Minimizing Inheritance Tax

[Hazard]

I was wondering if this arrangement would be beneficial in minimizing inheritance tax:

My mother (no spouse) owns her own house in the UK. When she wanted to buy a second house, I lent her 100,000 pounds (with no specific repayment date). The current value of both houses together exceeds the current 325,000 pound exemption limit by a fair bit.

1. I assume that when I inherit both houses, the debt of 100,000 pounds will not count toward the exemption amount?
2. If I add a reasonable rate of interest to this loan, would the amount that accrues in owed interest also fall outside the exemption amount?

Any thoughts on this issue would be much appreciated!

-Mark H.

[tax_schmax]

True. Assuming your mother dies first. What if you get hit by a bus?

[pqtaxation]

Hi Mark/Hazard

You write you lent your mother that £100k so that she has the entire legal and beneficial ownership of second house and her estate has a liability to you of £100k currently interest free. Is that house let out and your mother receives all net rent? Any interest chargeable in future will be taxable income to you when earned, but a tax deductible expense to her only if property commercially let.

IHT is calculated based on the value of net estate (assets less liabilities) and there is nil rate band (threshold) of £325k currently. If, say, the open market value at time of her death of first house is £300k and of second house is £200k and your interest-free loan of £100k then (ignoring other parts comprising the estate):

Value of estate taxable at 40% £000 = (300+200-100)-325 = 175
And IHT payable = 175*40% = 70

However for your loan to be accepted by HMRC as a liability of your mother's death estate your loan has to provable, preferably by a written agreement between you and her.

In the absence of any such proof of the loan then HMRC could argue it was a gift from you to her and so not be a liability of her death estate; also if you were die within seven years of making the "gift" it would become a failed PET for calculating the IHT payable as a result of your death (ignoring quick succession relief).

[Hazard]

Many thanks to all who have replied thus far!

Tax_shmax: Thanks for the confirmation. If I get hit by a bus, both Mum's and my estate go to my child in the end, so it all comes out in the wash!

pqtaxation: Thank you for the detailed and thoughtful reply. In answer to your questions: (1) Yes the house is let and Mum receives all rent; (2) I can document the cash transfer but will ensure that we reduced our arrangement to writing as you indicated; (3) if we further agree that interest on the loan in the amount of 5% p/a (to which I would ordinarily be entitled) becomes part of the loan each year, in effect upping the loan by 5% every year, then is it possible to increase the debt incrementally in this fashion (thereby reducing net estate value downstream) while avoiding immediate tax consequences to either party? If I am barking up the wrong tree on point three, can you perhaps suggest a different part of the wood?

Again, your assistance and insights are greatly appreciated.

-MH

[maths]

On the date the original £100K was lent the terms (ie repayment dates; security; interest etc) should have been agreed as would have been the case between third parties; you cannot therefore now suddenly agree to charge interest on the loan.

[pqtaxation]

On the one hand, Maths’ brief comment could be read to imply that the terms of a loan can never be altered by subsequent agreement between the parties which is not the case.

But on the other hand, OP’s idea that the loan should accrue interest that only will become payable to OP (as taxable income to OP) upon the death of the mother is fraught with accounting and taxation problems.

Without more information on the income and assets of mother and OP, it is difficult to offer alternative ideas for mitigation of IHT payable as a result of mother’s death: but maybe just IHT exempt annual gifts of £3k and £2k out of income by mother would correspond to the £5k per year reduction in her estate that OP is seeking.

Alternatively or possibly in addition to such exempt gifts, maybe a part of any increase in the value of the property over its cost could be shared by OP. For example, his interest-free loan might entitle him to say a 30% share of the uplift in market value over cost with 70% share to Mum. That share would reduce the value of her death estate (IHT taxable at 40%) but would create a taxable chargeable gain for OP when property is sold. Of course if there has already been some unrealised gain in the value of the property then it could be argued (by HMRC in future on seeing the subsequent date of loan agreement) that agreeing now such a share was a transfer of value from Mum to OP; but OP could properly rebut that by explaining that some benefit to OP for making the loan was always their intention and they had not got round to agreeing and documenting that intention till now.

[maths]

If the debt due by the mother is to rank as deductible in computing the mother's estate on death for IHT then it needs to be in the nature of a loan that would have been agreed between third parties.

Third parties would not enter into a loan agreement without agreeing the terms prior thereto and then executing a loan agreement.

In the present case this does not appear to have been done and it would be difficult (if not impossible) to argue successfully that the "debt" is deductible on death.

Prima facie the loan was interest free; any borrower would not now agree to an interest charge (ie a change in the terms of the loan) unless there was some quid pro quo.

There is no indication of any discussions made at the time or when the loan was originally which may impact on the above.

[pqtaxation]

In the present case this does not appear to have been done and it would be difficult (if not impossible) to argue successfully that the "debt" is deductible on death.

If the transfer was not a loan then it must have been a gift -- prima facie this would make no sense in the circumstances here and so the later written agreement would serve only to confirm the prior verbal agreement at time of loan.

Prima facie the loan was interest free; any borrower would not now agree to an interest charge (ie a change in the terms of the loan) unless there was some quid pro quo.

As I mentioned in a previous post I’d question whether starting to charge interest is appropriate in the circumstances of OP and his mother; but in general the quid pro quo for agreeing to start paying interest is that there will be no demand for repayment of a loan whose term so far has been unspecified and whose repayment is on demand.

But without knowing the full circumstances of OP and his mother, the appropriateness to their situation of any of the ideas mentioned here is unknown – it may for example just be best for OP to acquire a part interest in the house in exchange for the loan but agree that all the net rental profits go to the mother -- see PIM 1030 http://www.hmrc.gov.uk/manuals/pimmanual/PIM1030.htm

[section 44]

If the transfer was not a loan then it must have been a gift

No, that's too much of a stretch. There could (for example) be a trust.

[pqtaxation]

No, that's too much of a stretch. There could (for example) be a trust.

What type of trust and what assets are you thinking of in these circumstances?