Borrowing to Mitigate your Inheritance Tax (IHT) Liability
The former Labour chancellor, Roy Jenkins, once described IHT as “a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue”. In the previous article we looked at various IHT planning options. However, these all require either a change of asset ownership, liquidity to either gift to others or acquire tax advantaged assets. So, what can be achieved if none of these are immediately possible, perhaps it’s because your asset base is tied into your property or because the gifting of assets would crystallise a liability to capital gains tax.
Here we use a client case study to demonstrate how a tailored lending solution can help to mitigate IHT.
Mr and Mrs Smith have a net worth of £6.5m. They wish to borrow £1m on an interest only basis secured against five unencumbered Buy-to-Let properties worth £2m and owned in their personal names
They do not qualify for the Resident Nil Rate Band (RNRB) on the basis that their estate is worth more than £2 million. They both have the full benefit of their £325,000 Nil Rate Band (NRB)
The loan proceeds are given away by Mr and Mrs Smith to their two children who are to be recipients of both the capital and future income from the gift absolutely and without reservation.
The clients have been able to gift £1m without giving up ownership of any assets. If they survive for seven years after the date of the gift, the value gifted will fall outside of the value of their estate for IHT purposes
Laura Hutchinson, Partner at specialist tax adviser Forbes Dawson, says “HMRC must believe that the recipients of the gift (the donees) have enjoyed the monies gifted to the entire exclusion, or virtually to the entire exclusion, of the donor and of any benefit to them by contract or otherwise”. The words ‘virtually to the entire exclusion’ are not defined by HMRC but the Oxford English Dictionary defines this as ‘to all intents’ and ‘as good as’. She also confirms that in order for the debt to be an allowable deduction against the estate for IHT purposes, it has to be repaid either at the end of the term or on death if this comes sooner
Furthermore, on the basis that there are no restrictions to the loan deduction and the loan has not been attributed ‘directly or indirectly’ to the acquisition of assets subject to IHT relief i.e. shares qualifying for 100% BR, for Inheritance Tax purposes the borrowing will be deducted against the value of the client’s total estate value.
From the view point of a responsible lender, the first question I ask of clients is “how would this strategy make you feel?” For many of our clients, Inheritance Tax planning is an emotive subject often addressed in the later years of their life. If the idea of borrowing at this stage of life makes you feel uncomfortable, this strategy may not be for you.
A careful assessment of the ongoing affordability of the loan itself has to be undertaken. A loan contract obliges the mortgagor to meet future repayments of loan interest or capital – and if you’re borrowing later in life, this may mean a reliance on retirement income. How sustainable is the income over the lifetime of the loan contract? What if interest rates and therefore the cost of borrowing were to increase in the future?
A credible repayment strategy is needed. In the scenario quoted, by gifting the money now, Mr and Mrs Smith are able to start the clock ticking from an IHT perspective reducing the value of their estate by the value of the loan plus any interest paid. Consideration needs to be given to what their means are to repay the loan capital in the future and what if this repayment strategy were to fail. The loan becomes repayable at the end of the term and there is no guarantee the lender will refinance the loan upon expiry.
Finally, death. What happens if the borrowers were to die within seven years of making the gift? Any gifts start to use up the NRB. Where IHT does become payable, the full amount becomes due on death within three years of the gift and reduces thereafter subject to a taper relief. So, have provisions been made for this eventuality and can the estate ensure that it meets both the repayment of any outstanding bank borrowing as well as any IHT payable by it?
Only 4-5% of estates in the UK pay IHT. The Brexit Party has pledged to scrap IHT altogether; the Labour Party would consider slashing the NRB threshold and introducing a £125,000 lifetime gift allowance upon which Income Tax rates would apply; and the Office of Tax Simplification has recommended that the seven year gifting period be shortened to five years. The outlook remains increasingly uncertain and we can only work within the current rules, but plans made today may be adapted in the future through ongoing and well informed advice.
IHT planning is a complex area and we would encourage you to contact your usual Brown Shipley Adviser to discuss your plans further
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