Save Inheritance Tax on your Investment Properties

With rates of inheritance tax at 40%, this can represent a huge chunk of your wealth that goes to the taxman. Anyone with a substantial estate will therefore be looking at opportunities to reduce the potential Inheritance tax charge in the future.

Even with the slow property market, property investors could be looking at huge inheritance tax liabilities. OK, the amount of any mortgage is deducted before Inheritance tax is charged, but nevertheless the net estate could be huge.

One of the problems for anyone with investment property who is also looking to reduce inheritance tax is that simply gifting the properties to children or grandchildren will in many cases not be tax efficient. Although from an inheritance perspective it will be excluded from their estate after 7 years, the transfer would also be a disposal for capital gains tax purposes.

For capital gains tax, any mortgages are excluded and the gain will essentially represent the uplift in value. Of course the capital gains tax rate is now 28% for higher rate taxpayer so the tax charge could be substantial.

One option to 'have your cake and eat it' is to use a property investment trust.

The trust could be established as a discretionary trust or even an interest in possession trust. In both cases they would still be 'relevant property trusts'.

Relevant property trusts are treated as a separate entity to the settlor (ie the person who makes the transfer), and therefore property held within such a trust will usually be excluded from the settlors estate for inheritance tax purposes. The two provisos here are:

• they still need to survive for at least seven years from the date of the transfer.
• the settlor and his wife need to ensure that they don't retain the right to benefit from the trust. If they do, anti avoidance rules (known as the reservation of benefit provisions) can apply to treat the property transferred as part of the settlors estate

What about capital gains tax?

The transfer to the trust is still a disposal for capital gains tax purposes, however it's possible to holdover the capital gain on the transfer. The trustees can also holdover the gain if they transfer the property to a trust beneficiary in the future. Effectively this means that the eventual beneficiary will hold the property at the same cost that the settlor had.

To claim holdover relief though it's important that the settlor their spouse and any minor children can't benefit from the trust. You'll therefore need to make the trust for the benefit of:

• Uncles
• Adult children
• Grandchildren
• Brothers
• Sisters
• Aunts
• Nephews
• Nieces
• Cousins
• Separated couples
• Divorced couples
• Relatives of your partner you are living with (if you're not married or in a civil partnership with your partner)
• Relatives of divorced parties

It's also worth noting that you can't use this and also claim principal private residence ('PPR') relief. So, you couldn't transfer a property to a trust for the benefit of your adult children, claim holdover relief to defer the gain and also have the trustees claiming PPR relief on the basis it was his main residence.

Downsides

This all sounds pretty good. Transfer investment property to a trust for adult children or grandchildren. Defer any gain and avoid IHT after 7 years.

It is good…but the downside is that the trust itself is subject to a separate inheritance tax regime. This can get very complicated however essentially there are 3 key points when inheritance tax can be an issue:

• On the transfer to the trust
• After 10 years
• On the transfer of properties out of the trust

Nevertheless there is good way to minimise the effect of the provisions. This relies on using the inheritance tax nil rate band. This is currently fixed at £325,000. Assuming no other transfers in the previous 7 years you could transfer a property to the trust with a value of up to this amount free of any inheritance tax to the trust.

If, as many people do, properties are owned jointly this means you could transfer a value of up to £650,000 to the trust. In fact when you take into account the annual inheritance tax exemption it will be slightly more than this. Each person has a £3,000 annual exemption that is deducted from gifts before inheritance tax is taken into account. As a bonus this can be carried forward for 1 year.

This means that as a couple you could transfer a property with a value of up to £662,000 into the trust tax free. This could easily represent a couple of properties and represents a CGT free transfer. It would also be free of inheritance tax after seven years.

This could then be repeated seven years later to take account of the new 'untouched' inheritance tax threshold. Assuming this was £400,000, you could transfer £812,000 as a couple. Over the course of 20 years or so this would easily allow £2,000,000 worth of properties to be transferred out of the estate. This would save inheritance tax of £800,000 and also be free from capital gains tax.

This £800,000 inheritance tax saving is not though a complete picture. The trust would also need to consider it's own position. It will be subject to an inheritance tax charge on the value of the trust assets every 10 years.

The extent of any inheritance tax charge would depend on the value of the trust asset as well as the nil rate band at that point.

If we assume that a couple transferred property worth £662,000 into a trust, and then 7 years later transferred property worth a further £812,000 into the trust the cost of the trust assets would be £1.474M. Assuming that these properties have now grown to £2,000,000.

The nil rate band may be £500,000.

The 10 year tax charge in the trust is calculated as:

Trust Assets £2,000,000

Nil rate bands -£1,000,000

Chargeable amount in the trust = £1,000,000

IHT charge at 20% = £200,000.

Effective rate = £200,000/£2,000,000*3/10 = 3%.

There is then a reduction in this for each calendar quarter that the properties were in the trust.

Therefore the property in the trust originally would be taxed at 3% and the property transferred in after 7 years would be charged at 2.1%. The inheritance tax charge could therefore be in the region of £50,000.

Although not an insignificant amount, when compared to the value of the assets in the trust (£2,000,000) and the potential IHT charge if held personally (£800,000) it represents a considerable inheritance tax saving.

For more Inheritance tax planning, see our tax book Inheritance Tax Planning Handbook

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Disclaimer

i) Please note that the articles/answers contain general guidance only and do not constitute accountancy, tax, investment or other professional advice.

ii) The contents of this article/answer are for information only and are intended to assist readers in identify any tax planning opportunities that may be available to them. The information contained in this answer is not intended to be a substitute for taking proper taxation advice and should not be relied upon in this way. Always consult a qualified accountant or taxation adviser. Your situation will then be looked at individually and specific advice relevant to your circumstances can be given. The Expert does not accept responsibility for any loss arising as a result of reliance on any information contained in this answer.

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