Lee Sharpe breaks down the main principles of inheritance tax.
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For more in depth discussion on this important area of property taxation, please see our new tax report ‘Passing Down The Property Portfolio’. Save 40% Today.
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This section is included to ensure that readers are at least passing familiar with the basics of IHT, as may be relevant to a rental property business.
IHT is charged on the value of one’s ‘estate’, essentially assets less liabilities. It is a separate regime from capital gains tax (CGT).
The value of assets comprised in the estate is generally their open market value if sold on the day of death or other disposition (IHTA 1984 s 160).
Importantly, IHT is basically chargeable when a ‘disposition’ (generally a gift) reduces the value of a person’s estate – their wealth. It can even apply during one’s lifetime but most people will not have to worry about IHT being triggered on lifetime gifts because those gifts are usually to another individual, typically a close relative, and lifetime gifts to another individual are ‘potentially exempt transfers’ (PETs) that will fall out of the IHT net so long as the donor survives the gift by seven years.
(These two statements might seem at odds with each other; how can you tax the estate that is left over on death but assert that IHT attacks reductions in the estate? The answer is that IHT law deems the deceased to give away the value of their entire estate the instant before they die (IHTA 1984 s 4). So, while it may practically take months or even years to administer a complex estate following someone’s death and to distribute the assets, the IHT calculation assumes this all gets compressed into the second before death.)
While gifts to another individual are assumed to be exempt unless or until the donor dies within seven years, gifts to other entities, such as trusts and trustees and to companies ARE potential triggers for lifetime IHT – chargeable immediately:
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Lifetime rate – chargeable lifetime transfers (CLTs) |
20% |
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Death rate |
40% |
IHT is assessed on that reduction in the value of the estate, and this approach is very important where the gift is not simply money.
Example 1: Old Bill and his Chippendales
Old Bill is a wealthy individual and has a set of 12 Chippendale dining chairs worth £200,000. Without the head chair, the value of the remaining incomplete set would be only £50,000. But the head chair on its own is worth a mere £25,000.
Old Bill wants to reduce his IHT exposure on death, but he is also concerned about minimising his CGT while he’s still around, so he gives the head chair on its own to one of his daughters.
CGT typically focuses on the value of the thing being given away, which is a mere £25,000 (although there are special rules for attributing CGT costs when an item is part of a set or for transferring a set over a series of transactions). Bill’s CGT exposure is therefore very modest. Meanwhile, from an IHT perspective, Old Bill has made a gift to another individual – a PET – which is not immediately chargeable to IHT and will be fully exempt so long as he survives the gift by more than seven years.
Old Bill is pleased that the value of his estate has fallen by £150,000, with a nugatory CGT cost. Old Bill dies in a car accident a few months later, so that gift loses its ‘potentially exempt’ status and becomes chargeable (we call this a failed PET). Alongside the value remaining in Old Bill’s estate on his death, HMRC will look at the fall in value of Old Bill’s estate as a result of any gifts in the previous seven years rather than the value of the gifts themselves. In relation to the gift of that single chair, IHT will be assessable on a value of £150,000, not on £25,000.
This may look like Old Bill made a mistake in his planning but, in truth, his only ‘mistake’ was to die within seven years of the gift – in other words, the planning might have worked if he had lasted (survived) at least another seven years from the date of the gift. Of course, giving away valuable property during one’s lifetime typically carries substantial CGT risk, as well as losing out on rental income.
If the gift made by Old Bill had been a chargeable lifetime transfer (CLT) instead, then 20% IHT would have been due on any amount exceeding Old Bill’s ‘nil-rate band’ available at the time of this gift (see also Chapter 4 below). That would be:
£325,000 minus the value of any CLTs made in the seven years prior to this CLT (PETs are ignored). In other words, you cannot just consider one CLT and the nil-rate band in isolation; one must also consider the history – broadly, the seven years leading up to the current CLT.
CLTs will be chargeable again if the donor dies within seven years of making the gift. The tax rate rises to 40% on death, but credit is given for any IHT already paid against that gift on the initial CLT lifetime charge.
Be careful with shares in a small or family company. We used a set of antique furniture to illustrate how IHT works by gauging the ‘loss to the donor’s estate’. Perhaps a few readers will collect antique furniture but it seems likely that many more readers will own shares in their own company, or their family’s company.
Many readers will be aware that the value of one’s shareholding falls significantly as soon as one loses the controlling interest – so, for example, the value of a 51% shareholding is worth a lot more than the value of a 49% holding. The gift of a 2% stake on its own may not be worth very much at all but, again, IHT will be assessed on the reduction in the value of an estate in consequence of the gift, not the value of the gift itself. An investment company such as a BTL rental business will not enjoy business property relief on its shares (see reliefs at Chapter 5 below), so it is likely that a shareholding in such companies will be exposed to IHT. The ‘loss to donor’s estate’ principle may well bite particularly hard around that transition from holding a controlling stake to holding just a minority interest.
While a gift of shares to another individual will typically trigger CGT, it will usually be a PET for IHT purposes, so giving away shares is not an inherently bad idea, but it carries risk if the donor does not live for seven years from the date of the gift, and the PET fails.
