As the expression goes, there are only a few things in life which are guaranteed, death and taxes….
Not something many of us think about or want to consider but it’s the inevitability none of us can escape.
One question we are often asked by our clients is how do I pass on the maximum tax efficient value of my estate to the next generation and avoid paying excessive inheritance tax.
This is often triggered by the fact that many of us have one big asset in the form of our house and how to pass this onto the next generation without the dreaded hefty 40% inheritance tax!
Considering that this asset has already been bought and paid from taxed sources it is often a bone of contention for many hard working families to then have a large death tax applied to the value of the assets in the estate.
This article will tackle some common inheritance tax scenarios that many people suggest to us as being the magic solution to the problem with the actual tax effect of these solutions.
In this article we will run through one available relief for married or civil partnered couples which can often reduce the tax on a large estate plus provide some guidance on gifts and their implications.
What is inheritance tax and what are the limits and tax rates
Inheritance Tax is usually paid on an estate when somebody dies. It is also sometimes payable on trusts or gifts made during someone’s lifetime.
If your estate is valued at less than the threshold of £325,000 (tax year 2014/15) there will be no Inheritance Tax. If the estates value exceeds the limit, this will be taxed at 40% on the amount over and above this threshold, or 36% if the estate qualifies for a reduced rate as a result of a charitable donation.
Tax is payable by different people in different circumstances. Typically, the executor or personal representative pays it using funds from the deceased’s estate and trustees are usually responsible for paying Inheritance Tax on assets in, or transferred into, a trust.
Gifts of assets and the implication to inheritance tax
You can give up to £3,000 away each year tax free, either as a single gift or as several gifts adding up to that amount – you can also use your unused allowance from the previous year but you use the current year’s allowance first. This gift is known as the annual exemption gift but cannot be done in addition to the small gifts exemptions (see below).
You can make small gifts of up to £250 to as many individuals as you like tax-free but this cannot be carried out in addition to the annual exemption gift. This is known as the small gifts exemption.
Gifts to someone getting married or registering a civil partnership are exempt under the following circumstances –
Up to £5,000 from each parent of the couple, £2,500 from each grandparent or more remote relative. Up to £2,500 from bridegroom to bride (and vice versa) and between civil partners plus up to £1,000 from anyone else.
What happens if you gift over these limits?
The answer to this question isn’t quite straight forward as with most things tax! You can potentially gift many things to who you want up to a certain value as long as you survive seven years from the date of the gift. These kinds of gifts are classified as ‘potentially exempt transfers’ (PETs).
If you survive for seven years after making the gift that exceeds the limits, no inheritance tax is due. However, if you die within this time, two things happen.
The PET is reassessed
The PET is reassessed and added to any other taxable gift you may have made in the seven years before making the PET. This has to happen to see whether any tax is now due on the PET itself. This means that gifts made during the 14 years before death could be relevant.
If tax does become due on a PET, the person who received the PET will be asked to pay the tax. However, the tax due may be reduced by ‘taper relief’.
Taper relief can reduce tax due on PETs as follows:
- If the gift was made less than three years before death, no reduction in tax is due
- If the gift was made three to four years before death, tax is reduced by 20%
- If the gift was made four to five years before death, tax is reduced by 40%
- If the gift was made five to six years before death, tax is reduced by 60%
- If the gift was made six to seven years before death, tax is reduced by 80%
- If the seven-year running total of taxable gifts and PETs made comes to less than the tax-free allowance (at the date of death), no tax will be due on the PET but it will reduce the amount of inheritance threshold left for the remaining estate (see below for more details).
- While taper relief may reduce tax on PETs if you die within seven years of making them, it won’t reduce the tax due on your estate.
The PET is added to your estate
The second thing to happen if you die within seven years of making a PET is that the PET is also added to your estate to work out how much tax is due on the estate. If the seven-year running total of PETs, chargeable gifts and your estate comes to less than the unused tax-free allowance, no tax will be due.
However, if much of the tax-free allowance has been used up against PETs and taxable lifetime gifts, this can leave little or no allowance to be used against the rest of the estate.
So what happens if you gift your home?
This scenario can be seen as having your cake and eating it and the tax man isn’t having any of it if certain rules are not adhered to!
You can give your home to your children – or someone else – at any time. For Inheritance Tax purposes, it’s treated as a gift.
When passing on property, you need to remember the PET rules mentioned above may apply if the gift was less than seven years from date of death. If you survive seven years after giving it away, it’s exempt from Inheritance Tax. However if there are conditions attached when you give away your home (e.g. if you continue to live in it rent-free) it’s known as a ‘gift with reservation of benefit’(GWR) and won’t be exempt.
What are the different scenarios for the gift of property?
Giving your home away and moving out
You can gift your house and as long as you no longer live in it, you can make social visits and stay for short periods in the home you give away and this will not be subject to IHT. Normally this can be achieved if you have a buy to let you wish to pass on to your children. As this is not your principle private residence there will be no issues with you continuing to live in the property and will not fall foul of the gifts with reservation rules. If the property is kept as a rental property the rental income can no longer be received by you after the gift. There should be a clear break in ownership and benefits. Please note in this situation there will be capital gains implications as all gifts have to be at an arms length and you have to survive for seven years as discussed above.
Giving your home away and living in it
If however the home you gift is your principle private residence, you can still live in your home after you give it away but to avoid Inheritance Tax you will have to pay the new owner a ‘market rent’ (the going rate for similar local rental properties). If there is still a mortgage left on the property you will still be responsible for the mortgage but you will also have to pay market rent to whoever you transfer the asset to as long as you still live in it. Once you start to pay market rent is when the seven year PET period commences i.e. if you gift the property in 2014 but don’t start paying market rent until 2016, your seven year PET period won’t start until 2016. If at any time the market rent increases but you continue to pay an older market rate the GWR clause will then apply as market rent is no longer being paid.
Selling your home and giving the money to your children
If you sell your home and give the money to your children, the gift won’t be included in your estate for Inheritance Tax purposes if you live for seven years after you make the gift.
If you sell your home, give the money to your children and then move into their home it counts as a ‘pre-owned asset’ and there might be Income Tax due if you don’t pay the market rent.
If both you and your children sell your homes, pool your money and buy a new home to live in together, the part belonging to you is considered part of your estate for Inheritance Tax purposes.
Giving your home to your children and they move in with you
Inheritance Tax is still due if you do this as it’s counted as a ‘gift with reservation of benefit’.
If you just give half of your home to your children, they move in with you and you share bills, the half you give them isn’t part of your estate for Inheritance Tax purposes as long as you live for seven years after giving it away.
Transferring an unused inheritance tax threshold
In most peoples circumstances it is not viable to gift property and not receive some ongoing benefit from this in some shape or form i.e. continue to live in the property and not pay market rent.
Therefore what happens if your property makes up the majority of your estate? If you are married or in a civil partnership there is some good news. Under husband wife / civil partner transfer rules, assets can be transferred between spouses tax free.
And since October 2007, you can transfer any unused Inheritance Tax threshold from a late spouse or civil partner to the second spouse or civil partner when they die. This can increase the Inheritance Tax threshold of the second partner – from £325,000 to as much as £650,000 for the current tax year 2014 / 15, depending on the circumstances.
How does the transfer work?
Married couples and registered civil partners are also allowed to pass assets to each other during their lifetime or when they die without having to pay Inheritance Tax. It doesn’t matter how much they pass on – as long as the person receiving the assets has their permanent home in the UK. This is known as spouse or civil partner exemption.
If someone leaves everything they own to their surviving spouse or civil partner in this way it’s exempt from Inheritance Tax. It also means they haven’t used any of their own Inheritance Tax threshold or nil rate band. This can be used to increase the Inheritance Tax threshold of the second spouse or civil partner when they die – even if the second spouse has remarried. Their estate can be worth up to £650,000 for tax year 2014 / 15 before they owe Inheritance Tax.
To transfer the unused threshold, the executors or personal representatives of the second spouse or civil partner to die need to send certain forms and supporting documents to HM Revenue & Customs.
There are a number of ways of reducing inheritance tax in relation to the largest asset that most families will have to pass on. There are ways to gift the property subject to conditions and assuming you meet the conditions you can achieve a large reduction in your estate and the potential tax that would have been paid.
This is only a brief guide to inheritance tax and ways to reduce the liability by potentially gifting large assets and or the transfer of allowances between spouses and civil partners. There are a number of other scenarios and issues that can come to light for tax planning with very different outcomes and approaches which we are able to assist you with.
Need advice? We are here to help.