Protecting property assets for family legacy in the UK

August saw the highest ever recorded increase in UK residential rental prices, beating the previous record set in July.

By contrast, house price growth has seen a notable slowdown this year. The UK Office for National Statistics reported a meagre 0.6 per cent increase in the year to July 2023, down from the peak of 14 per cent in July 2022.

Years of stagnant housebuilding have left the housing supply unable to meet the growing demand. Yet, the recent fluctuation in rental versus purchase prices can be attributed to a sudden rise in interest rates earlier this year, making homeownership unattainable for many aspiring buyers and compelling them to embrace renting.

For those with substantial financial means who may be less reliant on borrowing, this could represent a unique opportunity to secure attractive real estate deals at lower prices, especially if they are eyeing investment properties with the potential for strong rental yields.

This may explain the enduring appeal of UK prime residential real estate to overseas investors who may also enjoy favourable exchange rates, enhancing the perceived value of sterling-denominated properties.

However, for those seeking to keep a property within the family for generations to come, careful consideration of investment structuring is paramount to navigate the ever-evolving UK tax landscape. Beyond the immediate tax implications upon acquisition, forward planning is essential to address the impact of potential taxes on property disposal, such as capital gains tax (CGT), and inheritance tax (IHT) upon death.

Gone are the days when buying a UK property through offshore companies was a silver bullet to avoid UK taxes. While there are still advantages to such structures, particularly for rental investments, owners must still grapple with UK inheritance tax if they fail to plan properly. This can lead to a hefty 40 per cent tax charge on the property’s value in the event of the owner’s demise, even if held through a company or trust.

One common strategy to mitigate IHT exposure is to leverage debt finance, which reduces the property’s net value.

For instance, if Tom owns a £10 million property (and we ignore the relatively small £325,000 IHT allowance), he essentially faces a potential £4 million inheritance tax liability (40 per cent of the property’s value), payable by his estate upon his death. However, had he partially financed the purchase of the property with a £5 million mortgage, his inheritance tax liability would have been halved to £2 million, thanks to the reduced net property value.

Nonetheless, the long-term borrowing costs may outweigh the potential IHT savings, prompting well-informed investors to explore alternative solutions.

For instance, transfers between spouses are generally exempt from IHT, making it prudent for individuals to ensure that their property passes to a surviving spouse upon death. On the other hand, bequests to children or other family members do not enjoy this exemption.

Subsequently, a surviving spouse might consider gifting the property to the next generation, which can trigger a CGT charge if the property has appreciated in value during ownership. However, if the donor survives for seven years from the date of the gift, the property can pass to the next generation entirely free from IHT.

To safeguard against potential IHT liabilities, individuals can acquire insurance during their ownership period or for the seven-year period after a gift. While this does not reduce IHT exposure, it provides immediate liquidity to cover the liability without the need to sell an asset that is intended to remain in the family for generations.

Navigating the US landscape

For non-US investors keen on purchasing US properties, similar estate and tax planning issues emerge. Upon their passing, non-US citizens domiciled outside of the US become subject to US estate tax on US real estate holdings. There is a small exemption of US$60,000, leaving any amount above this threshold subject to US federal estate tax, which can reach up to 40 per cent of the real estate’s market value at the time of the owner’s passing.

To mitigate this US estate tax exposure, one effective strategy involves acquiring and holding US real estate through a non-US holding company, that is, a company incorporated and administered outside the US. At the time of the non-US owner’s passing, they would be treated as holding shares in a non-US company, not US real estate. It is crucial to draft a will that considers the jurisdiction of the non-US company and outlines the intended disposition of the US real estate.

While owning property through a US limited liability company (LLC) is often seen as an estate and tax planning strategy, it does not provide US federal estate tax protection. For US tax purposes, a non-US person owning US real estate through an LLC is treated as owning the property directly.

Another viable strategy involves holding US real estate through an irrevocable trust, which generally cannot be altered without agreement of the beneficiaries.

Structured properly, an irrevocable trust benefiting family members (excluding the settlor) can shield against US federal estate tax. Special considerations on whether the trust should be US or non-US may depend on the US status of family members and other assets held by the trust. Additionally, this trust setup circumvents probate and facilitates broader succession planning for the family.

For non-US owners already holding US real estate in their personal names or through an LLC, they may consider life insurance policies to help cover potential US estate tax liabilities. To further mitigate US estate tax exposure, they may contemplate transferring US real estate to a non-US holding company, though this could trigger US capital gains tax on property appreciation since acquisition.

Protecting your family’s future

In the dynamic landscape of UK and US property investments, securing your legacy for future generations involves understanding how the property market works and knowing the tax rules. By using smart investment strategies, you can protect your property and ensure that it provides long-term benefits for your family.

This article was first published on The Business Times.