Practical guide: Tax-efficient will planning with residential property

Scenario

An individual has recently been widowed after their spouse died in 2020. Their spouse’s entire estate was left to them, and mainly consisted of a joint interest in a property investment portfolio. They are looking for inheritance tax (IHT) advice and are aware that making lifetime gifts could help reduce exposure. The problem is they need all of the income to live on.

The total estate is worth approximately £2.35 million, comprising the family home (£700,000), cash and other investments (£150,000) and investment properties (£1.5 million). The will currently bequeaths everything to the only child - the individual's daughter. The daughter has recently divorced and has moved back to the family home.

Recap - IHT thresholds

It was announced in Budget 2021 that both the standard nil rate band (NRB) of £325,000 and residence nil rate band (RNRB) of £175,000 will be frozen at their current levels until 5 April 2026, and so too will the RNRB taper threshold of £2 million. The IHT exposure in this scenario is therefore £610,000 (£2.35M-(2 x £325K)-(£175K) x 40%).

100% of the NRB and RNRB of the late spouse will be available to transfer as they left all of their assets to the individual and so went unused. However, as the individual's estate exceeds £2 million, their own RNRB will be tapered.

The RNRB is tapered by £1 for every £2 that the value of the estate exceeds £2 million. With an estate worth £2.35 million, the individual’s RNRB is tapered in full such that no allowance is available, hence there is only one amount of £175,000 in the calculation above, i.e. the late spouse’s.

If the individual were to make effective lifetime gifts to their daughter, not only would this reduce the value of their estate and so reduce their IHT exposure, but it would also unlock their RNRB and so in turn further reduce their IHT exposure.

Example. If the family home could be put into joint names with the the daughter, the individual's estate value would fall to £2 million and no taper of the RNRB would apply. The IHT exposure would therefore fall to £400,000. This is because there is a double saving as the value has reduced and the available exemption has increased, i.e. IHT would be charged on £525,000 less of the assets, even though the gift is only of £350,000.

The RNRB claimed can’t exceed the value of the residential property passing to the direct descendant. On a gift of half the family home to the daughter, the property value still in the individual's estate would be £350,000; therefore the full £350,000 of RNRB would be available. If instead a 25% share were given under a different arrangement, the RNRB available would be restricted, e.g. to 25% x £700,000 = £175,000.

Potential problem

In the long term, the individual needs the income from the investment properties to live off and could not afford to pay a market value rent for the family home; therefore it appears that lifetime gifts of any of the property assets will not be appropriate. But is there a way they could gift their home without having to pay a rent to live there?

Where an individual makes a gift of an asset but retains the possession and enjoyment of it, s.102 Finance Act (FA) 1986 will treat the asset as being subject to a “reservation of benefit”, and it will remain in the individual’s estate for IHT purposes.

The rules also apply where the asset is not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor. These rules can be negated if a market rent is paid for the continuing benefit of the asset.

On the face of it, if the individual were to gift their home to their daughter, the value of the property would remain in their estate as they cannot pay a market value rent for it, so it would be subject to a reservation of benefit . However, were they to gift a share of the property instead of the whole of it, they could take advantage of one of two important exemptions to the reservation of benefit rules for gifts of an undivided share of an interest in land.

Exemption 1 - sharing

The first exemption is applicable where:

• the donor and the donee both occupy the land; and
• the donor does not receive any benefit, other than a negligible one, which is provided by or at the expense of the donee for some reason connected with the gift.

As the daughter is now living in the family home, the individual could put the property into joint ownership with her and continue to occupy the whole property without the reservation of benefit rules applying. HMRC’s guidance is at IHTM14360.

To ensure that the individual does not receive a benefit by occupying the whole property, it is crucial that the daughter does not pay more than half of the household expenses. However, it would be fine for the individual to continue paying 100% of the expenses as this is not a benefit for them. To be effective, the joint ownership must be structured as a tenancy in common, not a joint tenancy.

Where this exemption applies, the gift will be a potentially exempt transfer (PET) subject to the usual seven-year survival rule. The gift will also be a disposal for capital gains tax (CGT) purposes, but private residence relief (PRR) would be available.

Exemption 2 - non-occupation

The second exemption is less well known. It applies where the donor does not occupy the property, e.g. an investment property. Whilst  gifting half of an investment property would save IHT, the individual could not afford to lose half of the rental income in our hypothetical scenario, and so they are not particularly interested in this option.

However, they can potentially have their cake and eat it here. There is nothing to prevent them from gifting 50% of an investment property but retaining 100% of the income if this is agreed with the daughter.

Income from jointly held property is only taxed 50:50, or in accordance with the actual ownership split, where the joint owners are spouses. With non-spouse joint owners, the income can be split as agreed amongst the owners, although any capital proceeds on sale will be split in accordance with the ownership proportions.

Unlike with the sharing exemption, there is no requirement that the donor must not receive a benefit. Retaining all of the income whilst only owning half of the property would not jeopardise the exemption. The individual could therefore hold the properties as a tenant in common with the daughter, reduce the IHT exposure, but still keep the rental income.

The gift of investment properties would also be a PET for IHT purposes, but there would be no PRR for CGT. Consideration would need to be given to the amount of CGT that would be triggered on such a gift, although taking into account that half of the properties will have an uplifted probate market value due to the first spouse’s death. It may also be possible to review the value of each property and cherry pick to minimise CGT.

Best of both worlds

Subject to CGT, if our individual were to take advantage of both exemptions, holding the family home and all the investment properties as a tenant in common, the estate value would fall to £1.25 million. The IHT exposure would fall to just £100,000 after deducting the available NRB and RNRB.