Inheritance Tax Planning with the Family Home

For many people, the family home is the most valuable asset they have in their estate, and probably the most frequent question which those advising on inheritance tax matters are asked is how inheritance tax can be saved on the main residence.

There have been numerous ideas over the years which have been designed to provide a solution to this problem. One of the most ingenious and effective solutions was an arrangement by which you granted a lease to yourself over the property carefully structured to terminate effectively on your death whilst the freehold to the property was given away to the next generation. Both interests were transferred into a family trust so as to provide full capital gains tax exemption in respect of both the freehold and the lease with there being no inheritance tax liability so long as you survived the setting up of the arrangement for seven years.

This complex structure was counteracted by legislation in 1999. Thereafter, an alternative device was widely marketed which became known as the gift and loan structure. Under this scheme, you sold your freehold interest in the property to a trust of which you were the principal beneficiary, with the purchase price owing by the trust being left outstanding as a debt due to you. This debt was then given away to the next generation. There were quite a few variations of this scheme, particularly as regard to the nature of the debt - some had debts repayable on demand and others had debts which were not repayable until after the death of the home owner. These types of schemes were effectively brought to an end by the introduction of pre-owned assets tax in 2004.

Pre-owned asset tax was controversial since it not only applies to new schemes entered into after the introduction of the charge, but it also applies to schemes previously entered into, even those dating back to 1986. The tax effectively causes income tax liability on the benefit of living in your own home, the taxable figure being based on the proportion of the value of the property which has been given away. For elderly people who had embarked upon this scheme, it was often better to pay the annual income tax charge rather than take action to unwind the scheme although of course the tax payer concerned would be a pensioner on fixed income and this might cause great hardship. Those who were not elderly were often advised to unwind the scheme, although given that the debt had been given away, usually to a trust of some sort, getting back to square one as things were before the scheme was set up often meant breaching the terms of the trust holding the debt.

The lesson is to recognise that HMRC clearly has strong objections to inheritance tax schemes which relate to a person's main residence. In fact, their objection runs deep enough for them to continue to attack the gift and loan schemes which were set up prior to 2004; it has recently been reported that one variety of the schemes is to be the subject of a forthcoming appeal at the Tax Tribunal, where the main point at issue will be whether or not the scheme was effective from the outset to save inheritance tax. The technical argument here centres on the nature of the debt which was given away.

Our general view is that home owners should think very carefully before compromising their security and tenure. The truth of the matter is that inheritance tax planners should only enter into arrangements which involve the main residence as a last resort.

Following the introduction of pre-owned asset tax, a variation of the gift and loan scheme was devised for married couples. One party would sell his/her interest in the home to the other leaving the proceeds outstanding as a debt due which could then be given away, as with the original gift and loan scheme. The reason why this succeeded after 2004 where normal gift and loan arrangements did not succeed is because the pre-owned asset legislation contains an exemption where there is a disposal by one spouse to the other. Even so, it is now clear that HMRC will not accept that this device is any more effective than the existing gift and loan schemes which are the subject of the forthcoming tribunal hearing. Even if the tax payer wins at that hearing and there is no further appeal, tax payers should still bear firmly in mind that HMRC may at any time introduce further legislation to prevent variations of the gift and loan scheme from successfully avoiding tax liabilities.

The possibilities for those who are still minded to consider inheritance tax mitigation in relation to the main residence, not withstanding this warning, are as follows:

The homeowner can borrow on the security of the property and give away the borrowed cash to the next generation. This has the very significant draw-back that the borrowing will normally incur unacceptable interest charges. If, however, the release of cash from the value in the home is under a commercial equity release scheme, the terms might be more acceptable, although inevitably the finance company will sooner or later want an adequate return out of the whole arrangement.
The homeowner may give cash funds to the next generation to enable them to buy an interest in his/her main residence. This avoids the inheritance tax rules relating to gifts where the donor reserves a benefit in what he/she gives away, because in broad terms those rules do not apply to gifts of cash. Even so, the gift and the purchase of the interest in the property should not be closely connected and it must be accepted that the pre-owned asset income tax charge will apply each year, less the taxable benefit is below the exempt threshold of £5,000 per annum.
The homeowner can grant a lease of the property which takes effect from the time of his/her death, this being known as a "reversionary lease". The existence of this lease will heavily devalue the property at the time of death, thus securing the saving in inheritance tax. An essential feature of the case must be that the freehold in the home has been owned for at least seven years when the idea is implemented. Once again it must be accepted that the pre-owned asset legislation will apply, although in the early years after the scheme is set up, it is likely that there will be no charge as the de minimis exemption of £5,000 in taxable benefit will normally be applicable. It should be noted that HMRC has wavered in its view about these schemes, although leading tax counsel advise that they should succeed.

Only a brief outline of the various schemes is set out above and it should be noted that this is not a complete analysis of them. Some of the schemes incur liability to stamp duty land tax, and there may be capital gains tax complications which will erode or compromise the possible inheritance tax saving. Also, of course, where there is a gift of asset, the donor must survive for seven years in order to achieve the anticipated saving inheritance tax. The only inheritance tax scheme in relation to the main residence which HMRC accepts the validity of, and in fact it is provided for in the relevant legislation, is a co-ownership arrangement. This applies where, for example, parents and adult children all live together in one property. The parents may put the property into the joint names of themselves and their children under a co-ownership arrangement as tenants in common. This type of arrangement is not within the inheritance tax reservation of benefit provisions nor within the pre-owned asset provisions. The only area of dispute with this arrangement is whether the co-ownership must be equal between all parties, or whether it is possible to retain only a small interest and for each child to have a substantially greater interest than is retained by the parents. The legislation does not require equal sharing, although HMRC claims that it is implicit in the relevant statutory provision.

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