A love-hate affair

The maxim, an Englishman's home is his castle, may have originated to express a householder's right to prevent another from entering their home, but today it feels equally applicable when describing the relative value of property.

The rise in property prices has significant inheritance tax (IHT) implications but, unfortunately for clients, the maxim cannot be invoked to keep the taxman at bay.

With the growth in property prices in recent years vastly outpacing the nil rate band (which has remained stubbornly static at £325,000 since 6 April 2009) an increasing number of clients are making plans for their property.

As with any asset, a client has a choice about whether their estate planning should take effect during their lifetime or on death.

Effective planning on death

The main advantage of an estate planning strategy that takes effect on death is that capital gains tax (CGT) liability is extinguished - personal representatives are deemed to have acquired the assets for consideration equal to their market value at the date of death. This is beneficial for clients who own more than one property.

Residence nil rate band

The residence nil rate Band (RNRB) announced in the Summer Budget 2015 implements, in broad terms,
the government's election pledge to increase the effective IHT threshold for married couples and civil partners from the current £650,000, to £1m.

Unfortunately for clients and their advisers however, the means to achieve this are not straightforward. Instead
of simply increasing the existing nil rate band to £500,000 per person,
an additional nil rate band will become available where property is left on death.

The value of this RNRB will be the amount of the band or, if lower, the net value of the interest in the residential property after deducting any liabilities such as a mortgage. At the time it is introduced on 6 April 2017, the RNRB will only be £100,000.

It will rise by £25,000 in each following year until it reaches £175,000 on 6 April 2020, creating the effective £1m threshold when added to the nil rate band. Thereafter it is proposed that the RNRB will rise in accordance with the consumer prices index.

IHT on the value of the property below the RNRB will be charged at zero per cent. The amount above the RNRB will be taxed in the usual way.

There are a number of requirements to qualify for the RNRB. First, the deceased must have owned a residential property which at some point they occupied as their residence. Where the deceased downsized into a less valuable property or subsequently disposed of a property which they owned on 8 July 2015, including by way of gift, the deceased's estate should still be eligible for the RNRB, providing assets of an equivalent value pass on their death and the remaining conditions are fulfilled.

These downsizing or disposal provisions will be contained within the Finance Bill 2016.

Another caveat is that the property must be closely inherited. The definition of closely inherited encompasses someone who is a lineal descendant (such as a child or grandchild), the spouse or civil partner (hereinafter for the sake of brevity, spouse) or a lineal descendant, a step-child or a foster child
of the deceased.

Where an individual or couple are childless, their estate will not be eligible for the RNRB. Where the property passes to the client's spouse, on their subsequent death, a claim may be made to transfer any unused proportion of the RNRB so that it is available for the estate of that spouse.

Finally, the RNRB will be tapered away by £1 for every £2 that the net value of the estate (of which the property is part) exceeds £2m. The net value is the sum calculated after deducting any liabilities but before deducting reliefs and exemptions. Therefore the RNRB will be of no benefit if an estate significantly exceeds £2m. The taper threshold will also rise in line with the consumer prices index from 2021 onwards.

The majority of the RNRB provisions are contained in the recently enacted Finance (No 2) Act 2015. The legislation is complex and care will need to be taken when advising clients. Although the RNRB will not commence until 6 April 2017, it is important that advisers start considering the arrangements their clients have in place now, to ensure that any potential benefit is not lost in the event of a first death beforehand.

Wills should therefore start to be reviewed with the RNRB firmly in mind. If the client wishes to benefit from it, arrangements should be made to ensure that from 6 April 2017, they leave their residence (or a sufficient share of their interest in it) to either their spouse or qualifying beneficiaries, or would have done but for downsizing or a disposal which occurred on or after 8 July 2015.

This may necessitate changing how, or in what percentages, property is currently owned. Particular care should be taken where a client's will creates
a trust on death, as depending on
the nature of that trust it may cause
the benefit of the RNRB to be lost. Other potential estate planning points arise to ensure that, where desired, the net value of an estate will not exceed £2m on death.

Transferrable nil rate band

Since 9 October 2007, the nil rate band has been transferrable between spouses, bringing an added dimension to estate planning. Under these provisions, the personal representatives of the estate of a surviving spouse who dies on or after 9 October 2007 can claim the unused portion of the nil rate band of the first spouse to die. Special rules, however, apply where that first death occurred under the old estate duty regime.

As the amount claimed is the unused percentage, rather than the value of the nil rate band on the first death, the estate will benefit from an uplift of the nil rate band in force at the date of the second death. Therefore IHT is reduced where the nil rate band rises in between deaths.

The transferrable nil rate band (TNRB) creates additional opportunities for lifetime estate planning. It enables assets to be left to the surviving spouse on the first death, preserving the NRB for the benefit of the surviving spouse's estate.

The surviving spouse can then gift assets to reduce their estate for IHT purposes. Where this gift involves a second property, this strategy brings with it the added benefit of washing out any capital gains because of the rebasing which occurs on death. Providing the spouse survives the requisite period of time, their estate will benefit from both lifetime planning and an enhanced NRB on death.

While the advent of the TNRB has brought wills which preserve the nil rate band on the first death to the fore, advisers should not overlook the benefits of utilising the nil rate band for a number of reasons.

First, as it appears set to remain frozen at £325,000 until at least 5 April 2021, it may actually be beneficial to utilise it on the first death to dispose of appreciating assets, such as property. Where that asset is a share of a property owned with a spouse, on the survivor's subsequent death the remaining portion may receive a discount of 10-15 per cent for IHT purposes.

Second, it is only possible to transfer up to 100 per cent of the unused nil rate band of a deceased spouse. Therefore, where a client has previously been widowed and already benefits from an existing TNRB, their affairs should be arranged to utilise it if they die first. Otherwise one TNRB is lost.

Finally, if the nil rate band has been preserved on the first death with the intention of the surviving spouse subsequently making gifts, not only must the surviving spouse carry out the intention, but they must also have the capacity to do so. Attorneys under a lasting or enduring power of attorney will not be authorised to make such gifts on behalf of a surviving spouse who lacks capacity.

In certain circumstances, therefore,
it may be advisable to make the property subject to a determinable interest in possession (IIP). This would preserve the nil rate band (a potentially exempt transfer (PET) would arise on termination) and the IIP can be arranged so as to be terminated without the involvement of the surviving spouse if they lack capacity.

Lifetime planning - outright gift or a trust?

The gifting of assets during lifetime is well documented. There are two main choices when making a lifetime gift of a property; gifting outright or placing the asset into trust.

An outright gift is a PET. Broadly speaking, to be effective for IHT purposes the client (the donor) must survive seven years after making it. A gift made three or more years before death, however, still has benefits due to the tapering which applies on any IHT payable. Normally stamp duty land tax is not payable on a gift of property.

New trusts, with certain exceptions, will be treated and taxed as a relevant property settlement. A gift into a relevant property trust is immediately chargeable to IHT. Where the gift is below the client's available nil rate band, the liability is at zero per cent.

Above the band, the IHT liability is at the lifetime rate of 20 per cent. If the settlor dies within seven years, the lifetime charge is recalculated at the death rate, with credit given for tax already paid and the same tapering as for outright gifts available.

Further IHT charges may also arise during the lifetime of the trust depending on the value of the assets within it, on every tenth anniversary of its creation and on exit. As a general rule, the donor and their spouse should not be a beneficiary of the trust to prevent additional and unfavourable tax treatment.

The benefit of using a trust is that it provides control. The client can act as a trustee if they so wish. Asset preservation trusts are a useful tool for beneficiaries who are at risk of divorce or bankruptcy, or are prone to playing roulette. In addition, hold-over relief could be claimed on entry so any chargeable gain that would ordinarily arise on disposal is added to the gain that accrues on the next disposal of the asset.

Pitfalls of lifetime planning

Clients should be reminded that the RNRB will not apply to reduce the tax payable on lifetime transfers that become chargeable as a result of death. Unless hold-over relief is claimed, the biggest hurdle facing lifetime planning is CGT. Where property is subject to a gift during a client's lifetime, if the donor cannot claim principal private residence relief, which exempts gains on a property for the period which it has been the client's main residence, CGT is payable. Where the donor cannot fund this from other sources, the property may need to be sold to finance the tax prior to making any gift.

Another significant hurdle is the gift with reservation of benefit (GROB) rules. Broadly speaking, where a property is given away and possession and enjoyment of the property are not bona fide assumed by the donee, or the property is not enjoyed to the entire, or virtually the entire, exclusion of the donor, it is ineffective for IHT purposes.

This is unless the donor survives seven years after such a reservation of benefit ceases to occur, or the donor provides full consideration for that benefit, such as paying market rent. Where the gift is not caught by the GROB rules, it may still be caught by the pre-owned assets charge under which there would be an annual charge to income tax on the benefit received.

Where the client makes a gift during their lifetime and the avoidance of care home fees is a significant motivation for it, the value of that gift may be brought into account by the local authority when means testing the client's available funds for care fees. Advisers should therefore take particular care when the client has a reasonable expectation of the need for care and support at the time of the gift.

An alternative approach

An alternative approach is to sell the property, possibly triggering a CGT charge, and invest in assets which are subject to IHT reliefs in the form of business property relief or agricultural property relief. Benefits in the form of IHT relief at either 50 per cent or 100 per cent are generally achieved after holding the asset for two years, providing the qualifying conditions are satisfied. The asset can then be passed tax efficiently during a client's lifetime or on death.

Conclusion

The most effective strategy for property is likely to utilise a combination of death and lifetime planning but, as with any asset, this will depend on the client's objectives and particular circumstances. The need for planning will not cease once the property has been disposed of, as the person receiving it is likely to experience the same issues in time.

Matthew McCormic is an associate at Druces