TORY MPs Sir Nicholas Winterton and his wife, Ann, were under fire last week
for putting their £700,000 second home into a family trust to escape
inheritance tax (IHT). However, accountants said the uproar shouldn’t put
ordinary taxpayers off using the same perk.
It wasn’t the trust or their attempt to avoid death duties that raised
eyebrows, but their use of MPs’ expenses to pay rent on the property – the
rental payments are essential to obtain the IHT exemption.
Even though ordinary taxpayers can’t dip into the parliamentary purse,
accountants said that following the Wintertons’ lead could save a typical
family tens of thousands of pounds.
George Bull, head of tax at accountant Baker Tilly, said: “Putting a second
home into trust can wipe out an inheritance-tax bill after just seven years,
provided a proper rent is paid. The government tried to throw a spanner in
the works by introducing charges on trusts but clients of ours still think
it is worthwhile. Many more families could be taking advantage.”
IHT is charged at 40% on the value of your estate over the nil-rate band
threshold – £300,000 for an individual and £600,000 for a married couple.
Once you factor in the family home and second homes, as well as savings and
investments, many people’s estates are now over this limit.
Giving away assets during your lifetime is a simple and legitimate way to take
the sting out of death duties. You can gift up to £3,000 a year and it is
immediately exempt from IHT – or you can hand over anything above this and
it will be exempt from IHT as long as you live for seven years.
However, it is not that simple with a property. If you handed your second
property to your children, it could trigger an immediate capital-gains-tax
(CGT) bill.
That’s why the Wintertons used a trust – transferring a property into a trust
means the CGT bill can be deferred until the property is sold, usually after
the parents’ death.
Putting the property into trust is not without complications, though. If it is
worth more than the nil-rate band when the transfer occurs, there is an
immediate IHT charge of 20% above the threshold, or £80,000 on a £1m
property. This assumes you are a couple owning the property jointly and
together have a £600,000 nil-rate band. The payment can be spread over 10
years in annual instalments of £8,000.
There is also a 6% IHT charge every 10 years, plus an exit charge of up to 6%
on proceeds above the threshold at that time.
However, it can still be worth doing. Peter Legg at the accountants Vantis
said: “It can still be cheaper than doing nothing and paying the full 40%
IHT charge. It depends on how long you live and how much you have to pay in
other costs.”
Parents also like the trust route because it gives them greater control. The
children can’t sell the home without the agreement of the trustees. Parents
can appoint themselves as trustees for extra peace of mind.
The biggest extra cost, once you have set up the trust, is that you must pay
rent to the trustees if you want to continue living in the property. That’s
why the arrangement works best for a second home rather than your main
residence. If you are living there all the time, the rent you have to pay
will soon mount up and quickly offset any IHT saving. But if it’s a second
home and you holiday there only occasionally, it can be worthwhile.
The tax authorities will check you have paid a fair market rent, so an estate
agent should confirm the going rate in your area in writing.
Technically, you pay the rent to the trustees but, in practice, you can pay it
straight to your children as beneficiaries – although they must pay income
tax on the rent they receive. You and your children need to review the rent
payments every few years.
Many children pay their parents back in effect by buying them holidays or
paying for improvements to the property. But if the Revenue discovers there
was an agreement to reimburse the parents, the scheme will fall foul of the
reservation of benefit rules wiping out the IHT saving.
So when might gifting work? Take a couple whose IHT-free allowances are used
up by other assets and have a holiday cottage, which they bought nearly five
years ago for £200,000.
The property is now worth £300,000 and they decide they want to pass it on to
their daughter tax-free. If they simply transferred ownership to her it
would trigger a capital gains tax bill of nearly £33,000 at the higher rate,
taking into account taper relief and the annual CGT allowance.
They don’t want to pay this, so transfer the property into a trust. Because
the gift is worth less than the nil-rate band threshold there are no
immediate taxes to pay.
The couple die 10 years after making the gift, meaning the house is exempt
from death duties. During the 10 years the house has gone up in value to
£400,000. If the rest of their estate uses up their nil-rate band
allowances, the daughter would save 40% of £400,000 or £160,000 in IHT.
There are other taxes to pay, though. The couple spent three months each year
at their holiday cottage and were required to pay £400 a week rent, just as
they would if they were hiring a cottage.
The bill for their annual three-month stay worked out at about £5,000 a year
or £50,000 over the 10 years, but this isn’t a real cost as it is paid
straight to their daughter.
If the daughter is a high-rate taxpayer she pays £20,000 income tax on the
rent. Giving away your home is particularly tax-effective if your children
are liable to lower or basic-rate income tax.
If the daughter decides to sell there will be a CGT bill on the £200,000
increase in value since the house was bought. After April 5 she will pay 18%
tax on the increase or £36,000, assuming she has used up her annual CGT
allowance elsewhere. Add in trust administration charges of £6,000 and
that’s a bill of £62,000 to escape £160,000 in IHT.
There are easier ways to escape death duties. Loan trusts are designed for
people who cannot give away assets as they need to live off the income, but
want future investment growth to be IHT-free. You make a payment to a trust,
which is treated as an interest-free loan to the trustees. The trust then
repays your loan capital in instalments, giving you an income. When you die,
any outstanding loan forms part of your estate, but all investment growth is
free from tax.
GUIDE TO SAVING THOUSANDS
- Suppose a couple have a holiday home worth £300,000.
- They transfer the property into a trust for their daughter. Because it is
worth less than their joint nil-rate bands of £600,000, there is no tax to
pay on the transfer.
- They must pay rent to the trust for the time they spend there. They holiday
for three months a year, paying £400 a week – or £5,000 a year.
- The couple die 10 years after making the gift into the trust. During that
period, the property has gone up in value to £400,000. If the rest of their
estate uses up their nil-rate band allowances, the daughter would save 40%
of £400,000 or £160,000 in IHT. Over that period, the daughter would pay
£20,000 in income tax on the rent, assuming she is a higher-rate payer –
compared with an IHT saving of £160,000.
- Trust charges would come to £6,000 and the daughter would also have to pay
capital-gains tax of £36,000, reducing the saving to £98,000.
TRUST MOVE TO PROTECT A SECOND HOME
JEFF and Christine Knott, from Horsforth, Leeds, are exactly the sort of
people who could benefit from putting property into trust.
The couple, who run a marketing business, have a second property which with
careful planning could be taken out of the inheritance tax net.
They are keen to find a way to avoid death duties which they regard as an
‘iniquitous tax on ordinary middle-class taxpayers’.
They have already started planning and have recently been advised to take out
a loan trust by their adviser at Skipton Financial Services.
Jeff, 66, said: ‘We’ve worked hard for what we have got and want
to pass on as much as we can to our two daughters and four grandchildren.’
