With changes to Inheritance Tax coming into effect April 2017, Vidhur Mehra, Finance Director at Benham and Reeves Residential Lettings looks at how this will affect landlords and property investors, both UK-based and overseas.
Rising house prices have meant that many modest estates have been valued above the Inheritance Tax (IHT) threshold. As a testament to this, the UK government collected £4.7bn from IHT last year, that’s a 20% increase on the previous year. And according to HM Revenue and Customs, three times as many estates will incur IHT this year compared with six years ago.
New IHT thresholds
For modest estates, the sharp rise in property value of the main residence has meant a crippling 40% IHT bill. Currently the IHT threshold for a single person is £325,000 and consequently £650,000 for a couple (either married or in civil partnership) and this amount can be passed to children or grandchildren tax-free. This is set to rise incrementally where the transfer of estate includes the main residence, so that by 2020, this amount will be £500,000 for a single person and consequently £1m for a couple that can be passed on to children or grandchildren. (Spouses or civil partners that leave their estate to each other are exempt.) The first of these incremental rises takes place in April this year.
Martin Bamford, Chartered Financial Planner & Chartered Wealth Manager for Informed Choice notes that the rise comes with a proviso: “The phased introduction starting this April of a new inheritance tax break for homeowners should ensure fewer families pay this death duty in the future. The ordinary nil rate band for inheritance tax of £325,000 has been frozen, but alongside it will be an residence nil rate band, starting at £100,000 for the 2017/18 tax year and rising to £175,000 in 2020/21. Once fully implemented, married couples and civil partners will benefit from a combined nil rate band of £1,000,000 fulfilling a long-held Tory party ambition.
“Despite the apparent generosity of this new tax break, there are some important quirks of the new system which need to be considered. The new enhanced nil rate band will only apply when the homeowner dies after 5th April 2017. In order to qualify, the taxable estate will need to include a residential property and this must be a genuine home of the deceased. This means the property must be included in the deceased’s estate and lived in by the deceased at some stage before their death. For this reason, it will probably not be available for most buy-to-let property investments.
“There is also a limit of the value of the estate which qualifies to use the new residence nil rate band. When the value of the estate is more than £2m, the residence nil rate band will be gradually tapered away. In order to qualify, the deceased’s direct descendants such as children or grandchildren will need to inherit the home or a share of it.
“Whilst this new enhanced nil rate band looks attractive at first glance, homeowners and their families will need to examine the details to understand how they might qualify. The introduction of the residence nil rate band in April is a good opportunity to review your inheritance tax planning and make sure you are making best use of available gifts, exemptions and allowances.”
UK property investors
This is all well and good for families with one main residence but what happens if the estate you are passing on includes a buy-to-let property portfolio?
The UK has long been considered a safe location for property investment and it is the buy-to-let market that is being held responsible for the rising values of property. As such the government has in recent years sought to restrict it, though not thwart it altogether (the reduction in mortgage interest relief, the removal of the 10% ‘wear and tear’ allowance and the 3% addition in Stamp Duty on any property that isn’t the main residence).
If you are a buy-to-let investor, it may be wise to consider distributing the assets early to children and grandchildren as gifts (though these will still incur a 40% tax if you die within seven years of giving the gift).
Overseas investors and the non-domicile rule
For non-UK residents investing in UK property, the government has again sought to restrict the buy-to-let market without thwarting it altogether. If you already own a home, even if it isn’t in the UK, you will now have to pay the 3% Stamp Duty on any property you buy in the UK. If you are a foreign expat, or non-UK domicile, the timescale for considering you a UK domicile has been reduced from 17 out of 20 years, to 15 out of 20 years. Once you become a UK domicile you will also become liable to UK IHT on your worldwide estate.
You may have been benefitting from paying tax on a remittance basis (ie not paying tax on foreign assets) and that is set to change too. After 15 years, you will be considered UK domiciled, no longer have the option to pay tax on the remittance basis and liable for UK tax and IHT on your worldwide assets. While that sounds serious, it is still only a reduction of two years and the chances are you will have planned ahead anyway.
Lyndsay Wolfe, a representative of St. James’s Place Wealth Management, comments that there is a ‘window of opportunity’ for those about to become UK domiciled: “Individuals due to become deemed domiciled from April have been offered two tax concessions to sweeten the pill. The first is called ‘rebasing’, which will make it possible for assets to be given a new Capital Gains Tax (CGT) base value equal to their value at 6 April 2017 (several rules apply). While it will not always be beneficial to elect for CGT revaluation, this will generally reduce the capital gains charge on future disposal.
“The government is also offering a two-year window from 6 April in which people can reorganise their overseas-based funds (whether foreign income, foreign capital gains or ‘clean capital’). The ‘clean capital’ (i.e. income or gains realised before an individual becomes UK tax resident) can then be brought back to the UK without a tax charge. In order to avoid later tax charges, individuals may need to consider investing the clean capital in tax-efficient, non-income-producing investments such as offshore bonds.”
For a non-UK domiciled property investor however, there’s a more significant change from April that you should be aware of. Certain property had been excluded from IHT considerations ie non-UK situs owned by a non-UK domicile or non-UK situs held in a non UK trust by a non-UK domicile. From April 2017 however, IHT will apply to residential property, even if it is held within an offshore company (historically classed as non-UK situs and excluded from IHT from non-domiciled persons).
Enveloping and de-enveloping
Trusts have been used by non-UK domiciles to mitigate any income and capital gains tax arising from assets held outside the UK before becoming UK domiciled; and envelopes have been used to mitigate IHT on UK property by owning it in an offshore company or similar vehicle. A Financial Times investigation in 2014 showed at least £122bn of property in England and Wales was held through companies in this way.
The government’s new legislation has made enveloping a less attractive option however. From April, UK properties held in such envelopes will now be subject to IHT when the individual owner dies. Many investors are consequently considering passing the portfolio onto the youngest grandchild to delay the payment. It may be a consideration to de-envelope the trust altogether if the ongoing fees outweigh its purpose to ensure beneficiaries have enough money to pay the IHT.
These significant considerations make it worthwhile consulting a tax expert says G M Fairfax, Partner Trusts Tax & Estates for Bishop and Sewell: “Owning a house in the UK, there are three or four taxes to consider: Stamp Duty Land Tax; the Annual Tax Enveloped Dwellings for a company; capital gains tax on sale or gift and inheritance tax (IHT) on death or gift. All taxes will apply for all buyers including IHT, from April 2017.
“Extracting a property from a structure (de-enveloping) will incur all tax charges. Loans to acquire, maintain or repair UK residential property will be charged to IHT and if sold, the proceeds will be taxable to IHT for 2 years following. In addition, Double Tax Treaties will not apply to the new IHT charges.”
Some good news for trusts though, after April 2017, ‘foreign source income’ such as that generated by a UK investment, will be considered as income from the trust rather than the individual and won’t be subject to tax (as a way to encourage money into the UK). This income will only be taxed when a beneficiary receives money from the trust.
The new and complex rules make taking financial advice even more important to protect your investments and navigate tax pitfalls. John Saunders, Head of International at Coutts agrees: “The changes being introduced from April will bring all UK residential property within the scope of inheritance tax regardless of the ownership structure and irrespective of whether the property is for personal use or is an investment property. Professional advice should be obtained before new investments are made and thought given to whether existing structures remain appropriate. We think that sole and joint personal ownership, financed by mortgages, is likely to be more popular in the future. Complex lending, including for non-resident and non-domiciled clients with UK interests, is Coutts’ raison d’être.”
It’s important to remember that these tax changes have been made precisely because the UK is still a highly attractive option for property investment, house values continue to rise and the rental market is still in great demand.
In conclusion, Inheritance Tax is one of those things that is often not considered until it is too late. It is especially important for those who own properties to carry out some estate planning. UK property prices have increased considerably historically and so estate values and inheritance tax liabilities may be higher than expected and the changes being introduced may mean a different approach is required to original intentions.
A little bit of thought now could save a lot of trouble later.