If you’ve invested in buy-to-let, you’ve probably done so with the intention of creating a steady income for yourself, together with capital to hand on to the next generation when you’re gone. But unfortunately, wealth tied up in residential lettings often comes with a significant Inheritance Tax burden.
If you’re renting out properties for income, you’ve got a business as far as HMRC is concerned. But whilst trading business can usually be passed on to the next generation without incurring Inheritance Tax, that’s most definitely not the case for buy-to-let. Trading businesses are up to 100% exempt from Inheritance because of Business Property Relief. But buy-to-let portfolios are classed as “investment businesses” by HMRC, so the relief simply isn’t available.
Which means that, if you build up a buy to let portfolio that’s large enough to replace your earned income, you’ll have a lot of taxable capital behind you. And you’ll struggle to pass that capital to your kids when you’re gone, without saddling the kids with an almighty Inheritance Tax bill. That’s an almighty tax bill, by the way, that must be paid within six months of your death, and must even be paid before the kids can sell any of the properties - so how are your kids supposed raise the cash to pay the tax?
That’s the worst-case scenario, of course. But it’s what WILL HAPPEN if you don't do anything about it. However, if you get started as soon as possible, and take some professional advice, there’s a lot you can do to reduce the Inheritance Tax burden to manageable levels, and even get rid of it altogether.
Here’s a quick guide to some of the things you can do:
This is a simple and effective way of reducing the value of your estate – and thus your Inheritance Tax bill. Simply sign over some - or all - of your properties to your kids during your lifetime, live on for at least another seven years and voila! No Inheritance Tax to pay on those properties.
But it’s not just a matter of surviving seven years. You must completely divest yourself of all ownership in favour of your kids. Which means foregoing the rental income. So, this is no good if you depend on that rental income to meet your living expenses.
If your property has gained in value since you bought it, you may also have to pay Capital Gains Tax – gifts to your children are not Capital Gains Tax-exempt.
If there’s still a mortgage on the property you want to give away, you’ll need the mortgage company’s consent. But if your kids take over the mortgage, HMRC classes this as payment for the property – which in turn can trigger Stamp Duty.
2.Create a Trust Fund
If you can afford to give away the property, there are no mortgage concerns and the Capital Gains Tax implications are tolerable, you may still feel uncomfortable about simply gifting properties to your kids. If your kids are too young, or less responsible that you’d like, or are disabled or vulnerable, or have partners or spouses you don't fully trust, a simple gift may not be a good idea.
However, you can instead set up a Trust for your kids, to hold the properties on their behalf. You can even take on the role of Trustee, to make sure the properties are safeguarded and properly managed. Provided you don't include yourself as a beneficiary of the Trust, there’ll be no Inheritance Tax to pay after seven years. This is one of the strategies Tony and Diane opted for in their estate plan.
You can only put a maximum of £325,000 into this kind of Trust - £650,000 if you’re a couple - without incurring Inheritance Tax at 20%. But if you stick to those limits, you can do it again in seven years’ time. So, if you start early enough, you can create multiple Trusts for your kids at seven-year intervals.
However, all the same issues regarding Capital Gains Tax and the mortgage company apply as for simple gifts, so you need to look at it carefully from all angles before you begin.
3.Use your Pension Lifetime Allowance
You have a £1million lifetime allowance for pension funds. If you’re a couple, you have £2million between you. So, if you have plenty of unused pension allowance left, you can transfer ownership of the properties into your pension fund, and shield them from Inheritance Tax.
There’s a catch, however. This only works for commercial properties, not residential properties. So, before you could even consider this option, you’d need to sell up and reinvest the proceeds in shops, offices or other commercial premises for rental.
4.Incorporate your portfolio
Your accountant may already have been encouraging you to set up a limited company to own your rental properties, to get around some of the punitive Income Tax changes that have hit buy-to-let investors of late. You may have to pay Capital Gains Tax when you incorporate your portfolio. But if you have four or more properties in your portfolio, you may qualify for “s.162 Incorporation Relief”, which takes away the Capital Gain Tax burden.
Incorporating your portfolio gives you a lot more flexibility when making estate planning decisions. With simple giving, you have the option of giving your kids shares in the company instead of whole properties. This can help you manage your exposure to Capital Gains Tax, by giving shares a little at a time, to a value that’s within your annual allowance for Capital Gains Tax. It can also help you control the speed at which you divest yourself of income in favour of the kids, to make the process more affordable for you.
It also gives you an opportunity to restructure the company to your advantage, using Class A and Class B shares, and preference and ordinary shares, to control yours and the kids’ access to income and control of the company. You will need a lot of support from your accountant in exploring this option.
5.Have your Cake and Eat it
If you depend on your rental income to meet your living expenses, having an incorporated portfolio can also enable you to steadily transfer the portfolio to the kids whilst retaining income for yourself.
You can transfer your shares to the kids whilst staying on in a paid role in the company and receiving a PAYE salary. Your role would be supervisory, or advisory, in nature, and you’d have a contract of employment and a monthly pay slip. That way, the kids acquire ownership of the company and you retain a monthly income.
You can also sell shares to your children at full market value, but take payment by monthly instalments. The monthly instalments would be classed as loan repayments for tax purposes, and would be yours without incurring Income Tax. You can even include a clause in your Will releasing your children from the obligation to continue to make further repayments on your death.
If correctly set up and properly documented, either arrangement would be a valid commercial arrangement that passes your portfolio to the next generation without incurring Inheritance Tax. Again, some heavy-duty support from your accountant would be essential.
6.Use Life Insurance
You can take out a life insurance policy to cover your Inheritance Tax liability. You’d need to work out the value of your portfolio and the amount of Inheritance Tax that would be payable on that value, and your policy would be in that amount.
You must, however, make sure that your policy is “written in trust” in favour of the executors of your Will. This is for two reasons. First, if you don’t do this, the policy proceeds will simply be added to the value of your estate when you die, and will only increase the size of your Inheritance Tax bill. Second, it gives your executors instant access to the ready cash they need to pay the Inheritance Tax bill within six months of your death.
You’ll also need to keep an eye on the overall value of your portfolio, reviewing it every few years to make sure you have adequate life cover.
This option works well and is affordable if you’re in good health and relatively young. But the older you get and the less healthy you are, the more expensive it is. Talk to your financial advisor to explore this option.
7.Chuck it all in!
One radical option is to sell up and reinvest the proceeds in an Enterprise Investment Scheme. If you do this, you’re exempt not only from Inheritance Tax after two years – because you get Business Property Relief - but also from Capital Gains Tax, and you can also qualify for some attractive Income Tax incentives.
But there are significant downsides. Enterprise Investment Schemes are inherently risky, so you have to tread very carefully and you’d be unwise to put all your eggs in this particular basket. Second, selling up can be a real emotional wrench, especially if you’ve spent years diligently building up your portfolio.
Lots to Think About
As you can see, there’s an array of choices before you when it comes to mitigating your Inheritance Tax exposure as a buy-to-let investor. There are great advantages and scary downsides to all the options. However, you don't have to choose just one option – you can mix and match, and come up with the combination of strategies that works best for you.
Whatever you do, it’s important to get proper, professional guidance from your accountant, your Financial advisor – and, of course, your Estate Planner – before you decide how to proceed.