Pre-owned asset tax
Written by Ray Coman
In tax speak, a pre-owned asset is one purchased from wealth previously held by the donor. The regulations are an anti-avoidance provision. In particular, pre-owned asset legislation aims to block a manipulation of funds during a person’s lifetime which results in the avoidance of inheritance tax. The gift with reservation rules deal with the situation where a person gifts a property but continues to enjoy it. The pre-owned asset rules deal with the situation where the property has been disposed of and the proceeds have been used to purchase a new property from which the donor benefits.
Pre-owned assets can include property, land, art, antiques and other valuables collectively referred to as chattels and intangible assets. The value of any chattel worth less than £5,000 is not subject to the pre-owned asset regime. This report is focused on the type of asset which usually results in the greatest exposure to inheritance tax, namely residential property.
Effective 6 April 2005, the pre-owned asset tax charge is given force by: “The Charge to Income Tax by Reference to Enjoyment of Property Previously Owned Regulations SI2005/724.” The Finance Act 2004 regulation makes a person liable to tax on property acquired with funds purchased from a previously owned asset.
A lifetime gift can be used to reduce the value of the estate subject to inheritance tax on death. However, it also diminishes the funds a person needs to support themselves through old age and retirement. If a person gifts their home but continues to live in, the property has not left that person’s estate for inheritance tax purposes. This is because it is described as a gift with reservation. To sidestep the rules, it used to be possible for a person to live in a property funded by the by the sale of their former home and purchased by the persons (usually offspring) who were given the cash from the sale.
A person living in a gift with reservation is exposed to inheritance tax on the property. A person living in a pre-owned asset is exposed to income tax on the property. There is an option to elect for a pre-owned asset to be subject to inheritance tax in the same way as a gift with reservation.
Where accommodation has been purchased with cash from a property previously owned by the occupant, the occupant is exposed to income tax. For tax purposes, the donor is treated as receiving a benefit which is equal to the market rent that could be obtained for that property. For tax purposes, there is a requirement to review and, if necessary, adjust the rental value once every five years.
Let’s say a parent sells their property, gives the money to their children who buy another property for the parent to live in, rent free. For income tax purposes, the parent will be treated as receiving income equal the market rent of the space which that person occupies.
The concept of a person being subject to income tax on their accommodation is peculiar. However, the principal invoked is perhaps not dissimilar to that used for taxing employees on benefits-in-kind. A person receiving gym membership or private medical insurance from the employer will be taxed on the cash equivalent of that benefit as though it were employment earnings. In a similar sense, a person is being given the benefit of enjoying their wealth free of tax.
Whatever the principal, in a practical sense the regulation attempts to prevent families from avoiding inheritance tax by transfers which are not unconditional gifts. The rules produce taxable rental income on space that could be let out - if unoccupied by the person who funded the purchase.
Pre-owned asset charges are reported as other income on the Tax Return. At the time of writing this appears in box 20 of the main tax return. There is no deduction for expenses. The gross market rent is treated as taxable non-savings income and taxed at the marginal rate of the occupant. Personal allowance could be available to reduce the taxable amount and in this case an election to include property in the estate would not be tax efficient. A Tax Return is the only mechanism for reporting the tax and it cannot be handled through PAYE. There is therefore an annual compliance cost to consider. A disclosure facility can be used for bringing affairs up to date and ‘getting the house in order’ for estate planning purposes.
It is possible for the donor to avoid the charge to pre-owned assets by paying the market rent for the property. This effectively shifts the charge from income tax from the occupant to the owner. It is rarely desirable or practical. However, in the rare situation in which a person has sufficient wealth to distribute after relinquishing their home, market rent payments could help to further reduce the value of the taxable estate. Consider that the occupant will be subject to tax on the rental receipts. Given that a person tends to have higher income during working life than in retirement, this arrangement is unlikely to spare the family from income tax.
A person can choose to make a pre-owned asset part of the taxable estate. The election has to be made by 31 January following the tax year in which the pre-owned asset charge arises. At the time of writing the form of the election is labelled IHT500.
If the value of the estate is less than the nil rate band, this would be an effective tax avoidance strategy. If the donor is a widow or widower, the nil rate band includes any unused nil rate band transferred to that person as a surviving spouse. The taxable estate could be further reduced by use of residential nil rate band. This is an additional exemption applicable to the main family home of the deceased.
The longer the life expectancy of the occupant the lower the value of the election. Further tax implications are explored in the tax planning section of this report.
A person often chooses to downsize when their living situation changes. This could be on becoming a widower or widow, on retirement or on all the children leaving home. It could be a combination of the above or simply a need for cash to support the individual through old age. The arrangement to bestow proceeds from the family home onto children could be dependent on the purchase of a building which is jointly occupied by parent and child. The charge to income tax on a pre-owned asset is determined by the value of the property which can be enjoyed by the occupant.
To limit the value of the property which is assessed to pre-owned asset charge, the area occupied by the donor should be self-contained. A separate entrance can prevent HMRC from assessing market rent of the whole property to income tax. It will only be that part of the property clearly identified as the pre-owned asset living quarters. Kitchen, bathroom amenity and adequate, habitable living space will support the argument that it is only the exclusive living area which should be regarded as subject to the income tax charge. A separate front door is a practical step. The determinant of a lodger in tax regulation could be helpful guidance.
Where a property is jointly owned and each owner contributes to their share of running costs, the pre-owned assets rules are not applicable. The exemption from tax in this situation mirrors the exemption which applies to the gift with reservation rules. If a person gifts part of his or her property and the incoming cohabitee shares the cost of running the property it is not treated as a gift with reservation. That is because a straightforward gift has been made. The donor can no longer enjoy the part disposed of. For this exemption to apply, the share of the upkeep and other costs should match the enjoyment of the property. FA 2004, Sch 15 para 11(5)(c)
The gift with reservation rules cannot be avoided where proceeds from the sale of a property are given to a connected person who purchases a replacement for the donor to live in rent free. As explained previously, in this situation the former owner is subject to a pre-owned asset charge.
However, if the donor and donee cohabit in the replacement property and each pays a commensurate proportion of their household expenses, there is no pre-owned asset charge. The donor has to pay towards the cost of the new property and in that sense is not benefiting from it. The original transfer of cash is still a potentially exempt transfer for inheritance tax purposes.
Paying for upkeep and household costs of a property is not sufficient to avoid the pre-owned asset charge where the property is not shared. The requirement to pay a market rent - rather than merely a proportion of household costs- arises when occupation of the replacement property is not shared with the donee.
A self-contained living space in two conjoined properties is not likely to stand up to HMRC scrutiny as evidence of cohabitation. The property would require a single address and probably a shared front door. In a self-contained situation, it is not necessary to consider the share of household expenses, since responsibility for costs will be clearly identifiable. In the same way as a separate property, the occupant of a self-contained annex can only avoid the pre-owned asset tax by paying a market rent.
Paying a share of costs could be more costly for the donor than paying the tax on pre-owned assets charge. However given that the expense would have to be met by the co-habitee, this route would work out cheaper for the family and could avoid an annual Tax Return requirement for the donor.
A person is not subject to pre-owned asset charge on disposing of part or all of their former home where the following apply:
- The home which is given to an unconnected person. An unconnected person in this case is someone other than a family member. In this case no proceeds have been received. A Potentially Exempt Transfer has occurred, meaning the gift will be outside of the estate if the transferor survives seven years after the date of the gift.
- If part of an owner’s property is sold at arm’s length. In this case, a gift has not been made.
- A scheme in which a third party organisation agrees to buy the property and let it back to the vendor. This is similar to equity release schemes.
It is not the disposal of the property that gives rise to a pre-owned asset charge. A pre-owned asset charge arises where the proceeds are given to someone else who buys a different property that the owner then enjoys.
If a property is sold, even to a family member, for its prevailing asking price, a gift has not been made. If the new owner allows the previous owner to live in the property rent free, the previous owner is not subject to a pre-owned asset charge. However, consider that the proceeds from the sale still retained by the original owner on death will form part of the estate for inheritance tax purposes.
There are more complex schemes which typically involve the creation of a Trust. The donor gifts the family home to a Trust but continues to live in it. Since the property is now owned by a Trust it is outside of the estate for inheritance tax purposes. Since the property has not been sold in return for cash, the Trust has a notional loan equal to the value of the property. The benefit of the loan is transferred to a second Trust, also created by the donor. On the donor’s eventual death the property is sold and the proceeds are paid to the loan beneficiaries who are usually children of the settlor.
The tax regulation determines the settlor is benefiting from property previously owned. Therefore the settlor is deemed to receive the benefit of rent-free accommodation and is therefore subject to tax on this benefit under the pre-owned asset regulation.
Usually the value of the property is the same as the amount loaned. However, to the extent that the property value exceeds the loan, the excess is part of the taxable estate for inheritance tax purposes. The excess is a gift with reservation.
The regulations are complex and have not been expended up on in this report because such Trusts do not avoid Pre-Owned assets charge and are therefore not worthwhile.
The donor could have sufficient personal allowance to soak up most, if not all, of the pre-owned asset charge. The market value of an annex or smaller separate area could be relatively nominal.
The state pension is generally less than the personal allowance and the savings allowance, dividend allowance and capital gains tax exemption could all be used to prevent other forms of income and gains from using up personal allowance. This would leave personal allowance intact for the purpose of the pre-owned assets charge.
Alternatively, the recipient could have available personal allowance. In this case, payment of market rent would not be taxable in the hands of the property owner. For instance, if a child has temporarily given up full time work to care for their parent, and the child has not yet started drawing on a pension, the rent received would not be taxable income. The owner would be able to deduct costs from rent paid in the same manner as a rents received from an arm’s length agreement. By contrast, the occupant cannot deduct expenses from pre-owned asset charge.
Where the donor has lower life expectancy, the total of income tax on market rent for the number of years is likely to be lower than inheritance tax on the value of the property in the estate. By the same token, consider that inheritance tax would apply to a lifetime transfer made in the seven years prior to death. The inheritance tax rate starts to taper once the gift is over three years old. Making an election to treat the asset as part of the estate makes sense where the gift of the property has been made recently and lift expectancy of the donor is limited. This is because the gift would be subject to inheritance tax in any case as a lifetime transfer.
Equity release is a mechanism where the bank lends money based on the value of the home. Cash transfers could be made in smaller stages or as part of a Trust arrangement. It would not be suitable where there is a preference to downsize or share accommodation as part of retirement living situation. The estate for inheritance tax purposes is reduced by an liabilities or debts of the deceased.