Feature

posted 24 Mar 2005 in Volume 10 Issue 3

Tax planning for the family home

Chartered tax adviser Stephen Yates looks at some options in the light of the new pre-owned assets anti-avoidance legislation.

The significant value of the family home often makes it a natural focus for possible Inheritance Tax (IHT) planning, but care is required. Since the introduction of IHT in 1986, gift with reservation of benefit provisions have ruled out, in most cases, simple strategies such as giving away a property to the children and continuing to live in it.

Even if IHT is not a concern, the loss of private residence exemption as a consequence of such a gift would represent a significant capital gains tax (CGT) cost.

Estate planners must now also consider the impact of the new income tax charge on pre-owned assets introduced with effect from 6 April 2005. Strategies effectively blocked by the pre-owned assets rules include deferred (reversionary) leases, Eversden arrangements and double trust or home loan plans. Pre 9 March 1999 Lady Ingram carve outs, which the Inland Revenue are on record as accepting for successful IHT mitigation, are also caught. What planning now remains available?

There are arrangements which allow the donor to mitigate IHT and maintain security of occupation for the rest of his life, without bringing the anti-avoidance measures into play. Often, it will be possible to preserve CGT exemption as well.

This article outlines the scope of the pre-owned assets tax charge in relation to the family home and looks at some planning ideas which are still effective in the new regime. References are to the pre-owned assets provisions of Schedule 15 FA 2004, unless otherwise indicated.

When does the pre-owned assets charge apply?

Subject to limited exemptions, the pre-owned asset provisions will produce, from 6 April 2005, an annual income tax charge for individuals who continue to enjoy a benefit from assets they have given away, in circumstances where the existing gift with reservation of benefit rules do not apply to that gift. In the case of land, the income tax charge is based on the market value rent which would be payable on a notional tenancy, under which the landlord is responsible for all repairs, maintenance and insurance. Relief is given generally for any part of the value of an asset which is included in the taxable estate of the individual for IHT purposes. For example, in a deferred lease arrangement, a long lease was granted under which the donee would take possession in 20 years time.

The donor’s estate would then include, initially, the value of his right to remain in occupation for the next 20 years.

In this case, the ‘appropriate rental value’ on which income tax is charged, is that proportion of the market value rent which the current value of the part given away (the deferred lease) bears to the value of the house ignoring the deferred lease.

Payment of full consideration

Neither the gift with reservation of benefit nor the pre-owned assets rules will be in point if the donor gives away his home but then pays market value rent for his continuing occupation. The income tax charge on that rental income in the hands of the donee may, however, be a significant disincentive.

One technique for limiting the income tax charge involves a gift of the home followed by the purchase of a lease for life by the donor for an actuarially calculated lump sum premium. To date, it has been possible to restrict the income tax charge on this premium to the basic rate of 22 per cent, by making the gift to an interest in possession settlement. It had been anticipated that the trust modernisation proposals, presently under consideration by the government, would remove this planning opportunity from 6 April 2005 by imposing a 40 per cent tax charge on lease premiums from that date. It now appears that any change here will be deferred to a later date (possibly 6 April 2006). Otherwise, there is scope to mitigate the income tax charge on periodic rental income if the gift is made to an accumulation and maintenance or discretionary settlement, and the income is distributed to beneficiaries who have unused personal allowances. CGT private residence exemption will not usually be available to the donee, or donee trustees as the case may be.

Any future CGT charge would, however, be based only on the increase in value during the period of ownership since the gift, and maximum non-business taper relief will reduce the effective rate to a maximum of 24 per cent after ten years ownership. This may be an acceptable price for a potential IHT saving at 40 per cent of the value of the property.

Shared ownership and occupation

If an individual gives away a share of his home and then occupies the property with his donee, S102B FA 1986 can provide statutory exemption from the reservation of benefit rules, provided the donor receives no benefit provided by or at the expense of the donee in relation to the gift. Broadly speaking, this requirement is satisfied if outgoings of the property are paid by donor and donee pro rata to their respective shares, but care will be required in apportioning, for example, living expenses which may be attributable to donor and donee in different proportions. It is acceptable for the donor to continue to pay all the outgoings, what is important is that he does not pay any less than his pro rata fair share.

Where the conditions of S102B are satisfied in this way, a corresponding exemption from the pre-owned assets charge applies. Occupation of the property by donor and donee as their main residence will ensure continuing CGT private residence exemption in respect of the whole property.

Partition

Sometimes the layout of the home is such that if a part is suitably adapted for the donor’s use, he or she no longer needs to occupy the remainder. For example, a widow might occupy a granny flat and give away the main house to her children. Complete physical separation of the two parts, and separate registration at the Land Registry, is recommended. In these circumstances, there should be no reservation of benefit or pre-owned assets issues.

However, the position becomes more complex when the part given away occupies the same footprint as the part retained (what might be described as ‘horizontal’ rather than ‘vertical’ partition). For example, an individual occupies the lower two floors of a four-storey house and makes a gift by granting a long lease of the upper part.

It is possible that there may be a planning opportunity in such cases. At the time of writing, Inland Revenue guidance on the interpretation and operation of Schedule 15, promised by Paymaster General Dawn Primarolo in a written statement on 7 March 2005, has not been published.

Family equity release plans

A home owner wishing to raise capital on his property may sell it to a commercial finance house for a cash sum. Typically, the sale will be subject to the individual’s right to remain in occupation for the rest of his life. The price paid by the finance house will be at a discount to the vacant possession market value, to reflect the anticipated period before the interest falls into possession.

In principle, it is possible for an equity release arrangement of this sort to be made between family members, with the cash purchase price being provided by the children from their own resources or from borrowings. The sale would be subject to the parents’ right to remain in occupation either for life or for a fixed period and the market value price paid by the children will be discounted to reflect this. With care, it should be possible to arrange for little or no taxable value remaining on the death of the surviving parent. The parents might use the funds they receive to supplement income or they might, perhaps, settle part on accumulation and maintenance trusts for grandchildren, for example.

For IHT, there will be no transfer of value if a transaction is at market value and it can be demonstrated there is no intention to confer gratuitous benefit.

For pre-owned assets, the disposal of an individual’s whole interest in a property, except for any right expressly reserved by him over the property, by a transaction such as might be expected to be made at arm’s length between unconnected persons, will be an excluded transaction (Paragraph 10(1)(a)).

The encumbered freehold interest acquired by the children in this scenario will not qualify for private residence exemption, unless they occupy the home with their parents as a main residence. This CGT cost might be removed if the children transfer the required funds to a suitable settlement, the terms of which give the parents a life interest. In this way, a tax-free uplift in CGT base cost could be achieved on the death of the survivor of the parents, and at the same time the reverter to settlor IHT exemption in S53 IHTA 1984 should apply if the children survive their parents and the trust fund reverts to them on the second death.

It will be noted that the pre-owned assets rules only provide excluded transaction status for sales of the whole interest in a property. Many commercial equity release schemes involve the sale of a part interest; the pre-owned assets legislation, as originally drafted, would have applied to these transactions.

The government recognised at an early stage the inequity of bringing innocent equity release arrangements within the pre-owned assets regime. The pre-owned assets regulations, published on Budget Day, 16 March 2005, extend the excluded transaction status given by Paragraph 10(1)(a) to arm’s length sales of a part of the vendor’s interest. Perhaps remaining suspicious of part sales within the family, the government has declined to extend the exemption to part sales generally.

The regulations will however provide exemption for any part sale which did occur before 7 March 2005 (the date of Dawn Primarolo’s written statement) and which was made on terms which might be expected to be made at arm’s length between unconnected persons.

Interestingly, exemption will be extended to future part sales if they are made on ‘arm’s length’ terms and for a consideration other than money or ‘readily convertible assets’. The example given in Dawn Primarolo’s statement is of a child who moves in to care for an aged parent and acquires an equitable interest in the home as consideration for that care. One might question whether such a transaction is one ‘such as might be expected to be made at arm’s length between persons not connected with each other’. That aside, this situation is perhaps similar to the shared occupation described above, where the exemption for gifts in S102B FA 1986 is available. The benefit in the donor making a sale on this basis, rather than a gift, is that there would be no impact on the taxable estate at death if the donor fails to survive for seven years.

Will drafting and deeds of variation

Paragraph 16 provides that any disposition made as a disclaimer or a variation under s142 IHTA 1984 is disregarded for pre-owned assets purposes. In addition, it is understood that the beneficiary of an interest in possession trust does not make a disposal (and is therefore not within pre-owned assets) when his interest is terminated, in whole or in part, by the trustees. For IHT, although the life tenant is treated as making a potentially exempt transfer in these circumstances, he does not make a gift and consequently the reservation of benefit provisions will not be in point. As explained below, this treatment leaves the possibility of further planning if, on the first death of husband or wife, property passes to a life interest trust for the survivor.

Provision for a discretionary trust in husband and wife wills, to avoid wasting the IHT nil rate band on the first death, is now commonplace. Where the nil rate band legacy can only be satisfied using part of the value in the family home, debt or charge arrangements are routinely used to avoid any possible suggestion from the Inland Revenue that the survivor has an interest in possession in the will trust. These arrangements are unaffected by pre-owned assets.

In recent months there has been concern that debt and charge arrangements are, however, subject to stamp duty land tax. In a statement published on 12 November 2004, the Inland Revenue confirmed the view of many that it is possible to implement a charge arrangement without attracting a stamp duty land tax liability.

An alternative to a debt or charge arrangement is available if the deceased’s share of the family home passes to a trust in which the survivor has an interest in possession. The children might also be beneficiaries, with the value of their interest initially equal to the amount of the unused nil rate band. CGT private residence exemption should be available for the whole of the value of the property in the trust by reason of S225 Taxation of Chargeable Gains Act 1992. In addition, a part of any increase in value of the property – attributable to the children’s interest – will accrue outside the survivor’s taxable estate.

Whether the surviving spouse is the sole or a joint beneficiary of the interest in possession trust, there may be an opportunity for further IHT mitigation if the trustees subsequently reduce his or her share in favour of the children. As noted above, there should be no reservation of benefit or pre-owned assets implications arising from this variation, and the survivor would continue to occupy the property by virtue of the retained interest in the trust.

Expert advice is essential

While many previously popular strategies are now blocked, the well advised client may still find scope for significant IHT mitigation. However, now more than ever, expert professional advice will be essential in steering a safe course through the legislation.

Stephen Yates works in the estate planning and trusts team at tax consultancy Chiltern plc. He can be contacted on telephone: 020 7153 2458 or via e-mail: yatess@chilternplc.com