‘I inherited two properties worth £500k – how can I gift them to my daughters without a huge tax bill?’

Ask A Lawyer: our reader wants his children to inherit in a tax-efficient way

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Dear Gary,
I jointly own two rental properties with my brother, one of which we inherited from our parents. The value of my half is £500,000.
With the value of my primary residence increasing significantly over the past 30 years, my daughters would be liable for a large inheritance tax bill on my death.
I was thinking of setting up a trust and making my daughters the beneficiaries, also giving them the rental income to finance them at university.
Is this a sensible estate-planning strategy, and what are the risks and disadvantages of doing this?
– Andy
Dear Andy,
What you suggest in terms of creating a family trust is a well-trodden path for long-term estate planning and I am glad to say it remains an available option following the Budget. A family trust is a way of mitigating the risk of inheritance tax on the basis it will eventually serve to remove assets from the estate of the person gifting assets into the trust, but please note a couple of key points.
First, there is a limit to the value you can place into trust before a lifetime charge to inheritance is triggered. Second, it is very important that you are 100pc confident that, in relation to any assets you give away, you will not need to benefit again from either the capital or income. I will say more about these points below.
If a person making a lifetime gift (the donor) makes a gift into a discretionary trust (which is often thought to be an optimal trust arrangement because it is very flexible) there is a limit applied after which a lifetime charge to inheritance tax is payable.
The limit is the donor’s available nil-rate band for inheritance tax. The standard nil-rate band is currently £325,000, but this may be reduced by the value of lifetime gifts made previously (see below about making a “potentially exempt transfer”). The lifetime charge to inheritance tax is 20pc.
If a donor makes an outright gift to an individual there is no limit on the amount that can be gifted regarding the so-called lifetime charge to inheritance tax. However, there are two major catches with an outright gift.
One is the inherent risk when a recipient receives a gift with no restrictions imposed on them – they may spend the money on something you do not approve of, or just fritter it away!
Second, for tax purposes the gift will trigger capital gains tax (CGT) if there is a taxable gain (which almost always is the case nowadays since the tax-free allowances were reduced).
A gift into a discretionary trust is also a trigger for CGT, but if desired the tax can be “held over” and, in effect, the original base value for CGT passed on to the trustees. Note that a formal election for “hold over relief” must be sent to HMRC.
Whether a person makes an outright gift to an individual or a gift into an existing or newly created trust, the inheritance tax rules as they stand state (in simple terms) that the gift is relevant to the inheritance tax allowances available on death for a period of seven years. Gifts like this are sometimes called a “potentially exempt transfer” or PET.
It is a further requirement of the legislation that the donor of the gift should no longer benefit from the asset gifted at any point in the future. This rule is often called a “gift with a reservation of benefit”, and applies even after the seven years referred to above has elapsed.
As I surmise your daughters are young, I suggest it would be madness to make a gift of funds they could access at age 18. In my view, you would be wise to create a discretionary trust under which the named trustees (of which you could be one) may exercise discretion as to when the defined beneficiaries should receive either capital and/or income.
So, the plan should be to gift rental property in your name up to the value of your available nil-rate band into a discretionary trust. You will have to retain (for now, but think again after seven years) any part of the rental property which would take you over your available limit.
You will also have to be absolutely sure with regard to the rental properties you are thinking of gifting, that you will not be able to receive the rent or use the capital for your own purposes. Otherwise, it will fall foul of the gift with a reservation of benefit trap.
You say you would like the rent to be paid to your daughters to pay their university fees, and again that is an excellent idea. However, for this to be tax efficient there is a slight “faff”.
Income paid to trustees is taxed at 45pc. As I say, trustees have discretion to pay out income to beneficiaries and, if your daughters are non- or lower-rate taxpayers, they can claim back the tax paid on the income the trustees give them, in accordance with their own tax rate.
Discretionary trusts are subject to so-called exit charges and a 10-year anniversary charge where an amount of inheritance tax is paid upon each event. There is a relatively complicated calculation to work out the tax payable.
Your idea to create a family trust will also have benefits beyond the mitigation of inheritance tax. The proposed structure will mean your daughters will not own the assets in the discretionary trust in their own right, so the assets concerned will be sheltered from upheavals they may encounter in future – such as bankruptcy, divorce and death.
Therefore, all in all, I think this is an optimal arrangement to allow you to give away assets in a manner which is not putting those assets in jeopardy regarding your daughters’ future lives, and at the same time allowing you to retain control if you wish to.
Ask a Lawyer should not be taken as formal legal advice, but rather as a starting point for readers to undertake their own further research.