Gifts with reservation
Written by Ray Coman
A gift with reservation occurs where someone reserves benefits from a gift. The reservation could be written down in a contract or brought about by the actions of the donor. The most common type of gift with reservation occurs when parents gifts their home to their children but continue to live in it. In legal form, a conveyance of the property has occurred, but in substance the donor has continued to enjoy the property. For inheritance tax, a gift with reservation has not left the estate. The probate value of the property is part of the estate assessed to tax on death.
A gift with reservation can occur on the transfer of a variety of asset classes, such as intangible assets, valuable belongings such as jewellery and antiques, also known as chattels. This report will focus on the family home since that is the typically the asset in which the most inheritance tax is at stake.
Double tax charge not applicable to gift with reservation
Associated operations and pre-owned assets
Giving away a share of the home to avoid gift with reservation
Sharing accommodation to avoid gift with reservation
Payment of market rent to avoid a gift with reservation
Occupation due to illness is not a gift with reservation
Tax on outright lifetime gift
If a person makes a gift during their lifetime and survives seven years that gift is outside of the estate for inheritance purposes. Between years 3 and 7, the rate of inheritance tax tapers at an effective rate of 8% per annum. The rate reduces from 40% if the deceased dies just before the third-year anniversary of the gift to nil if the deceased dies on or after the seventh anniversary of the gift. The rates of tax can be read in the table on taper relief.
A lifetime gift is described as a Potentially Exempt Transfer (or PET.) The intention of a gift with reservation is usually to avoid inheritance tax by gifting the property and surviving seven years.
Gift with reservation
In the situation where a person makes a lifetime gift but continues to enjoy the property which has been given away, the gift does not leave the estate for inheritance tax purposes. The most common situation in which this occurs is where a parent gifts their home to their children but continues to live in it until death. Tax laws generally seek to tax individuals based on beneficial rather than legal ownership. In this example, the legal title of the property has transferred but the ability to benefit from the property has not transferred. This occurs even if there is no contractual right to live in the property. If an individual has benefited from a property, in this example by living in it, that person is taxed as beneficially owning the property.
Double tax charge not applicable to gift with reservation
Where a property is gifted during a person’s lifetime, it is described as Potentially Exempt Transfer or a PET. It is potentially exempt because the transfer will be outside of the estate on the condition that the transferor survives seven years. A gift with reservation is a failed PET. Because beneficial ownership has been retained it is not treated as exempt. The property will form part of the estate on death.
In the case of a failed PET, the value transferred is that which is in the estate at death. If the reservation is relinquished at some point during the transferor’s life, the gift will be treated as a PET and taxed accordingly. Continuing the example, if the donor leaves the home, the market value of the property at the date on which the benefit is no longer enjoyed determines the value of the lifetime gift.
The regulation explained above prevents a person from being subject to inheritance tax twice on the same property simply because the property been transferred for legal (such as land registry) purposes but remained a gift with reservation.
Associated operations and pre-owned assets
HMRC will seek to enforce gift with reservation rules where linked transactions cause an outcome comparable to a straightforward gift with reservation. Commonly this occurs where proceeds from a property are gifted to the beneficiaries (usually children) of the deceased. The proceeds are used to purchase a property which the original door lives in free of rent. The donor is regarded as being able to enjoy the benefit of a pre-owned asset and subject to tax as explained in a separate report.
Home loans, double trust and other schemes have been used to sidestep Gift with Reservation rules. Most of these have been legislated against under various anti-avoidance provisions and more information can be read in the report on pre-owned assets.
Giving away a share of the home to avoid gift with reservation
Giving away part of the family home would suit someone who wants to continue living in their home but also wishes to enrich his or her heirs while avoiding inheritance tax. A part disposal of the home is treated as a potentially exempt transfer. Provided the transferor survives seven years there would be no tax on that part of the gift. A gift with reservation has not arisen because the transferor does not enjoy the share of the property which has been given away.
The gift with reservation rules are only avoided where the gift is unconditional and each party occupies their respective share of the property. The enjoyment by the former occupant of the part of the property given away must be negligible to avoid the gift as being regarded as reserved for tax purposes.
Sharing accommodation to avoid gift with reservation
Making a gift of part of the family home in which each owner occupies only their space might be impractical and/or undesirable. An alternative method of avoid the gift with reservation regulation is for the donor and donee to co-habit. Provided that donor pays a reasonable share of household expenses the transfer will be treated as an outright gift. The amount gifted is the property share conferred upon the co-habitee.
Where the donor does not pay their share of household expenses, the donor would be treated as benefiting from the whole property and therefore not making a gift. The donor is receiving something in return and has therefore not made a gift.
Where the donee does not keep up a share of household expenses, there could be a practical issue in demonstrating that the donee lived in the property.
In order for the transfers to be regarded as a gift, each co-owner must pay their share of the upkeep and outgoings associated with the property.
Shared ownership of a property can be achieved either as joint tenant or tenant in common. Using the example of a couple with equal shares, as joint tenants, each owner has a 50% share of the whole property. By contrast, each tenant-in-common owns 100% of one half of the property. An arrangement in which the property is shared as tenants in common would clarify for inheritance tax purposes that a distinguishable gift has been made.
Unless specifically arranged most sharers are joint tenants. The surviving spouse of a married couple automatically acquires his or her share of the jointly owned property by right of survivorship. A tenant in common arrangement provides a simpler method for the deceased to gift their share to someone other than the co-owner.
Payment of market rent to avoid a gift with reservation
Provided the donor pays a full market rent for the property that he or she used to own, a gift with reservation has not occurred. This is rarely practical because it requires a donor to first give away their home and having received no cash in return to make rental payment for their continued enjoyment. A further drawback is that the recipient, usually one of the transferor’s children, will be subject to tax on the rental income. Given that a person tends to be subject to tax at a higher rate during working life than in retirement, this approach will rarely save tax for the family.
The gift of the property will be regarded as a Potentially Exempt Transfer. The gift has the potential to be exempt if the donor survives seven years from the date of transferring the property. It is a requirement for the rent to be reviewed at least every five years to ensure that it is still at a market rate. Rental payments provide a mechanism through which the donor could avoid inheritance tax on cash through a series of lifetime rental payments. Income tax payable by the beneficiary on the cash could be less than as inheritance tax on the same amount. This could be especially tax efficient where the beneficiary has unused personal allowance.
Occupation due to illness is not a gift with reservation
By concession, HMRC will not treat a gift as reserved where the property is occupied due to infirmity of the donor. The following conditions need to be met for the exemption to apply:
- The donor is no longer able to take care of himself or herself due to old age or infirmity;
- The circumstances of being dependent were unforeseen at the date of the original gift of the property;
- The recipient of the gift is a relative of the donor.
The exemption would cover a situation where a parent returns to the former home to be cared for by the child who was previously gifted the property. The exemption does not cover a situation where a parent is already in need of home care at the date of the gift. This could not be reasonably regarded as ‘unforeseen’.
Sadly, by the time a person requires live-in home care their remaining life is often limited. Gifting property at that late stage is unlikely to avoid inheritance tax because of the requirement to survive seven years. A lifetime gift that does not avoid inheritance tax is described as a failed PET. A formal agreement to re-occupy the former home following serious illness would fall foul of the gift with reservation restriction because the gift was not unconditional. However, an informal understanding could suit the needs of both parties. Where the children have agreed to care, it could be more practical for the older infirmed individual to move premises. The children could have work and minor children, and their home could be larger and/or better positioned for medical care.
Residential nil rate band
Since 2017-18, an additional exemption from inheritance tax has applied to the family home. This has reduced the motivation for families to pursue schemes which could get caught by gift with reservation or pre-owned assets anti-avoidance regulation. A separate report covers the residential nil rate band.
Tax planning options
Equity release can be an appropriate method of sidestepping the gift with reservation rules. A Potentially Exempt Transfer would have occurred when the cash from the equity release is given to the beneficiaries. However, this ensures that the value of the gift is outside the estate if the donor survives seven years. The rate of inheritance tax tapers between three and seven years after the gift. The value of property subject to inheritance tax is reduced by any outstanding mortgage on estate property.
Sharing accommodation is likely to be another popular option where the donor wishes to remain in the property and provide for children.
Tax is not avoided in an arrangement in which the property is sold and proceeds gifted to children who use the funds to purchase a property that the donor subsequently occupies. In this situation the occupant is open to a pre-owned asset charge. Care should therefore be taken when conceiving of more elaborate methods of inheritance tax planning. Various anti-avoidance provisions have been written into the rule book and consequently it is worth researching a tax plan in advance to ensure its success.
Comments
On the basis that your Dad’s estate is not liable to inheritance tax, there is no need to take steps to ensure that your Dad has not made a gift with reservation. The least contentious course of action would be to include the property in his estate. You should however seek professional advice and clarification to if your father’s estate is exempt from inheritance tax, probably from a surveyor and/or probate solicitor.
A gift itself is not aggressive tax planning. You are subject to tax based on beneficial rather than legal ownership. If you gift 70% of your property and the donee has beneficial ownership of 70% of the property, the transfer remains potentially exempt. In your circumstances, beneficial ownership is occupation of that portion of the property. If she decided to let her portion, she should be entitled to rent on 70% of the whole property.
If the respective areas are self-contained, your PET should stand up to HMRC scrutiny. However, if your share is ‘undivided’ (to use the term adopted by the legislation), you can establish that you pay for the portion that you live in. To use your scenario where you transfer 100%, provided you do not occupy her 70% portion and pay for the 30% portion that you live in, you will have made a PET. Pay for could be way of paying the transferee a market rent, ass you have suggested, or by covering the living costs in your portion. Establishing what constitutes 70% can be open to interpretation. Floor area is usually adopted but this is not necessarily reflective of the value transferred, for instance if her 70% has a lower valuation.. The services of a surveyor could assist in establishing the value transferred.
The specific subsection is 102B Gifts with reservation: share of interest in land.
Provided you are not able to enjoy that part of the property that you have given to your son, you will be treated as making an unconditional gift. If you still have to pay to live in the part of the property that you occupy that is the part that has not been gifted and remains part of your taxable estate.
I cannot advice on case by case examples, except to say that there should be a just and reasonable apportionment. Floor area alone might not constitute a just and reasonable basis.
My son will continue to live in the house with his girlfriend - the house is freehold with no mortgage - my wife passed away 3 weeks ago. It is a 5 bed house but I will occupy only 1 bedroom so does it mean my rent and bills will be 1/5 of the whole house
I would like to gift her the 70% as a PET but I can't do this as it would mean splitting the title deeds. The only option seems to be tenants in common. Given that HMRC would consider a 70% gift as 'aggressive tax planning' and given that my part would not be a fully self contained fllat, do you tthink this is still worth a try?
Alternatively, I could gift her the whole house and pay her the market rent for my 30%. She is a low earner and would pay little or no tax on the rent?