Mum and Dad have £3,000,000 of investment properties with no mortgages. Their home and other personal effects use up their entire nil rate band for inheritance tax purposes, so their children are exposed today to £1,200,000 of IHT if their parents were to pass away.
Mum and Dad take an equity release mortgage and borrow say 30% of the value of their investment properties today, ie. £900,000, and they gift that money to their children. If Mum & Dad live for seven more years that gift is no longer subject to inheritance tax, so in that scenario Mum & Dad would have reduced the value of their estate which is exposed to inheritance tax by £900,000. That’s a saving of £360,000 of inheritance tax. However, after seven years the debt outstanding to the equity release provider might be say £ 1,368,332.67 if the interest has rolled up at say 6% per annum. Therefore, the inheritance tax saving on this amount would be £547,333.07.
At face value this might look attractive, but the kids who have received the money might well say it’s almost a pointless exercise on the basis that the rolled up interest has reduced their inheritance by £468,332.67, which is the difference between the amount originally borrowed and the amount eventually repayable. The longer Mum & Dad live the wider this margin becomes, so this is often where people write off this idea as a bad one. However, they may well be wrong to do so! This is why ..
If the £900,000 gifted to children is invested into property which also grows at 6% per annum compound the reducing balance of Mum & Dad’s estate is compensated by the £468,332.67 of property appreciation the children have acquired. When coupled with the inheritance tax savings the children are now significantly better off.
It gets better though.
Bear in mind that Mum & Dad’s properties might also be appreciating by 6% per annum, so that’s yet another £468,332.67 their estate has grown by over seven years. Whilst 40% of that growth will be exposed to inheritance tax the remaining 60% will eventually go to their children.
The final financial advantage, which is often overlooked, is that the rolled up interest might be eligible for the 20% tax credit ofn finance costs. This means that Mum & Dad’s tax bill could also reduce significantly as soon as they enter into the transaction. That position could further improve with Mum & Dad’s interest on interest rolled up.
Q) What if Mum and Dad live for another 30 years, won’t the rolled up interest be astronomical?
A) Yes it would. Based on the example above the figure would be £ 5,420,317.69. However, that could apply to all sides of the equation, so actually it could be very good news for everyone. This is because the increase in property values could well match or exceed this figure. On top of that there is the advantage of the potential 20% tax credit on finance costs to factor in.
Q) What happens if mortgage interest rates increase to the 15% + levels witnessed in the 1990’s?
A) One of the key features of equity release mortgage products is that interest rates are fixed for life, so this cannot happen. This is one of the reason’s that I’ve used a 6% interest rate, which is typical for Buy-to-Let equity release at this time. Equity release interest rates are higher that traditional mortgage interest rates for these reasons.
Q) What happens if the loan balance eventually exceeds the value of the property?
A) One of the protection features built into equity release mortgages, which are highly regulated, is that the mortgage lender can never recover more than the sale proceeds of the property it is secured against.
Q) What if Mum & Dad are in their 80’s or 90’s?
A) That could actually work in their favour, because the older a person is the higher Loan to Value they can borrow on equity release mortgage. This might first appear counter intuitive, but it makes sense on the basis that mortgage lenders know that the older a person is the sooner they are likely to get their loan repaid. On that basis, there is less time for the mortgage lenders to be exposed to the risk of the rolled up interest exceeding the property value they have taken security over.
Q) Surely the mortgage lender will not lend to a person indefinitely, i.e. until they die?
A) Yes they will, please see above.
Q) Is there a scenario where a family could lose out as a result of this planning?
A) Yes, there are two. The first is that Mum & Dad could die within seven years. However, the inheritance tax benefits do start to accrue if they live for three or more years. The second risk is if properties fall in value or that property values grow in value at a lower rate than the mortgage interest being charged. A pragmatic approach needs to be applied to these risks.
The funds received by the children in this instance could be invested as Directors Loans into a SmartCo structure.
The SmartCo could use those funds as deposits to acquire a rental portfolio, thus gearing up on the potential returns on capital invested.
The Directors Loans can be repaid to the children tax free. The value of the Directors Loan could also be gifted down to a further generation.
Neither Property118 Limited nor Cotswold Barristers are regulated to advise on Equity Release mortgages, but we can refer you to a specialist as part of our Tax Planning Consultation process, which is essential for any person wishing to look deeper into the above strategy.