Saving inheritance tax on the family home

The threat of a large inheritance tax (IHT) bill means that it is more important than ever to ensure that tax planning is up to date when it comes to the family home.

Inheritance tax (IHT) was historically only paid by the wealthiest members of the British population and even then, it is said, that those were the ones that hadn’t taken good tax advice!

Seen as a ‘voluntary tax’, IHT levies a 40% charge on everything we have at our death above the nil rate band, which is currently £325,000 and is frozen at this level until the end of the 2025/26 tax year. The issue is that the price of the family home is not frozen. In fact, quite the opposite.

Although there has been a lot of outrage recently about the frozen nil rate band, which was announced in the budget of 2021, in reality, the nil rate band has been frozen since the 2009/10 tax year. That’s nearly 12 years of cold stagnation.

The housing market on the other hand has increased vociferously. According to the office for national statistics, in 2009, the average price of a home in Great Britain was £227,000. In 2021 (the latest figures at the time of writing) the corresponding price was £327,000.

Not only is this a whopping 44% increase in the value of the house while the nil rate band stayed frozen, but the average price of a home in the UK now exceeds the nil rate band.

This means that more and more taxpayers – and not just the wealthiest members of the population – will be suffering IHT on their death estates. The upshot of this is that more and more clients are requiring solid advice about what can be done.

Could it be exempt?

There are very few assets that are exempt in the death estate and the family home is certainly not one of them. If the home is a farmhouse or a farm cottage, IHT agricultural property relief (APR) could be possible.

APR requires a working farm held for the requisite period, and for the farmer to live in the house, making all the decisions about the farm in the farmhouse and treating the home as the hub of the farm. The home would also need to be character appropriate. Likewise with farm cottages.

Although they too are residential properties, to satisfy the conditions of APR, they need to be inhabited by farm workers or their widows/widowers to satisfy the conditions of APR. Finally, even if the dwellings comply with the conditions, APR will only cover the agricultural value. This is the value on the assumption that the home is never used as anything else but for the purposes of agriculture in perpetuity.

Could it be gifted in life?

Most tax advisors are well aware of the gift with reservation of benefit rules, which prevent a donor having their cake (home) and eating it too (living in it). If benefit is retained the house, like a boomerang, the value goes straight back into the estate the donor tried to remove it from.

If the home is to be gifted (usually to the children) and the taxpayer wishes to ensure that the boomerang does not come back, they will need to retain no benefit from it.

This can be achieved in two ways:

(1) by actually receiving no benefit; or

(2) by paying for the benefit, which offsets the benefit received.

Receiving no benefit from the house would be achieved by the donor moving out of the home completely and being ‘virtually excluded’ from future benefit. HMRC state in their manual at IHTM14333 that this means the donor can stay no more than two weeks a year in the previously owned house in the absence of the donee or less than a month if staying with the donee in attendance to be virtually excluded from benefit.

If the donor wished to visit socially or needed to convalesce in the former home or attend for babysitting duties or other such household events, these visits would not challenge the ‘virtually excluded’ condition.

The problem with the donor moving out of their family home is that they really have given the cake away and they can only really snack on a crumb here and there, and certainly cannot eat it. And, they will need to find and finance somewhere else to live.

The other method of preventing a gift with reservation of benefit boomerang is for the donor to pay a market rent for the use of the home. The rent really must be paid and it really must be the going rate. The gift with reservation of benefit rules do not pivot on materiality and it is a cliff edge relief.

If a benefit is retained, unless it renders the donor ‘virtually excluded’ from benefit, the provisions will bite. Often, the donor does not wish to pay for rent on a property for which they psychologically feel is theirs, notwithstanding that they have ‘given it away’.

There is, however, one way of gifting a part of the family home where the donor can still retain a benefit. This can be found in Finance Act 1986 s. 102B(4) , added in 1999. This section allows the donor to gift an undivided share of the property, which the donee and the donor thereafter share, without the donor suffering a gift with reservation of benefit.

The donor must ensure that there is no other reservation of benefit from the share disposed of. For example, if a mother gifted a half share of her house to her daughter and her daughter then lived in the home with her mother, the daughter can’t then pay for all the groceries and repairs as a way of saying ‘thank you’ for the half of the house gifted.

In this case, the mother would have then retained a benefit from the gift and the part of the family home gifted would boomerang back into the mother’s death estate faster than you can say didgeridoo.

The daughter does not have use the home as her only house; it simply needs to be one of her residences. She would however need to use it as a residence; have a room or rooms filled with her belongings; have keys; and have full access to the property and grounds whenever she chooses. In addition, she should have some mail directed there, register for council tax and have some of the utility bills in her name.

In other words, she would need to treat it as a family home even if she didn’t live in the dwelling full-time. HMRC does not see this as being disclosable under the DOTAS regulations for IHT if the percentage is a simple 50% gift. However, where proportions creep up towards a 90% gift, HMRC have indicated that this could be disclosable.

Other ideas?

The family home is covered by the residence nil rate band if it is closely inherited (ie, gifted to the deceased children, grandchildren and further issue, and their spouses) and, since the 2020/21 tax year, it has reached its current maximum at £175,000 per taxpayer. This too is frozen until the end of 2025/26.

If there is a previously deceased spouse, who did not leave a family home to the issue, the surviving spouse may have £350,000. This would – only just – cover the average value of a family home in the UK in 2021.

Further, if the deceased had downsized or sold their former property, a downsizing addition can also be calculated, as long as amounts up to that value are left closely inherited. Of course, the nil rate and transferable nil rate can also be used, so in theory there could be up to £1m of nil rate bands to use.

Life assurance policies can be written into trust to provide the funds that are required to pay the IHT if it falls above the residence and nil rate bands ensuring the home does not need to be sold by the legatees.

However, all the above ideas rely on being proactive and planning now, for what will happen to the family home at death. To ensure the boomerang doesn’t come back, clients should be advised to seek advice from a fully qualified tax professional, considering their own particular family situation when making their plans.

Contact us if you need advice on Inheritance Tax Planning