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15 March 2011
A husband and wife own a valuable property. They intend to sell a share to one son who will live there with them, leaving the rest of the property to their children equally on their death
Our client and wife jointly own a valuable property and hope to live out their days in it, but are concerned about the inheritance tax impact of doing so and wish to bring forward, if they can, their intention to leave their home to their four children equally on their eventual passing.
It happens that a bachelor son has recently come in to about £200,000 which he needs to invest. At present, he lives in a rented flat close to the family home and has suggested that he uses most of the money to purchase a share in the family home from his parents.
About the same time that he moves into the home he would elect that his portion would be treated as his main residence for future capital gains tax purposes.
It is further proposed that, following the disposal, the parents give the part-sale proceeds to the children in the hope that one or other of them will survive the necessary seven years.
There are several aspects of this proposal from our client with which we are not entirely comfortable. First, is there a danger in including this son in the subsequent gift of capital since it is a return of part of his purchase price?
Secondly, how fastidious must the calculation of the value disposed of be, should it turn out that the fraction of the house sold to him represents more than the agreed sale price?
Thirdly, there is a prospect that within the next few years he might decide to move in with his girlfriend who lives some distance away.
Could this prejudice the continuation of the main residence capital gains tax exemption for his share in the family home in the course of time?
Taxation readers’ views would be very welcome.
Query 17,761 – Ignoramus
Reply from Terry ‘Lacuna’ Jordan, BKL Tax
I have a number of concerns about the client’s proposal and wonder whether matters might be approached in a different way.
Were it not for the fact that he might later leave the family home the parents might have taken advantage of the ‘sharing’ provisions in FA 1986, s 102B(4) to transfer a share in the property to their bachelor son.
Provided he met no more than his share of the running costs such a transfer would be a potentially exempt transfer (PET), not a gift with reservation of benefit and would be outside the income tax charge on pre-owned assets (POAT).
The son could, as suggested, elect that property as his main residence and would benefit from relief on the last three-year period of his ownership of his flat and perhaps also from lettings relief.
It would, however, be necessary for the parents to pay rent to the son in respect of his share were he later to cease to occupy the property during the parents’ lifetimes, otherwise they would be deemed to have resumed a benefit in the proportion gifted.
The proposed purchase by the son would incur a liability to stamp duty land tax of £2,000 and it would be provocative for the parents to return part of the purchase price to him as a gift. It would be necessary to consider whether the parents would be within the POAT charge as this would be a form of ‘equity release’ arrangement.
The exclusion in FA 2004, Sch 15 para 10(1)(a) applies only so long as the former owner has disposed of the entire interest in the property, apart from the right of occupation, and theCharge to Income Tax by Reference to Enjoyment of Property Previously Owned Regulations SI 2005 No 724 extend the exemption for all sales at arm’s length that involved the whole or part of the vendor’s interest in the asset and to any part sale, even if not at arm’s length, so long as made before 7 March 2005 and on arm’s length terms.
Unless and until the son marries his girlfriend they could each have a main residence and, provided the family home remained available to him, it could remain his main residence for capital gains tax purposes.
It might be that he could continue to ‘occupy’ the property, as well as his girlfriend’s, thereby obviating the need for the parents to pay rent.
Reply from Taxplanet
The proposals described are unlikely to cause any difficulty for capital gains tax purposes, but they could cause problems in relation to the stated purpose of reducing the inheritance tax due following the death of both parents. The pre-owned assets tax charge (POAT) may also apply.
For capital gains tax purposes if the parents transfer an undivided fractional share in the home that they live in to a child the transfer is a disposal of that share.
As the parties are connected persons within the definition at TCGA 1992, s 18 the disposal is treated as one made at market value. The price paid by the son is therefore irrelevant in terms of calculating the gain on the interest transferred.
If the son at any time during the period that he owns his interest in the property occupies the property as his only or main residence and then disposes of the property part of the gain will be exempt.
The exempt part is a fraction of the total gain where the aggregate of his actual periods of occupation, other periods deemed to be periods of occupation following TCGA 1992, s 223, and the last 36 months of his period of ownership in any case, will make up the numerator.
The denominator is the total period of ownership. For the fraction to apply to the whole of the gain the son and the parents should be occupying the whole house without any physical division of the property into separate self contained parts.
If the house is split into separate parts that each occupies independently the exemption would only apply to the gain arising on the self contained part that the son occupies.
For IHT purposes the value of the share purchased will be important since if the share acquired by the son is worth more than the £200,000 that he pays for it the value in excess of the purchase price will constitute a gift from the parents to the son.
If the parents continue to occupy the property following that gift, other than for full consideration, then on the face of it there is a gift with reservation and the gift is ineffective for inheritance tax purposes (FA 1986, s 102A).
The reservation may be avoided if the parents and the son occupy the house as joint owners and they share the costs of the upkeep of the property in proportion to their respective shares in the property, and the running costs in proportion to their respective periods of occupation, or if the parents pay more than their fair share (FA 1986, s 102B(4)).
The reservation will come back if the son ceases to live in the property at any time in the future which the question suggests that he might. The only way the parents could avoid the reservation then would be to pay a full market rent for occupying the fractional share in the property that has been gifted to the son some years earlier.
Quite how this might be calculated to a standard that would satisfy HMRC is not known since there is no market in rental values for undivided shares in properties. A safe option would be for the parents to pay a full market rent for the whole of the property, assuming that they had sufficient income to enable them to do that.
POAT (FA 2004, Sch 15) may also prove to be a problem. Any disposal of land which the disponer continues to occupy will in principle be caught by Sch 15 unless it comes within a specific exemption. A part sale of a property is not protected by any exclusion or exemption, and even if the son pays the full open market price for the share he acquires that is no help.
This was made clear in exchanges of correspondence between HMRC and representative bodies on the subject of ‘family’ equity release schemes following the introduction of the tax, and by the introduction of regulations following the Ministerial Statement on March 7 2005.
The only way to avoid the POAT charge would be for the parents to make an annual payment to the son equal in amount to the appropriate rental value of the interest in the house that they have sold to him. In the case of this tax, unlike for inheritance tax purposes, a statutory formula for calculating the appropriate rental value can be found at FA 2004 Sch 15 para 4(2).
As for inheritance tax purposes, it will be necessary to consider whether the £200,000 paid was the correct price for the share acquired by the son. The POAT will apply to the share sold only.
The inheritance tax provisions will continue to apply to any share gifted, and for periods when the provisions apply, even where there is no charge because of the FA 1986, s 102B(4) let out, the POAT charge cannot apply.
Reply from Ji Hao Zhang
The disposal to the son will be a typical transaction in which connected persons are involved and therefore it is deemed to be carried out at market value.
The residential property does not qualify as a relevant business asset and therefore TCGA 1992, s 165 relief is not available. Neither is it eligible for TCGA 1992, s 260 relief, as there is no inheritance tax payable as a result of the transaction.
Hopefully, the property has been the couple’s main residence for the entire period of ownership and therefore main residence relief should be due and there will be no capital gains tax payable on any capital gains.
Dependent upon whether the son is a first time buyer, there may be stamp duty land tax (SDLT) due. If he is not, the purchase price is greater than the £125,000 threshold and will be subject to 1% SDLT.
If one-quarter of the proceeds are to be gifted back to the son, this will be a potentially exempt transfer (PET), which is not subject to inheritance tax if the parents survive seven years from the date of the gift (there is, of course, taper relief available should they die more than three years after the gift).
Whether there is any danger in gifting back the £50,000 will depend on whether the parents can derive benefits in any shape or form from the cash gift.
If they can, the gift with reservation of benefits (GWR) provisions do not apply as there is no tracing rule for cash gifts. However, they will instead be subject to the pre-owned assets (POA) rules.
It therefore makes sense that after the son moves into the property, the parents pay off any domestic bills either in full or in proportion to their share of interests in the property. This should enable them to rebut any claim by HMRC that income tax is due.
There is nowhere in the query mentioning what the parents intend to do with the other three-quarters of the property.
Assuming that the disposal proceeds of £200,000 represent one-quarter of the current market value of the property, the remaining interests in the property are then worth approximately £600,000, just within the couple’s combined nil-rate bands (for tax year 2010/11 and ignoring other factors, such as, the value of other assets they hold and any chargeable lifetime transfers they may make in the seven years before death).
Whether this will continue to be the case on the date of either death will depend on whether the increase in the nil-rate bands can keep pace with the appreciation of the property value over the years.
There may be other ways in which the parents may exploit to reduce the value of their death estates’
First, to gift the whole property to children. Gifting away an asset that is likely to appreciate greatly in value is a simple but very effective way, as the value of a PET stays the same during the seven-year period.
Again, this will be a disposal to connected persons for capital gains tax purposes. However, as mentioned above, there will be no tax payable on any gains as main residence relief is likely to be available.
No SDLT is payable either because there are no considerations change hands. For inheritance tax purposes, the gifts are PETs and will fall out of the tax net completely once the parents survive seven years from the date of gift.
The potential problem here is that the GWR rules do apply should the parents continue to benefit from the property to the exclusion of the kids. They have two options to deal with it.
They can opt to do nothing and let the proportions of the property be included in their death estates. This obviously is not what they want in the first place.
Or, they can pay a full market rent to the kids to avoid the GWR treatment. Ignoramus will of course have to consider a few points when help with the decision making:
- The attitude of the parents towards paying rent for living in a property which they may still regard as their own after gifting it away.
- How much the full commercial rent will be and the age and health status of the parents, which will determine whether it is worth opting for this route.
- The income level of the children.
- Whether the parents are capital rich, but income insufficient.
Secondly, to gift to children but retain some interests in the property as co-owners. The parents may consider gifting only part of the property and bringing in the kids as joint owners.
As mentioned above, no capital gains tax, inheritance tax or SDLT is immediately payable. Upon death, their interests in the property will be passed to other co-owners instead of their executors (as joint tenants).
This is based on the assumption that the property is big enough to accommodate all and it is practical for all children to move into the property. As long as the parents pay in full or share the bills, there should not be problems with GWR rules.
It may be too optimistic to make such assumption, as the kids’ personal circumstances may prevent them from doing so. As a result, proportions of the property (represent the number of children who are not able to move in) may still be subject to the GWR provisions, assuming that paying commercial rent is not opted for.
However, this may still help greatly in reducing the value of the property that is to be included in the death estate to within the couple’s combined nil-rate bands.
The other point that is worth noting is that the legislation (FA 1986, s 102B(4)) does not mention to what extent the co-owners must occupy the property. In other words, provided there is some degree of co-occupation, the GWR rules may be avoided.
This relates to Ignoramus’ third point in his query. When the son moves out to live with his girlfriend, his proportion of interest in the property (gifted by the parents) may be in danger of being subject to GWR rules. He of course does not need to worry too much about his main residence relief, provided he lodges his main residence election in good time with his local tax office.
