By Louise Misiewicz
Are you worried about the mortgage interest relief cap and how it will affect your personal tax position?
Are you concerned about inheritance tax (IHT)?
You may want to transfer properties from your estate to your children but do not wish to pay Capital Gains Tax (CGT) and would like to avoid Inheritance Tax (IHT). Ordinarily, there will be a CGT liability if you wish to transfer a Buy To Let (BTL) property to your children. This is because HMRC deem that the market value of the property was received by the parent, even if the property was given away for free. CGT will be based on market value, less purchase price, less capitalised refurbishment costs.
The rate of CGT to be paid on BTL properties is 18% for basic rate tax payers and 28% for high rate tax payers after taking out their £11,100 CGT annual allowance.
We discussed how to minimise CGT by using a number of methods using a) Private Residency Relief PRR b) Enterprise Investment Schemes EIS and C) Incorporation relief (transferring assets into a limited company). Albeit these are sound CGT mitigation strategies there is an additional element that will help on transferring one BTL or a very small portfolio without CGT or IHT. You can do this by using a trust.
What is a Trust?
A Trust is a mechanism in which a property is held by the trustees for the benefit of someone else. We talked about Discretionary Trusts and Transferring assets to mitigate IHT using trusts in previous articles so we will not go into detail here. The one thing that these articles did not discuss was how to avoid CGT when transferring properties into a trust.
We will now focus on the subject of transferring a BTL property into a Trust whilst avoiding CGT and IHT. The piece of legislation that we will focus on is Section 260 of TCGA.
If the trustees pay, the rate of tax is 20% over and above the IHT allowance (£325,000 per person). If the settlor pays the Inheritance Tax instead of the trustee, this means there will be an increased loss from the settlor’s estate. These calculations are complex as can be seen on HMRC’s website and legislation pages. This is made a lot more complicated if transfers have been made in the past 7 years. Added to this is the additional IHT reliefs for gifts, weddings etc. For this reason alone we would ask you to seek specialist advice.
Download our tax efficient property investment guide for 2018 here
Why use this strategy?
You would transfer BTL properties into a trust and back to your adult child for the following reasons:
- Reduced income tax for the parent (especially if they are a high rate tax payer)
- Provides an income for the adult child
- Reduced the asset value of the parent for IHT purposes
Properties into trust and mortgages
It is very unlikely that the mortgage company will support the use of this tax avoidance strategy. As such you will need to ensure that all mortgages for the property is paid off and remain unencumbered upon the transfer.
Example of assets transferred into Trust with NO consideration paid
Lets now imagine that a father wishes to transfer an asset worth £450,000 to his adult child. He originally purchased the asset for £300,000. Ignoring CGT annual allowances he has a gain of £150,000 and will be taxed at 28% as he is a high rate tax payer. The CGT liability would ordinarily be £42,000.
By gifting the property with no consideration the CGT liability of £42,000 is now ignored.
Transfer of assets to minors
You need to be aware that the above strategy will not work if you are transferring assets to a minor. This is because any assets passed from parent to a minor remains an asset of their estate and any income derived from the asset is treated as income for the parent. As you can see that this only works whereby you transfer assets to an adult child.
IHT liabilities & Exit charges by transferring assets into trust and then onto the child
It is essential that you wait at least three months before you transfer an asset within a trust to your child; and transfer the property out of the trust within 3 months of the 10 year anniversary of the trust to ensure that CGT holdover relief is available.
Once you decide to transfer the asset from the trust to your child you will need to consider exit charges. The exit charge is another form of tax over and above the 20% paid. The value of the asset is the net asset value of the property.
This is a little more complicated so we will use an example:
- £450,000 asset value
- £325,000 less the nil band rate for IHT purposes
- £125,000 asset value chargeable to IHT on transfer into trust
- £25,000 IHT paid (£125,000 times by the 20% IHT rate)
We are now able to calculate the exit charge rate as follows:
- £25,000 IHT liability paid on transfer
- 5.56% being the notional tax paid of £25,000 divided by the asset value of £450,000
- 1.332% charge rate being 5.55% times by 30%, times by 32 being the number of complete quarters of the trust set up, divided by 40 (10 year anniversary of the trust being created)
- £6,000 being the exit charge of 1.332% times by the asset value of £450,000
As you can see that the total IHT liability on transferring an asset of £450,000 into trust is:
- £25,000 IHT on transferring the asset into trust
- £6,000 IHT exit charge
The total tax on transferring a £450,000 asset is £31,000. This is just 6.89% of the asset value.
Please note that any additional transfers would be taxable without the £325,000 lifetime allowance as it has already been used up.
There would be no IHT liabilities if the asset was worth less than the £325,000 IHT allowance, provided that no previous transfers had been made.
CGT for the child on disposal of the asset
Please be mindful that the above strategy is only deferring the CGT liability. The above example shows an asset transfer of £450,000 but because the father used holdover relief the deemed cost to the son is the original purchase price of £300,000.
Remember that there are many ways of minimising CGT using a number of methods using a) Private Residency Relief PRR b) Enterprise Investment Schemes EIS and C) Incorporation relief (transferring assets into a limited company).
3% SDLT surcharge considerations
Your child would have to pay the 3% SDLT surcharge if the child does not already have a home and you transfer the property to them out of trust. This is because they have more than one property as shown in our previous article
It is therefore important that you plan ahead before using this strategy as they may not be able to buy their own home without paying this additional tax.
Step by step guide to implement this strategy
It is one thing to understand the theory but it is another to implement the above successfully. That is why we have created a step by step guide:
- Identify a property that has a value of less than £325,000 (which is below the IHT threshold). Anything above this value will be subject to IHT at 20% (if paid by the settlor)
- Transfer the property into a Trust (mortgage free) and calculate the IHT liability
- After three months of the trust being created transfer the property from the trust to the adult child and calculate the IHT exit charge
- Complete and submit the IHT100 form within 12 months of the said transfer
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