Will Planning

This article provides a reminder and update of the key options available to married couples (and registered civil partners after December 2005) for inheritance tax planning where the main asset is the family home.

The problem of the family home

The average house price in the UK now stands at over £150,000. Research shows that in wealthy families the average home is valued at around £600,000. Although the rate of house price growth is currently slowing, prices are still rising. The latest Land Registry figures show that in the 12 months to March 2005 UK house prices rose by over 10%. There are many families who have an inheritance tax problem solely because of the value of the family home, with other assets being insufficient to use the nil rate band on first death. So is it possible to use the family home within a discretionary will trust by transferring the deceased’s share to a nil rate band trust? Many family homes are owned jointly under a joint tenancy, the deceased’s share passes automatically to the surviving owner on first death failing to make use of the nil rate band. If the joint tenancy is severed so as to create a tenancy in common, the deceased’s share of the home could then be put into a nil rate band trust on first death – so that the home is then owned jointly by the surviving spouse and the trustees. However, there are still problems to overcome.

Planning hurdles

The Revenue would attack the arrangement on the basis that the surviving spouse has an interest in possession by virtue of continuing exclusive occupation of the whole house. This means that the full value on second death is potentially taxable and the nil rate band on first death would be wasted. There are good counter arguments that could be put but resisting the attack could be expensive.

Even if the planning works for inheritance tax purposes, there may be a capital gains tax problem when the house is sold on second death. Any gain since the first death on the share held by the trustees is unlikely to qualify for principal private residence relief. Fortunately, practical will planning solutions are available. Following the introduction of the pre-owned assets income tax charge, the will is now the prime planning vehicle for the family home.

The IOU solution

Under the terms of the will, a legacy equal to an amount up to the available nil rate band, is left to trustees of a discretionary trust (incorporated in the will to take effect on death). The residue is left to the surviving spouse. A specific provision is included in the will, which gives the executors power to compel the nil rate band trustees to accept an IOU from the widow/er in satisfaction of all or part of the nil rate band amount.

If, on first death, there are insufficient liquid assets in the estate to satisfy the nil rate band legacy, the executors will utilise this provision so that the trustees end up with an IOU and the surviving spouse ends up with the deceased’s tenant in common share of the property (as part of his/her residuary entitlement). The IOU is expressed to be repayable on demand (but in practice will not usually be called in until the second death). On second death, the debt in the widow/er’s estate is repaid to the trust and accordingly deducted from the taxable estate before inheritance tax is calculated. This ensures that use is made of both nil rate bands.

Drawbacks

Where lifetime gifts have been made between spouses, the IOU route is not recommended. This is because of anti-avoidance provisions contained in section 103 Finance Act 1986 that disallow the deduction of personal liability debts from the taxable estate in cases where the loan was made from property directly or indirectly derived from the deceased. The equitable charge route described below avoids this problem, as the surviving spouse does not accept personal liability for the debt.

Since 1 December 2003, the IOU scheme will also have stamp duty land tax (SDLT) consequences. By giving a personal promise to repay in return for the deceased’s interest in the family home, the widow/er is treated as giving consideration for the land which is chargeable to SDLT. However, the IOU scheme does offer greater flexibility than the equitable charge scheme, so could still be considered where the SDLT liability is acceptable or the amount of the IOU is less than the £120,000 SDLT ‘nil rate’ threshold and no lifetime gifts have been made between spouses.

The equitable charge solution

Under the terms of the will, a legacy equal to an amount up to the available nil rate band is left to trustees of a discretionary trust (incorporated in the will to take effect on death). The residue is left to the surviving spouse. A specific provision is included in the will, which gives the executors power to satisfy the nil rate band legacy by imposing a charge on the home, in favour of the nil rate band trustees, in lieu of the legacy. The nil rate band trustees have no right to enforce payment of the amount of the legacy against the surviving spouse i.e. the widow/er are not made personally liable for payment of the debt.

Unlike the IOU scheme, the Revenue accept that the equitable charge scheme does not cause a SDLT liability (as the widow/er is not made personally liable for payment of the debt he/she provides no chargeable consideration). The widow/er receives the interest in the home subject to the charge and on second death the house is sold and the debt charged on the property is repaid to the nil rate band trustees.

Drawbacks

Because of the SDLT benefits, the equitable charge scheme will undoubtedly now become the most commonly used approach. However, it does have a disadvantage in that because the property is specifically charged with the debt, the debt must be repaid if the property is sold.

If a replacement home is needed but cannot be bought without a further loan by the trustees of the discretionary trust, this would re-open the possibility of a debt being disallowed in the estate of the surviving spouse under section 103 Finance Act 1986 (as the fresh loan would be a personal debt between the trustees and the surviving spouse). Again, this is only a problem if lifetime gifts were made between the two spouses. Where lifetime gifts have been made, one way around both this and the SDLT problem is for the will to be drafted to leave the residue of the estate to a life interest trust for the surviving spouse (rather than to the surviving spouse absolutely). The surviving spouse would still have the right to live in the property or any replacement property but any debt would be between the trustees of the life interest trust and the trustees of the nil rate band trust.