For many the family home is the most valuable asset that they own. It is also often the last asset to be considered when planning for inheritance tax (IHT). For owners of landed estates, the family home is often the focal point for family, community and the business activities of the estate itself, and has perhaps been so for many generations. This doesn't make planning impossible, but does mean that a myriad of practical and tax-related issues must be considered before anything is done.
Entering into a gift and leaseback arrangement is not right for everyone, but when done correctly it allows an individual to continue to live in their family home whilst ensuring that the property is removed from their estate for IHT purposes. For landowners, this must be done carefully, ensuring that the tax treatment of both the house itself and the surrounding assets (e.g. agricultural and commercial land) is not compromised.
What is a gift and leaseback arrangement?
An individual (or couple) makes an outright gift of their property to someone else (often a child or children) or into a trust, with the recipient leasing that property back to the original owner(s) at an agreed market rent.
If the property is given outright to an individual, this constitutes a potentially exempt transfer for IHT purposes. There is no IHT payable immediately upon transfer, or on the original owner's death if they survive making the gift by seven years. A gift into trust will generally entail an immediate IHT charge of 20% of the property's market value to the extent it exceeds the available nil rate band (currently a maximum of £325,000 for a sole owner and £650,000 for a couple), but otherwise the position is the same.
The gift and leaseback has a two-fold impact on the value of an individual's estate. Firstly, the continued rental payments will gradually reduce the value of the estate and subsequent IHT liability. Secondly, provided that an individual survives seven years from the date that they gave the property away, the value of the property will be removed from the estate in its entirety. Taper relief is available where a donor does not survive seven years, so the IHT benefits generally start to accrue three years after the gift.
A gift into trust has an added benefit as the property is owned by the trustees rather than by the recipient outright, so there is an additional layer of protection in the event of a divorce or bankruptcy in the family. If, like many larger farms and landed estates, the surrounding land is already held within a trust structure, there could be practical benefits of having the ownership in the same place, such as by providing a single entity for the employment of estate workers and central management of maintenance arrangements.
What are the pitfalls?
- The most common failing is where the gift is caught by the Gift with Reservation of Benefit (GROB) rules, and is therefore ineffective for IHT purposes. A GROB can arise in a number of circumstances, most obviously where someone gives away an asset but still retains the use and enjoyment of it without the payment of full consideration.
It is therefore essential that when an individual gives a property away, they pay a market rent to the new owner. This has to be negotiated on arms-length terms, fully documented and supported by appropriate valuations and professional advice as to the level of rent paid. If the donor continues to live in the property without paying a full market rent, the "seven year clock" for IHT purposes does not start to run. This of course makes it necessary to consider, from a cash flow perspective, whether the person paying rent has enough cash reserves or income to continue paying rent until their death. For this reason, a gift and leaseback is often most suited to being a relatively short term rather than long term arrangement.
- The individual needs to continue to pay a market rent throughout, not just for 7 years. So the rent needs to be reviewed every 2 to 3 years. If it isn't, the GROB rules can bring the property back into the estate of the donor, however long ago the original gift.
- The gift of the property will be treated as a disposal for capital gains tax (CGT) purposes. Where the property in question has always been the owner's main residence, it would normally benefit from principal private residence (PPR) relief for CGT purposes, in which case no CGT would be payable. A gift into trust may be able to take advantage of holdover relief, which enables CGT to be deferred, if PPR is not available. However, where a property has several units within it (e.g. flats and/or cottages) or extensive grounds, the PPR position must be carefully considered to make sure that a CGT charge will not arise. If a second home is owned, then care should be taken to be clear which property will attract PPR.
- For farms and estates, it is critical to consider if the gift will adversely affect the treatment of the surrounding land for IHT purposes. For example, if the property is the central hub for farming operations, it could be relievable from IHT in any event under Agricultural Property Relief provisions. The most suitable properties for this planning will probably be those which are in separate ownership from the surrounding land and/or where business activities are carried out from a different location e.g. the estate office. Each situation will be different so the particular circumstances must be carefully considered.
- The grant of the lease may also incur stamp duty land tax (SDLT), depending on the level of rent and term of the lease. Usually however, the SDLT is not significant by comparison to the potential tax savings.
- The rent, net of expenses (such as insurance, maintenance and repairs) will be subject to income tax in the hands of the recipient. Depending on the recipient's own tax position, this may lead to the rental income suffering tax at up to 45%.
Who needs to be involved?
Due to the fact that the transaction needs to be made at arm's length, it is important to seek expert advice on the various aspects of the transaction. This includes, but is not limited to, surveyors or land agents to ensure that a market rent is agreed, private client solicitors / tax advisors to advise on the estate planning and tax aspects and property solicitors to deal with the transfer of the property and subsequent leaseback.
Chattels
Gift and leaseback arrangements do not only apply to bricks and mortar, but can also be used in relation to family heirlooms and valuable chattels. The same principles apply and a market rent for the chattels must be negotiated. HMRC do scrutinize chattels arrangements carefully, as there is often no "real world market" for the chattels, so great care needs to be taken.
Conclusion
Gift and leaseback arrangements can be a very effective mechanism for reducing your IHT liability if set up correctly at the outset and kept under regular review. The costs of implementing such an arrangement are usually modest in comparison to the potential tax savings. This planning is generally accepted by HMRC, provided that the arrangement is carefully planned, executed and kept under review.
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