Everything You Need to Know About Inheritance Tax
Inheritance tax is a pretty miserable topic when you think about it. Tax, and death, all rolled into one
However, it is a topic that is worth understanding, because without a clear plan in place for what will happen to your portfolio when you depart, not only could you leave your loved ones with a hefty tax bill, you could also end up with costs to bear yourself BEFORE the worst happens. Ouch.
We’ve been joined by tax titan and Mashroom show regular, Richard Cunningham. A chartered accountant and chartered tax advisor, Richard understands that there are two inevitabilities in life – death and taxes – but knows that the outcome, inheritance tax, needn’t be as painful as you might think.
He’s here to explain the ins and outs to us, and give some guidance on how to plan for this pesky payment.
What is inheritance tax, and how does it impact me now?
‘Inheritance tax is a tax on the value of a person’s estate on death. Many people will agree that it’s a pretty nasty tax if you think about it,’ admits Richard.
Let’s say you’re a higher rate taxpayer. You’ve paid 40% tax on your earnings throughout your working life. You then die and they tax you again. There goes another 40%. So, it’s a tax that people are keen to try and avoid if they can.
Are there any exemptions to inheritance tax?
Short of working out the secret to eternal landlording life, is there any way round it? Is this one of those taxes that just has to be sucked up?
‘There are some exemptions. You get £325,000 nil rate band, so the first £325,000 isn’t subject to inheritance tax,’ explained Richard.
There is also an extra £175,000 allowance in relation to your main residence if your overall estate is worth less than £2 million. A lot of people will be within that band. But obviously house prices have only gone one way in the last 15 to 20 years, and if you’ve got a big portfolio, it could push you over those limits.
Is there any good reason why a landlord can’t just give their friends and family chunks of money, or transfer assets before they die? If a landlord knows who they want to have what, surely this is an easier way to do things, and would avoid the inheritance tax issue altogether?
‘You can gift up to £3,000 a year to whoever you like without that including your estate on death. That’s to any single person or to any number of people. On that £3,000 annual gift exemption, if you don’t use it in one year, the relief carries forward and you can use it in the next tax year,’ said Richard.
‘There’s also what’s called regular gifts out of income. If you do develop a regular pattern of gifts, so let’s say you give your daughter £3,000 a year and you’ve been doing it for the last five years, then potentially that’s outside your estate. There are a couple of things you’ve got to be a bit careful of. It’s got to be a gift out of income, it doesn’t work if you sell a property and use money that you’ve realised from the sale of the property – that’s not your income. What they’ll (HMRC) look at is your taxable income, income that you don’t need to maintain your normal lifestyle.’
What about the seven-year rule? Is there any truth in the fact that you can pretty much gift what you like as long as you then don’t die for the next seven years? Can it really be that simple to avoid chunking up your estate between your loved ones and HMRC?
‘Yes!’ laughs Richard. ‘Obviously the devils in the detail, but in simple terms, yes. And the way that it works is there’s a kind of tapering effect as well. So after three to four years, 20% of the charge drops off.‘
‘One of the things to be aware of though is the £325,000 tax free element. When calculating that, the first thing that the revenue does is they apply the gifts that you’ve made against it first. So, if your gifts are under £325,000, you don’t get the benefits of that tapering effect. It’s just netted off the exemption twice.’
Main residence tax issues
Whilst we’re looking primarily at your buy-to-let portfolio, one of the big considerations with inheritance tax is your primary residence – after all, your home is generally your main asset and the value of this will usually make up a large proportion of your estate value as a whole.
‘In most people’s estates, the biggest asset will typically be the main residence,’ agreed Richard. ‘One of the most common questions for advisors is what can I do about my main residence? And it’s a difficult one.’
‘Often people will say, ‘Well, can I gift it to my son, but I want to carry on living in it?’ and you can’t do that. There are rules, gifts with reservation of benefits. You can gift it to your son but if you carry on living there, you’ve reserved the benefit, so it’s going to remain inside your estate.’
‘Taking it a step further, it creates all sorts of other problems because whilst it remains in your estate for inheritance tax purposes, legally you have actually gifted that property, so we mentioned the seven-year rule earlier on. This is one of these things where you can’t say ‘I gift you my main residence now, but I’m going to carry on living in it for several years’. That just doesn’t work. No, you gift it now. If you’re currently living in it, it doesn’t work. If you gift it now and you don’t carry on living it and it’s an outright gift. After seven years, it’s outside of your estate.’
‘Because it’s your main residence. There shouldn’t be any capital gains tax on it, there’s no stamp duty on it. But it’s a difficult one because it’s very rare that someone wants to actually absolutely gift their main residence to one of their children.
There are other things that you can look at like co-ownership. That enables you to carry on living in it so you can give 50% of your property to your daughter. You can carry on living in it. But it basically has to become her house as well and then you’re going to be living with your daughter.
‘You have to demonstrate occupation. You have to demonstrate that you contributed to the repairs to the property, you have to demonstrate that you contributed to the gas bill. It fundamentally comes down to the paperwork – if you’re going to do it, you need to keep very good records. I’ve yet to come across a client that has said ‘yes, I want to do that with my main residence’. It’s fraught with too many dangers, I think.’
Eeek, absolutely – we’re all for sharing your assets with your children once you’ve passed on, but sharing a kitchen with them in the meantime might be a step too far.
What of your buy-to-let portfolio though? Are the rules around planning for that so fraught with pitfalls?
‘Let’s start with the basics’, explained Richard. ‘I’ve got a property I want to gift to my son or daughter’.
‘We’ve now got the challenge that we talked about when we were talking about incorporation in a previous discussion. That transfer is a taxable event for capital gains tax purposes. So, if you’re not receiving any consideration for that, you’ve got a dry tax charge that you’ve got to pay within 28 days.’
‘If that child is under the age of 18, the income that they receive is going to remain taxable on you, so transfers outright are difficult, and you’ve also got to accept that you cannot retain any interest in the income from that property. It’s relatively unusual.’
Trusting in trusts
So, a simple sign over of assets sounds like it’s a no-no, but there is a lot of talk around trusts as an option. Is this something that is worth considering to keep tax to a minimum?
‘It’s a common question that advisors get asked. Trusts are not the kind of magic bullet. There’s been a lot of changes in the last 15 to 20 years around trusts and the benefits are probably fairly limited,’ explained Richard.
You have potentially similar issues around capital gains tax, although if it’s a discretionary trust, there is an opportunity to hold over that gain. So effectively the trust takes on that property, but at its original base costs, so it will suffer the full gain on a future disposal.
‘You’ve got issues around the transfer, or cannot benefit from the income – if they can’t benefit from the income and that asset will remain part of their estate even though they’re gifted into trust. So it’s you know, it’s not often the right solution.’
Are there any differences depending on company structure? We spoke about incorporation in the last show, are there any other considerations if you have decided that this is the route you are going to take?
‘I had a client ask me the other day ‘I’ve got a buy-to-let portfolio within a limited company. I want to gift one of those properties to my daughter, what do I do?’ said Richard. ‘Again, you’ve got this issue where that transaction creates tax issues. For a limited company, making a transfer to a connected party to disposal for corporation tax purposes. So, there’s a corporation tax charge. You’ve got further issues around the loans to participators regime. You’ve potentially got further tax charges on the company based on the value that’s been transferred. There’s a whole raft of challenges in gifting those properties.’
So, what should landlords be doing right now?
‘Plan for it!’ stressed Richard. ‘You can be a lot more organised about it. Something that we talked about in a previous webinar, where you’ve got your buy-to-let portfolio in a company is around the shares. We talked about growth share. This idea of issuing your next of kin with a new class of shares that will have rights to future growth. So effectively you are freezing the value of your interest in your company, and that future growth is passing on to the next generation.’
‘What you can do with a limited company is amend the articles of association to enable you to issue different classes of share. And those different classes of share can have different rights. What you would do is you would issue a new class of share, let’s call it a B share, and that B share would have rights to future capital value of that company over a certain value. Let’s say the point at which you issue that share your buy-to-let portfolio within your company is worth a million pounds, net of any debt. What you would say is right, okay, so the new shares that I’m issuing, I’m going to put a bit of a hurdle value in there, there’s no real value in those shares being issued. So I’m going to say any value in that company over £1.2 million pounds is attributable to those B shares, And those B shares are issued to whoever you want to inherit that value’.
When the sad day comes that you pass away and your advisor is completing the inheritance tax form, the value that goes into your estate for inheritance tax purposes, is the £1.2 million. Everything over that is attributable to the B shares. It’s quite a neat way of doing it, it’s not hugely complicated to put in place, you need a lawyer, you need some tax advice.
‘The longer in advance you do it, the more benefit there will be because future value is occurring to someone else right outside of your estate.’
Are there any other options that people need to be thinking about way in advance. Clearly we’ve not got our crystal balls set up, but if we can plan to live long, happy lives, what do we need to get in place now, nice and early, with a view to passing on to our loved ones a long time down the line?
‘There are some great opportunities around leases. You can create a lease from your portfolio – say you’ve got a portfolio of 10 properties, you create leases for each of those properties for 125 years, but those leases don’t come into effect until a time in the future. Let’s say that’s 19 to 20 years’ time. You then gift the benefit of those leases to your next of kin. They’re entitled to the income but not for 20 years, so the value of those leases is not that significant, so it’s likely that your capital gains tax bill is not going to be significant, your stamp duty charges is going to be next to nothing. And for the next 20 years, you can continue to benefit from the income from your portfolio. Within 20 years’ time those leases come into effect, so you can no longer you can no longer benefit from the income from them, it’s gone to your next of kin, but what’s happened each year as you got closer to that lease coming into effect the value of the freehold interest that you hold is decreasing. And you’re gradually passing the value of your estate to the holders of the deferred lease.’
So, in a nutshell, although this isn’t the nicest thing to think about while you’re in the prime of health, the best thing to do with regards to tackling inheritance tax is plan plan plan. It may seem like a problem for a long time in the future, but the earlier you get your tax ducks in a row, the better chance you have of being able to leave as much of your estate to your loved ones as possible, and swerve lining the pockets of HMRC.
To hear more useful advice from Richard, you can catch up on our tax series from back in December, which covered all of the vital points that a savvy landlord needs to know when handling tricky tax issues.
All previous episodes of The Mashroom Show are available to view on our website, or on our YouTube channel.