A New Way to Avoid Inheritance Tax

With the freeze on the Nil Rate Band until 2015, Inheritance Tax (IHT) is back on the agenda for many people. If you have heard of Business Property Relief (BPR) but do not own a business you would be forgiven for assuming it wasn't something you could use. In fact BPR can be used to mitigate IHT by people that do not own a business.

BPR was introduced by the Treasury to enable business owners to pass on their family firms without paying IHT on any assets held for a minimum of two years. However, investors in assets such as portfolios of Alternative Investment Market (AIM) stocks and the Enterprise Investment Scheme (EIS) can also qualify for BPR.

Q: How much risk is involved in BPR assets?
A: Investing in AIM shares typically involves more risk than investing in quoted shares. BPR qualifying companies have been created that use less risky business trades that are backed by insurance and which focus on preserving your capital rather than growing it, which can make them less volatile than other AIM businesses, but they are still considered to be high risk.

Q: I thought ISAs the most tax efficient investment?
Once you have moved from accumulating assets to protecting them it may be worth moving your ISAs to BPR investments to avoid IHT. The reason for this is that whilst ISAs are free of Income Tax and Capital Gains Tax they are not free of IHT. However, tax is not the only consideration and you should also consider the potential differences in liquidity and risk.

Q: What happens if my spouse dies before the 2 year qualifying period ends?
A: Passing BPR investments from one spouse to another does not restart the two year clock, so if a husband owned them for a year and died and left them to his wife, and she died a year later, the assets would still be IHT exempt as long as they remain in BPR qualifying assets.

Q: I am in poor health or in my nineties. Will underwriting will be a problem?
A: There is no underwriting required so it can be used regardless of your age or health situation.

Q: Is it too late if I have already sold my business?
A: To qualify for BPR you must have owned qualifying assets for 2 years in the last 5 years and own them at your death, but the assets do not have to be the same as long as they all qualified. So if you sold a business or AIM shares 2 years ago which you had owned for 2 years, you can place the proceeds in another BPR asset now, and they will be IHT exempt immediately.

Q: Can I avoid Capital Gains Tax (CGT) as well as IHT?
A: If you have paid CGT on the sale of a business or other asset within the last 3 years, the proceeds can be reinvested into EIS assets so the CGT can be reclaimed and not paid until the EIS is sold. This means if the EIS is held until death, the CGT will never have to be paid as the liability dies with you. EIS investments can also benefit from 2 year BPR IHT exemption.

Q: Can a Power of Attorney (POA) use BPR?
A: BPR investments have to be held in the owner's name, so there is no relinquishing of assets which makes them suitable for POAs.

Q: Can BPR help reduce the IHT payable on my home?
A: If you have capital tied up in your home above the Nil Rate Band value, you can use an equity release mortgage to release cash to invest in a BPR asset. However this could have significant downsides if the value of your BPR investment was to fall compared with your outstanding debt.

Q: What if I have previously invested in a trust to reduce my IHT?
A: If you have invested in a loan trust within the last 10 years it is possible that you will have had little or no investment growth and therefore little or no IHT saving. One option you have is to cancel the loan trust and invest the proceeds into BPR assets.

Q: What pitfalls should I watch out for?
A: AIM shares are not generally as liquid as large company shares so you may not be able to realise your investment as quickly as you would with a mainstream investment. The schemes that focus on capital preservation tend to invest in one company and as such do not provide diversification between different shares which makes them high risk compared with a diversified portfolio of shares.

Summary

Whilst BPR assets do potentially involve high level of risk and less liquidity than mainstream investments; to some extent they do have the potential to allow you to have your cake and eat it by saving IHT whilst at the same time giving you access to your money and doing so without the usual risk level of AIM shares. They are certainly worth a closer investigation.

How to Avoid Capital Gains Tax and Inheritance Tax on the Transfer of Property to Children

Capital gains tax. Lets look first at the capital gains tax position of a transfer of property. On the assumption that the parent is UK resident and domiciled any transfer of property will be subject to UK capital gains tax. You'll therefore need to calculate the gain arising and crucially to consider the offset of reliefs to reduce this gain.

It's worth noting that the residence of the child is irrelevant for UK tax purposes. Therefore, even if they are tax resident in a tax haven, the UK resident and domiciled parent will still have to consider their own capital gains tax position.

As parents are classed as 'connected' with their children for capital gains tax purposes, any transfer from the parents to the child is treated as a market value transfer. As such, even though the children don't pay any proceeds to the parent for the property when calculating the capital gain it is the market value of the property that needs to be considered.

The gain will therefore represent the uplift in value from the date of acquisition or probate value to the market value at the date of transfer. Note if the property was acquired before March 1982 there are special provisions that can apply to deem the cost to be the market value at March 1982.

What reliefs are offset?

It is the reliefs that can significantly reduce any capital gain. The main reliefs that any parent would be looking to consider to reduce the capital gain would be:

Indexation relief if the property was acquired before April 1998. This adjusts the cost (or probate value) for the effects of inflation up until April 1998
Taper relief. You'll need to consider what type of property it is. If you're looking at transferring a residential property it will nearly always be a non business asset. This will reduce the capital gain by up to 40% if you've owned it for at least ten years. Ownership of less than this will qualify for a reduced rate of taper relief (eg ownership of 5 years will qualify for taper relief of 15%) dependent on the period of ownership above three years. So three years ownership qualifies for 5% relief, four years for 10% etc.If however the property is either a Furnished holiday let or is used for the purposes of a trade (eg it is a shop, office or factory that is transferred and it has been used by a trader) it will qualify for at least some business asset taper relief. This can be very beneficial as maximum business asset taper relief can reduce the gain by 75%. So if you're looking at transferring a business asset the gain is likely to be significantly reduced.




Gift relief. If a property is used for the purposes of the parents trade or their trading company they may be able to claim gift relief. This allows a deferral of the gain arising (provided the child agrees!) and allows the parent to pass the property to the child free of capital gains tax. The future disposal of the property by the child would then crystallise the deferred capital gain.
Annual exemption. If the parents own the property jointly the humble annual capital gains tax exemption should not be forgotten. It allows each individual to exempt (currently) £9,200 of any gains from capital gains tax in each tax year. So if the parents had no other capital gains, the annual exemption could ensure that a gain of around £18,400 was fully exempt from tax.
Other capital gains tax exemptions such as rollover relief and the EIS deferral relief would not apply as there are no disposal proceeds!

Non UK resident parents

If the parents are non UK resident and non UK ordinarily resident they can transfer UK property to their children free of CGT subject to two caveats.

Firstly this doesn't apply to any property that is used for the purposes of a UK trade. Therefore if you run a UK business and use the property for that business you can't claim the CGT exemption even if you're non UK resident.
Secondly if you own the property at the date you leave the UK you'll need to ensure that you remain non UK resident for at least five complete tax years to avoid UK capital gains tax. If you come back before the expiry of five tax years the capital gain will be charged in the tax year of your return.

Non UK domiciled parents

If the parents are UK resident but non UK domiciled they can transfer overseas property to their children free of capital gains tax. This applies irrespective of the residence and domicile status of the children. If the property was UK property this exemption would not be available and the capital gain would simply be charged as usual.

Form of transfer

It's important to note that the transfer needs to be of the beneficial interest in the property. This does not necessarily tie in with the legal interest.

This means that if you wanted to transfer the property to your children you could transfer just the beneficial interest and retain the legal interest, or transfer the legal and beneficial interest together. If you transferred just the legal interest and retained the beneficial interest there would be no effective transfer for Capital Gains purposes and you'd still be treated as the owner of the property in law.

It can sometimes be easier to just draft a deed of gift and arrange for the beneficial interest to be transferred.

Inheritance taxAny transfer at undervalue from the parents to the children will usually be a potentially exempt transfer ('PET') for inheritance tax purposes. Again I'm assuming initially that the parents are UK resident and domiciled.

So in the case of a gift of the property the full market value of the property will be treated as a PET. If the children were to pay some of the value to the parents it would only be the difference between the market value and the amount paid that would be a PET.

With a PET there is no immediate Inheritance tax charge on the parents and provided they survive for at least seven years from the date of the transfer the amount gifted would be excluded from their estates for inheritance tax purposes.

Note that the residence and domicile status of the children is again irrelevant.

Non Resident parents

Non UK resident parents would have no impact on the Inheritance tax position, and the transfer would still be a PET for inheritance tax purposes.

Non Domiciled parents

If the parents are non UK domiciled they can transfer overseas property to their children free of any Inheritance tax implications -- irrespective of whether they survive for seven years or not. UK property is unaffected (unless it's owned via an offshore company) and non UK domiciled parents would still be classed as making a PET on the transfer of UK property to their children.

Gift with reservation of benefit rules

If the parents make a gift to the children and retain a benefit in the property transferred there are special anti avoidance rules than can ensure that the property is not classed as a PET for Inheritance tax purposes.

Instead the property remains within their estate for Inheritance tax purposes until the benefit ceases. This could apply for instance if the parents continue to live in the property, of if they continue to benefit from the rental income obtained from the property. One way that they could get around having the property still in their estate would be to pay the children a market rate for the benefit that they get from the property (eg market rental).

Stamp duty Land TaxUnless the property is mortgaged the parents should be able to transfer the property to the children free of stamp duty providing it is a genuine gift. If there was any proceeds payable to the parents this would then be classed as 'chargeable consideration' for stamp duty purposes and a stamp duty charge would need to be calculated.

Note that if there is a mortgage or any other form of debt that is transferred from parents to the children with the property this would also be classed as 'consideration' for the purposes of stamp duty.

Inside the Inheritance Tax Mess

I think by now most of you have heard that there's no inheritance tax or estate tax this year. So if you're planning on passing away anytime soon, this would be a good year to do it - at least from an estate planning point of view. I'm kidding, of course. But in case you decide to take me seriously, you should know there's even a gotcha buried in this "giveaway" law.

The little gotcha comes in the form of increased capital gains tax. Here's how the gotcha is going to getcha. Last year, if you inherited an asset, your tax basis/cost basis was the value of that asset on the date you inherited the asset. So if you inherited a stock from a relative or parent that they bought 30 years ago for $50,000, even if the stock is now worth $400,000, you would not pay taxes on the $350,000 profit. This is because your stepped up basis was the market value the date you inherited the property. This was true regardless of what the asset was - it could be real estate, stocks, bonds, mutual funds or whatever the case may be.

Well the rules are different this year. Now, when you inherit property or assets (stocks, bonds, mutual funds, real estate) they are not given the stepped up tax basis. Which is going to put a whole lot more people in the position where they'll have to pay capital gains tax.

So it's kind of a good news/bad news scenario. The good news is you don't have the estate tax, while the bad news is you'll possibly have to pay capital gains tax. I say possibly because there are some exemptions or limits - the first $1,300,000 of assets are not subject to this capital gains tax, but anything above that is. There also is a provision for people who are inheriting a small business, and also for surviving spouses.

I'm honestly not sure how this is going to play out the rest of the year - everything that we're reading seems to suggest that at some point this year, Congress is eventually going to get around to fixing the problem. They do recognize that this capital gains situation is a mess, and the consensus is that this year, and if not, definitely next year, the estate tax exemption will be changed.

And what a mess it is. Last year everybody had a $3.5 million exemption, or $7 million for a couple. This year there is no estate tax, regardless of the size of your estate. And then next year it will be a $1 million dollar exemption, or $2 million for a couple, assuming estate planning is properly done. There just doesn't seem to be any logic behind any of this. From what I have heard, when the law is fixed they may make it retroactive to the beginning of this year. Stay tuned for when we know of an actual, definite law that's in place - when there is we will let everyone know about it and the impact it might have on your personal finances.

Copyright (c) 2010 Brian Fricke