- May lose the benefit of the IHT residence nil rate band.
From the donee's perspective:
- Rent received will be taxable income;
- If the donee does not live in the property, Capital Gains Tax will be payable at the higher rates of 18% and/or 28%;
- Stamp duty land tax could be an issue if there is any consideration involved in the transfer.
So, What Planning Can Be Effective?
The Residence Nil Rate Band
This is an additional nil rate band available where the main residence passes on death to direct descendants such as children and grandchildren. This additional nil rate band has been phased in and worth £100,000 in 2017/18, £125,000 in 2018/19, £150,000 in 2019/20 and £175,000 from 2020/21.
This can mean that from April 2020 you can have a total estate of up to £500,000 before IHT is payable on death. The Residence Nil Rate Band is also transferable between spouses/civil partners, so that on death of the first, the survivor could have a total estate of up to £1 million before IHT becomes payable (assuming the first to die has not used up any of his/her nil rate bands through lifetime gifts within 7 years of death or by gift of will).
There are certain qualifying conditions and it applies only to transfers on death and not to lifetime transfers – see the main Inheritance Tax Newsletter.
The Main IHT Planning Options For A Jointly Owned Family Home On Death
Most properties owned by couples are held as “joint tenants”. When the first partner dies, the legal ownership of the property automatically passes to the survivor; it effectively bypasses the will.
But when jointly owned property is held as “tenants in common”, the deceased's share of the property can be passed under the terms of their will. It does not automatically transfer to the surviving partner. Some of the possible options for distributing a share of property held as tenants in common include the following, but we suggest that legal advice should always be sought if considering any of these options.
(a) Gifting The Property To The Surviving Joint Owner
Leaving the property share absolutely to the joint owner provides the survivor with security of tenure as they will now own the whole property. This transfer will be exempt from IHT if the survivor was the spouse of the deceased.
Although the whole property will be included in the survivor's estate for IHT purposes on their subsequent death, the executors may be able to claim any unused part of the IHT Nil Rate Band plus any available Residence Nil Rate Band from the first spouse to die. If the second death is after 5 April 2017 the Residence Nil Rate Band may be available if the property is inherited by direct descendants. Furthermore, if the joint owners were spouses, the Residence Nil Rate Band of the first to die may be transferable to the survivor even if the first death was before 6 April 2017.
Owning the property outright allows the survivor to benefit from Capital Gains Tax private residence relief should they sell the property. However, it will also mean the property is included in any local authority assessment should social care be required in the future.
(b) Gifting The Property To A Life Interest Trust For The Surviving Owner
A common approach, particularly where there are children from a previous marriage, is for the will to create a trust giving the survivor the right to reside in the deceased's share of the property, but with the property eventually passing to the children.
This type of trust creates an immediate post death interest meaning that the transfer will be covered by the IHT spouse exemption, and the trust will not suffer IHT exit charges or 10 yearly periodic charges. It will, however, form part of the survivor's estate for IHT. The Residence Nil Rate Band will not be used on the first death even if this occurs after 5 April 2017 and any amount transferable from the death of the first spouse will be available on the second death as long as the property is inherited by direct descendants (including step children).
Where the survivor continues to reside in the trust property, Capital Gains Tax private residence relief will apply on any subsequent disposal by the trustees.
c) Gifting The Property To Children On First Death
The gift will be a chargeable transfer that uses some or all of the deceased's nil rate band. If death is after 5 April 2017 it will use the Residence Nil Rate Band first as long as the estate is not sufficiently large for it to be tapered to zero. Any unused Residence Nil Rate Band can be transferred to the surviving spouse in the normal way.
There are disadvantages here:-
- This type of planning relies upon a continued good relationship between the survivor and the children. Any breakdown in the relationship could jeopardise the survivor's continued occupation. The children could sell their share of the property, or could even choose to move in - not perhaps what you would have wished for.
- The divorce or bankruptcy of the children could also undermine the survivor's security of tenure as their share could come under threat.
- If the property is sold, the children would not benefit from Capital Gains Tax private resident relief on their share on the basis that they did not live there, so any gain would be taxable at the residential property rates of 18% and/or 28%.
(d) Gifting The Property Into A Discretionary Will Trust
Many wills create a discretionary trust into which assets, typically up to the value of the deceased's available nil rate band, can be passed. The surviving spouse is usually included as a beneficiary of the trust. When a share in the family home is included in the trust, care is needed as HMRC may argue that, if the survivor is given a right to occupy the property, an “immediate post death interest” has been created. This would result in the property forming part of the survivor's estate for IHT in the same way as for the life interest trust above.
Leaving a share of the family home to a discretionary trust on first death will mean that the Residence Nil Rate Band is not available – this is the case even if all the discretionary beneficiaries qualify as ‘direct descendants’. In this case, subject to the size of the estate on first death, the transferable Residence Nil Rate Band will be available to the surviving spouse.
You should also note that discretionary trusts have their own taxation regime with potential periodic and exit charges.
(e) Equity Release
Taking out an Equity Release loan on the value of the home could help if you are very concerned about IHT. The loan could be gifted immediately to beneficiaries so that it falls outside of your estate after 7 years. The value of the home that eventually falls into the IHT net (usually on second death) will be its values less the outstanding loan.
There are many disadvantages however – the loan accumulates rapidly over time meaning less equity if you want to move, and often the forced sale of the property if you need to go into care.
Inheritance Tax and the family home is a complex area needing careful thought.
Any references in this document to spouses and marriage apply equally to civil partners and civil partnership.
The above is based on our understanding of taxation and legislation and is not designed to provide specific recommendations as these can follow only after further discussion. The details provided are a brief summary only and certain aspects have been simplified. You should not therefore rely upon the details as advice for your own circumstances. Tax rates and reliefs can change.