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Inheritance tax trap – Gifting your home to avoid inheritance tax

When you start to think about inheritance tax (IHT) planning, most people would like to find ways to retain as much of their wealth within their family or with other loved ones. However the reality is that without forward planning, those with even reasonable sized estates could see thousands of their hard-earned wealth going straight to the taxman. 

The good news is there are many things you can do now to reduce the potential tax bill on your estate, however it’s important to fully understand the rules or you could be caught out. One inheritance tax trap that could catch you out is a gift with reservation. 

What is a gift with reservation?

A gift with reservation occurs when you give away an asset but continue to retain some benefit from it.

A common example of this is when someone gives away their main residence to their children (who don’t live there), whilst continuing to live in the property rent free. This would not be treated as a genuine lifetime transfer by HM Revenue and Customs (HMRC), therefore in this instance, the value of the property would be included as part of the donor’s estate for inheritance tax purposes and could be subject to inheritance tax at 40%.

In a previous court ruling, a judge explained that ‘not only may you not have your cake and eat it, but if you eat more than a few de minimis crumbs of what was given, you are deemed for tax purposes to have eaten the lot.’

How does this differ from a Potentially Exempt Transfer?

If a genuine gift is made to individual beneficiaries, with no benefit retained, this would be treated as a Potentially Exempt Transfer and if you survive seven years, the gift will not be subject to inheritance tax. To understand more about the 7 year rule in inheritance tax take a look at our other article.

How to gift the family home to your kids without it being treated as a gift with reservation 

If the person who made the gift pays rent at full market value to their children, this will be treated as a Potentially Exempt Transfer instead of a gift with reservation, which means the seven-year clock will start when the gift is made and after seven years there would be no inheritance tax to pay on the gift. There should also be a formal rental agreement in place that includes regular market rent reviews to ensure the house is being rented out on a commercial basis. Paying rent on a regular basis has the added benefit of reducing your taxable estate by reducing your cash reserves, although the affordability of this will need to be considered (and of course the rent paid is taxable income in the hands of your children).

Some individuals transfer their holiday home to their children to try and reduce their exposure to inheritance tax, but to avoid falling foul of gift with reservation rules, it’s prudent to pay market rent to the children whenever the holiday home is used. 

What are the potential capital gains tax implications?

If you give an asset away (e.g. a rental property), it may create a double tax charge:

  • Capital Gains Tax may be payable if the asset has made a profit or ‘gain’ at the time of the gift. 
  • IHT may be payable on death if the gift with reservation rules have not been adhered to.

Nevertheless, Capital Gains Tax will not usually be chargeable if the asset you are giving away is your main residence.

Furthermore, if you decide to keep an asset (e.g. a rental property) instead of gifting it to your children, the asset will benefit from a Capital Gains Tax uplift on death. This is where, for Capital Gains Tax purposes, the beneficiaries inherit the probate value as the purchase price, which means any profit or ‘gain’ for the asset is wiped out. 

If you made a gift with reservation instead, HMRC will deem the asset to be part of your estate. Also, because you do not legally own the asset anymore, your beneficiaries would not benefit from the Capital Gains Tax uplift (mentioned above) when you pass away. 

What happens if I move into care?

As a reminder, if you gift your main residence to your children without paying market rent, this would be treated as a gift with reservation, though the tax treatment usually changes if you move permanently into a care or nursing home.

As you don’t live at the property anymore, you no longer retain a benefit from that asset. This means the gift will be treated as a Potentially Exempt Transfer, which therefore starts the seven-year clock for inheritance tax purposes from the date you no longer reserve a benefit in the property. 

A London School of Economics study estimated that the average length of stay in a care home is 2.3 years; as a result, if you move into care after making a gift with reservation, it’s unlikely that this gift will be effective from an inheritance tax perspective. 

Alternatively, if you gifted your main residence to your children and paid market rent, moving to a care home should have no impact on your tax position as the original gift would be treated as a Potentially Exempt Transfer, therefore the seven-year clock will have started when the original gift was made. However, gifting an asset away to avoid paying care fees can be classed as deliberate deprivation.

Nil rate band & residence nil-rate band recap

When you pass away, the first £325,000 of assets can pass to your beneficiaries free from inheritance tax. This tax-free allowance is referred to as the nil rate band and is frozen at this level until 2026. 

The residence nil rate band is an additional allowance that is available to individuals who leave residential property to their direct descendants. The residence nil rate band is currently fixed at £175,000 until 2026, however, this allowance is gradually reduced if the net value of your estate exceeds £2,000,000.

Why should I consider the residence nil rate band?

Since it was introduced back in 2017, we are seeing fewer people gift their main residence to their children to reduce their exposure to inheritance tax.

This is because the residence nil-rate band provides a combined allowance of up to £350,000 to a married couple/civil partnership, which can only be used if you own your own home (or sold one since 8 July 2015) and are leaving it (or equivalent assets if property sold) to direct descendants. If you add this to the standard nil rate band allowance of £650,000 for a married couple (so £325,000 x2) then a married couple could pass on an estate worth up to £1million free of inheritance tax.

As a result, gifting your main residence to your children may not be the most effective way of reducing your inheritance tax liability.

As an alternative, some people choose to make lifetime transfers from their liquid assets such as cash or investments, in order to benefit from the residence nil-rate band on their main residence, plus the gift will be free from inheritance tax if they survive 7 years.

If you are concerned about inheritance tax on your own estate and would like to discuss ways in which you can reduce your loved ones’ potential tax bill, why not get in touch and arrange a free consultation

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Please note: that the Financial Conduct Authority (FCA) does not regulate estate planning, tax or trust advice.