Inheritance Tax – Pre-Owned Assets 7th September 2015

Posted in: Inheritance Tax

In this post I will explain inheritance tax in relation to pre-owned assets. In previous posts I have discussed some basic inheritance tax subjects such as lifetime transfers and the death estate.

To understand what the pre-owned assets rules on inheritance tax are about, we first need to look at the gifts with reservation rules.

Gifts with reservation (GWR)

This was introduced in Finance Act 1986 as an anti-avoidance measure. It prevents the donor from giving away an asset and continuing to enjoy the benefits of that asset.

The typical example here is the parents gifting away the family home to their children, while still relatively young and healthy in the hope of beating the 7 year rule on lifetime gifts.

That’s fine, as long as the parents don’t continue to live in the home. If they do, it doesn’t work, unless they pay a full market rent to the donee to continue to live there.

When it comes to working out the death estate, we simply ignore the gift and pretend asset still belongs to the donor and so forms part of the death estate.

Other examples could be the classic car tucked away in the garage or the painting on the wall. If you gift these away, but the car is still in your garage and the painting is still hanging on your wall, then they’re gifts with reservation.

HMRC have indicated that where the benefit to the donor is insignificant a GWR will not arise. They even give examples, such as the donor staying at the home for less than 1 month a year or 2 weeks if the donee is absent.

There is also another potential downside to this arrangement. Suppose you gift away your home to your children, but you still get a benefit from it such that it will be caught by the GWR rule. Further, instead of surviving more than 7 years, you pass away before that. Now you have a GWR, which will be included in your death estate and you have made a potentially exempt transfer (PET) on which tax is now payable. A double charge.

HMRC have a double charges relief for this situation. They prepare two inheritance tax computations, one with the PET but ignoring the GWR and the other with the GWR but ignoring the PET. They will then compare the two and pick whichever is higher.

Pre-owned assets (POAs)

In order to get around the GWR rules, taxpayers started to get creative. They came up with a number of schemes. One scenario might be:

The parents would sell the family home. They would give the cash proceeds to the children – this counts as a PET. The children would buy a home for their parents to live in. Provided the parents survived the next 7 years, there would be no tax on the PET and there would be no GWR.

Nicely done, you might think.

Finance Act 2004 plugged this little hole. From 6 April 2006, the pre-owned assets rule was introduced.

The POA rules impose an income tax charge on benefits received by the former owner of the property. The tax charge is levied on the notional amount of income equivalent to the annual rental value of the asset. This notional income will then be declared on the donor’s self assessment return and taxed accordingly.

There is an annual £5,000 exemption to the POA rules. If the aggregate value of the POA charges does not exceed £5,000 in the tax year, then there will be no notional income tax charge. The £5,000 limit is applied before any contributions from the donor, however, it does apply to each donor separately, so if you have two donors the limit would be £10,000.

It is possible to opt out of the POA rules, in which case the asset is treated as a gift with reservation. Unfortunately, when the children come to sell the family home the value of the home when ‘gifted’ to them (the price they paid for the new home) will be used to calculate the capital gain rather than the value of the home on the death of the parents.

The POA rules have been more difficult for taxpayers and their advisers to overcome. The key thing with inheritance tax planning is to start early. So many of the ways to avoid the IHT charge are dependent on the 7 year rule not being applied, because any transfer would have  happened more than 7 years before death.

There are other possibilities as well for business owners or by using trusts. The point is, you really have to play by the rules and not try to get around them, so if your main asset is your house and you want to remain living there, then there’s not much point in trying to gift it away.