Pay as you grow

For many years, long-term property owners and investors have been able to mitigate the impact of inheritance tax by careful tax planning. However, proposed changes to the way trusts are taxed could leave many beneficiaries facing a much steeper bill. Liz Saleka explains.

Inheritance tax (IHT) can take huge chunks out of the value of a property or a property portfolio, regardless of whether or not the owner is a UK resident. By careful tax planning several years in advance, many investors have been able to mitigate the impact of IHT on their estates, making residential property an even more attractive long-term investment. Recent proposals in this year’s Budget do, however, indicate the possibility of less favourable tax treatment of trusts in the future, meaning those liable for IHT should seek further financial advice. After taking into account reliefs and exemptions, the inheritance tax rate payable on estates, worth more than the current threshold of £285,000, is 40 per cent. This means that, without careful tax planning, almost half of an estate, the bulk of which is likely to be in property (or properties), could end up in the hands of the taxman.

Inheritance tax planning is not just for the seriously rich. The continued rise in property prices means the value of residential property is more regularly crossing the £285,000 threshold. According to figures from HM Revenue & Customs, £2.4 billion was paid in inheritance tax on estates in the tax year 2001-2002, three times the inheritance tax paid in 1999. Recent data from Halifax Financial Services reveals that 2.4 million households in the UK now face a potential inheritance tax liability of 40 per cent. Although there are plans to incrementally raise the current nil rate band to £325,000 over the next four years, calls for a reform of IHT went largely unheeded in this year’s budget.

Plan the future now
When seeking to minimise the impact of IHT, it is vital you work out what assets you have and how much they are worth, then plan ahead. Aside from property, investments and savings, you must remember to include company benefits, such as death in service. “The main thing is to realise that inheritance tax is potentially an issue and, therefore, to think and plan ahead,” says John Whiting, tax partner at accountancy giant Pricewaterhouse- Coopers (PwC). “That may mean doing nothing; it may mean setting up a pattern of giving – for example, making plans for passing on wealth or deciding how and where that wealth should be held. At a minimum, it will mean reviewing your will and making sure an effective one is in place.”

To date, homeowners and property investors have pursued different routes when seeking to mitigate the impact of IHT. Some have opted for highly complex schemes while others have taken straightforward and inexpensive steps.

Pass the property
One proven way of mitigating IHT is to pass on some of the value held in an estate to your beneficiaries in gifts prior to your death. Estate and property owners who use this option can benefit from an annual £3,000 gift  allowance, which can be rolled forward if unused, as well as complete exemption from IHT on gifts worth, or totalling, £285,000 or more if they are made at least seven years prior to death. Another IHT planning tool, often used by married couples with large estates, is to take advantage of two nil rate tax bands. By making a gift of up to £285,000 to their beneficiaries on the death of one spouse, a married couple can avoid paying IHT on this sum and a further £285,000 on the death of the other spouse.

In the past, where two spouses own one or more properties as tenants in common (where each of you own a share of the property as opposed to joint tenants, who own the property together), they have also been able to reduce IHT by arranging for their respective ownership stakes in an estate to be put into a nil rate band discretionary trust on behalf of their chosen beneficiaries.

Trusty options
To date, trusts have been commonly used to help estate owners mitigate the impact of IHT. A variety are available and include accumulation and maintenance trusts, which are suitable when leaving monies to very young people, and trusts that provide an interest in income to beneficiaries. Discretionary trusts also offer trustees flexibility over income and capital payments from the trust to beneficiaries.

To date, these vehicles have not only assisted in tax planning but have also helped estate owners lay down guidelines as to how and when their nominated beneficiaries receive their inheritance. “Trusts are fundamentally a management control device that lets somebody do more effective planning on how their wealth is directed,” explains Whiting. “Thus it has been possible to use a trust to combine basic inheritance tax planning – which is to give assets away and survive for further years – with not wishing to put assets in the hands of very young people, or, more positively, to set down how that wealth is to be used. “The fact is,” he adds, “wealth put into an interest in possession trust [a trust that gives the beneficiary an immediate right to the income from the trust] will get charged inheritance tax. And if a discretionary trust is used, that also has its own IHT regime.”

A regimented regime
However, radical changes were proposed to the tax regime for trusts in this year’s Budget, which could have a fundamental impact on their future. Although, the Finance Bill, which will put these proposed changes into effect, is still being debated in the House of Commons, a much harsher IHT landscape is now anticipated for trusts.

One of the most significant new proposals is that both new and existing accumulation and maintenance trusts and possession life interest trusts should pay a 20 per cent gift tax on sums they attract over and above the £285,000 IHT threshold in any given seven-year period. There are also proposals to make these trusts subject to an IHT charge every ten years, which will be equivalent to six per cent of the value of their assets over and above the nil rate band. “The very substantial tranche of changes in this year’s Finance Bill will certainly affect the use of trusts to mitigate IHT,” says Whiting. “In simple terms, they tip the playing fields very much against trusts in a number of circumstances, penalising their use rather than simply leveling the playing field as is allegedly the aim. Anyone with a trust in their will or already involved with a trust would be well advised to review its status once the Finance Bill is settled in order to ensure that the trust is still effective. If the current tax changes impact adversely upon the trust, clearly it will be sensible to do some work under the limited transitional provisions that there are.”

Attacks and defence
Similarly, Maurice Fitzpatrick, senior manager at Grant Thornton, believes the proposed changes will have major implications for existing trusts and their role in IHT planning. “Most of our worst fears have been realised. This attack means many people across the country will need to check their wills to ensure they still achieve what they want,” he says. “We will have to wait to see how this proposed legislation comes into law. Even then, it may be some time before the new law becomes clear.”

Although both Grant Thornton and PwC are advising estate owners not to take any immediate action over their assets and trusts until the new legislation comes into force, there are still a number of proven IHT planning options open to them – including basic planning. Fitzpatrick points out a successful IHT mitigation strategy should continue to be focused on making outright gifts or regular gifts of spare cash to beneficiaries. He recommends that people planning for IHT make full use of the £3,000 per annum IHT exemption and that two spouses, once they have sought financial planning advice, continue to make use of two nil rate tax bands.