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In the fifth of a series of articles, Malcolm Finney, author of 'Personal Tax Planning: Principles and Practice', looks at the tax implications of death and sole or main residence relief and how to avoid a possible tax trap when estate planning.

Introduction

Any capital gain made on the disposal of the former family home of the deceased by the executors during the administration period is in principle subject to CGT.

Executors are liable to CGT on capital gains arising on disposals of property made during the administration period (any capital gain will be the difference between the probate value (i.e., market value at the date of death) and the disposal value).

However, the disposal may qualify for sole or main residence relief (TCGA 1992 s 225A). The relief applies where the following conditions are satisfied:

• the disposal occurs on or after 10 December 2003;
• immediately before, and immediately after, the death of the individual the property is the sole or main residence of one or more individuals; and
• at least one of those individuals (or two or more of those individuals) has, under the will, an entitlement to at least 75% of the net proceeds of the disposal (broadly, sales proceeds less deductible expenditure; any IHT charge thereon or liabilities (e.g., mortgage) thereon are ignored for this purpose).

The entitlement to at least 75% of the net proceeds is an entitlement by those in respect of which the property, both before and after the death, qualifies as their sole or main residence.

This creates a problem where, for example, the property is not the sole or main residence of one or more of the beneficiaries who, under the will, are entitled to inherit a part of the property (if such beneficiaries’ interests amount to more than 25% of the property).

Example

Eric Dunce is a widower and has two daughters, Louise and Clare.

Following the death of Eric’s wife his daughter Louise, who is not married, sold her own property and moved in with Eric; the property thus becomes her sole residence.

Clare, who is married, continues to live in her family home with her husband and family.

Following Eric’s death Louise continues to live in the property as her sole residence.

Under his will Eric leaves the property to each of his two daughters equally.

Eric’s executors sell the property and distribute the sale proceeds equally between the two daughters.

However, as Louise is only entitled to 50% of the proceeds (i.e., less than 75%) a CGT charge arises on any capital gain arising on a disposal of the property (i.e., the difference between probate value and value at the date of sale) by the executors.

This reduces the amount of the inheritance of each daughter.

How to Avoid the Trap

The CGT charge in the example could have been avoided in one of two of the following circumstances.

If Eric had left the whole of the property to Louise (she would have been entitled to 100% of the proceeds on any subsequent sale by the executors and any capital gain on sale by them would have qualified for sole or main residence relief); alternatively, if following Eric’s death Clare had, within two years, executed a deed of variation (DoV) in Louise’s favour for CGT (and IHT) purposes Louise would be deemed to have inherited the property as to 100% from Eric and thus would be entitled to 100% of the sale proceeds on a sale by the executors (IHTA 1984 s 142 and any capital gain on the sale would have qualified for sole residence relief).

With respect to the former suggestion Eric could have compensated Clare by leaving her other assets in his will, failing which Louise could, following the sale, compensate Clare (e.g., by giving 50% of the net proceeds to her; this would constitute a potentially exempt transfer (PET) for IHT purposes on the part of Louise).

With respect to the latter suggestion above if Louise agreed to compensate Clare in exchange for Clare agreeing to execute the DoV the deed would be ineffective and a CGT charge would arise on disposal by the executors; thus, no such arrangement would have to be agreed in advance between Louise and Clare. Alternatively, it would be acceptable, however, for Louise to also enter a DoV in favour of Clare with respect to any other property which Eric had left her (i.e., Louise).

The executors must make a claim for the relief to apply (TCGA 1992 s 225A).