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Three ways to minimise inheritance tax

Opting for a loan, life interest or selling below market value are three options

With no changes to inheritance tax thresholds in last year’s budget and property prices posting further growth in 2022, more and more people are likely to fall into the capital acquisitions tax (CAT) net.

As Alan Murray, a tax partner in Mazars notes, “CAT isn’t just for wealthy people”, even if Central Bank figures released last week shows they are more likely to benefit.

Someone with a house worth in excess of €1 million – not unusual in several Dublin suburbs – plus a good pension, could have an estate worth about €2 million. With two children, this would leave a hefty tax bill of some €440,000.

No wonder that minimising potential tax bills is on the minds of many. So, when it comes to passing on property to the next generation, what are the options?

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1 Sell for below market value

This is something that often shows up on the property price register, where a home sells below market value. It could be that there is an issue with the property, or that it’s part of a portfolio sale; often however, it’s a case of an intra-familial transfer, where a daughter or son acquires a family property for below market value.

While it might be seen as a way to cut potential taxes, Murray says this is not the case, as Revenue will treat the discount as a “gift”, and this will be subject to taxes in the normal way.

Current inheritance tax thresholds mean that a son or daughter can inherit up to €335,000 tax free. After that capital acquisitions tax at a rate of 33 per cent applies. A lower group B applies when the beneficiary is a brother, sister, niece, nephew or lineal ancestor or lineal descendant of the disponer, and the tax-free threshold is €32,500. A third group has a threshold of just €16,250 and applies in all other cases.

Of course capital gains tax (CGT) might also apply to the parents when selling on a property, although this won’t apply if it is their principal private residence (PPR) – or family home.

“People don’t understand that a gift is a disposal for CGT purposes and the person selling has a CGT position that needs to be addressed,” says Marie Bradley, managing director of Bradley Tax Consulting. Consider the example of an investment property owned by parents that is worth €500,000. They bought it 30 years ago for €80,000, so their taxable gain on the property is €420,000.

“The parent might say ‘I don’t need the money’ [by selling it at market value], but at the same time, they don’t want to pay CGT at 33 per cent on €420,000,” says Murray.

What he suggests in such situations, is that the child pay a below market value price for the property that is pretty much equivalent to the parents’ CGT bill. In our example, the daughter could buy the property for €138,600, and the parents will use that to settle their CGT bill.

Remember, while the property may have just sold for €138,600, Revenue will consider the CGT owed to apply to the full market value of the property, hence CGT at 33 per cent is owed on the gain of €420,000, rather than on the actual €138,600 paid for the property, which would have been just €45,738.

What happens the child then?

“The recipient then has a gift tax issue if the price they pay is less than market value,” says Bradley. In this case, the “gift” equates to about €361,400.

What tax will be payable on this may depend on the child’s personal situation. If they have a threshold to use up, then no tax will apply for the difference in what they paid, and the market value.

If this threshold has already been used up, however, they will be subject to CAT at 33 per cent, so, up to about €119,000. But the child may not need to pay this.

“If a CGT charge arises on the transfer of property to the child, the child can claim a credit provided they keep the property for two years,” says Murray. “This wipes out the gift tax”.

So, the child has managed to buy a property worth €500,000 for €138,600, and the family has structured the transfer of the property for a net cost of this amount. If the child still had a threshold to use, they wouldn’t have been able to offset the CGT liability, so the timing of such transactions is important.

“You always have to take advice, estate planning is a journey that you’re on,” says Bradley.

The third tax issue that arises is stamp duty, which will also apply to the market value, so 1 per cent of €500,000, which is €5,000.

Of course in the example we use, if the parents had waited to transfer the property until they died, CGT wouldn’t have applied at all – but CAT would.

It’s a gamble, says Murray. “If you pass the assets now, you can tell how much tax is owed,” he says, “but if you allow assets to pass under a will, you’re taking a gamble as the asset value could increase, and there could be a tax change, and you could end up with a higher tax rate.”

On the other hand, waiting until the future means that the transaction could incur a lower tax cost.

“No one knows what the tax rules will be, so there is an element of risk to it”.

2 Be a lender

There can also be an advantage in transferring cash to a family member by way of a loan, which can then be used to purchase a property.

“It’s not a panacea [to taxes],” says Murray. However, it can be a way of mitigating the overall bill.

If going down this route, Murray warns that you should “tread carefully”. “It has to be a proper loan,” he says, which means that there should be a “legitimate expectation of repayment”.

He suggests that you get a proper loan agreement drawn up, “as if you were borrowing from a bank”.

In an ideal world, this loan would also be secured on the property, while the loan agreement could also include that you, as the lender, have the right to have it repaid (should the child end up doing something else with the money, for example).

There are a number of points to note from a tax perspective.

Firstly, as Bradley notes, there is an issue with respect to the interest rate being charged. The annual gift tax for a loan is computed on the basis the interest rate someone would have got on that money on deposit. With interest rates so low on deposits in recent years, this meant a low annual “gift” – which may not even apply.

While there were efforts in 2021 to link such loans to market lending rates, the then minister for finance Paschal Donohoe rowed back on this decision.

“If the annual gift is under €3,000 and there are no other gifts made, you can essentially have an interest free loan,” she says. This may be higher if there is a €6,000 gift between both parents.

“So, you can have quite a significant amount outstanding on an interest free loan basis,” says Bradley.

If the loan is repaid, then the loan ceases, and no taxable event applies. As Bradley notes, if the child is in a position to repay the loan, it can be a good way of giving liquidity to the parents if they need it.

Alternatively, if no repayments have been made on the capital of the loan, the parents might opt to waive the loan, or this might occur on death. In such cases, the benefit is then triggered to the child, and CAT will be payable. However, as 20 plus years may have elapsed since the loan was first taken out, it defers issues of tax for a later date.

If, for example, after 20 years the parents write off the loan, the child has to deal with CAT issues for the full amount of the capital value of the loan. But, the view can be that the time value of money means that the capital value will be a lot less in real terms after 20 years, while tax rates and thresholds may also have moved favourably over that time.

“It’s pushing the can down the road,” says Bradley.

3 Opt for a life interest

Another mechanism that may help reduce a potential bill is for parents to gift a portion of a property to their children, while retaining a life interest in it. This can be particularly useful if a property is expected to increase in value, as the tax bill is determined at the point in time that the life interest is retained – not on when the entire asset is passed on, typically upon death of the parents.

This means that tax would be payable on a house valued at €500,000 today – even if, when it eventually passes to the children, for example, some 20 years later, it could have doubled in value.

“It gives certainty,” says Bradley of the potential tax bill, adding, “but the parents must retain ownership for their lifetime”.

This can be a complicated structure, and Bradley recommends that everyone in the family understands clearly what is going on. Such a structure does however, “really protect the parents” says Bradley, as it ensures they can remain in their home as long as they wish.