Tax traps: gifting cash for a property purchase for children

This explains how the hugely complex pre-owned asset tax (POAT) can catch out parents who gift cash to fund a property purchase for children and later live in the property

After Chancellor Rachel Reeves announced her first Budget to parliament, much of the debate that followed focused on inheritance tax (IHT). Although it is widely believed that the changes brought in will affect only a small proportion of estates, many people are now perhaps slightly more familiar with how IHT is imposed than they were before.

Most adults, especially those who are retired or nearing that milestone, have at least heard of IHT and have a basic understanding of how it might impinge upon their assets.

There is, however, far less familiarity with another form of income tax charge which can be triggered when elderly people live with their family in their final years, rather than going into a care home.

That particular levy is called pre-owned asset tax (POAT), a tax so little understood that even some accountants and legal advisers might be unfamiliar with exactly how it functions. So, what is POAT, and how does it interact with IHT?

Some taxes and allowances are arguably designed to encourage or discourage certain action. The way in which IHT and POAT overlap is most definitely an example of this.

When working out if an estate must pay IHT, the rule is that any assets given away as gifts during the subject’s lifetime will be ignored so long as they lived for at least seven years afterwards. The certainty of that calculation becomes slight less stable if a person makes a gift but then benefits from it in some way.

An example of this might be if an individual is lucky enough to have a holiday home which they no longer use much, and so hand it over to their children to take advantage of.

If one disregards capital gains tax (for the sake of this example) they may still have to pay on the deemed disposal of the property. The reason for this is that despite surviving the requisite seven years to avoid having to pay IHT, the value would still be considered following the person’s death for estate valuation purposes if their children had allowed continued use of the holiday home without being paid a full market rent.

IHT anti-avoidance rules which would regard the privilege of continued use of the property as a ‘gift with reservation of benefit’. From an IHT planning point of view, the whole exercise could be perceived as a failure!

Another common scenario is when someone makes a gift from which they derive no immediate benefit but gain from indirectly many years later.

A typical story which encapsulates this trap would be the so-called ‘bank of Mum and Dad’ giving cash to their child to part fund a property purchase. If – happily – more than seven years pass, the parent involved would be entitled to believe they have reduced the value of their estate for IHT purposes, while also giving their offspring a crucial step on the housing ladder.

As it happens to us all, there will come a point when the generous mother or father can no longer live alone. They might appreciate the possibility of going back to live with their grateful child, who reciprocates the help which enabled them to buy the house they now live in with their own young family.

At this juncture, the elderly member of the family could sell off their own house to give their offspring some more cash, some of which could contribute to the construction of a ‘granny annexe’.

From a tax perspective, it all seems to configure perfectly with IHT rules: cash has been gifted and seven years have elapsed.

But here comes the unanticipated problem: the grandparent who has done everything by the book is actually benefitting from a pre-owned asset. POAT will bite because they are living in a property, albeit a much smaller one, which is part-funded by their own cash.

In this not uncommon situation, POAT seems excruciatingly unfair. It is a tax introduced to find a way of taxing those who have managed to circumvent the IHT gift with reservation of benefit rules. Put bluntly, if HMRC cannot tax people in one way, it will find another.

Unreasonable though it may seem from the outside, HMRC is simply doing what it is designed to do – taxing citizens if there appears to be a legitimate reason for so doing.

Given the public finance black hole that the new government has made so much of since taking office, it is unlikely this will change any time soon.

As well as seeming slightly underhand for those who might be unaware of its existence, POAT is also hideously intricate and complicated. Which begs the question, how can it be collected? POAT operates to treat occupation of the property as a benefit which, subject to a de minimis disregarded benefit any rental value seemingly higher than the threshold triggers an income tax charge on the elderly occupier at their marginal rate.

And how do you know what the benefit is? Inevitably, only after the additional expense of a chartered surveyors’ report to assess the rental value on an open market basis with a periodic review.

It is perfectly reasonable to enquire whether a tax such as POAT which only traps those with good tax awareness, through their own background reading or professional advice, is fair.

After all, this particular tax is so complicated that it is almost impossible to report to HMRC in self-assessment. In reality, the last chance for HMRC to recover it will be when an estate’s executors complete an IHT account. The form includes a lengthy section relating to POAT in the Lifetime Gifts Schedule.

Most executors, however, would not know or enquire about the history of funding for a property. With the rise of online DIY probate applications, it is even more certain that the majority of lay executors would not realise that POAT applies.

The unfairness of POAT from a tax collection perspective is self-evident: those who seek professional advice may become aware of and declare the position, whereas those who have no knowledge and manage their own affairs without professional input are likely to get away with it. This is not deliberate avoidance, but simply perfectly innocent ignorance.

POAT is the perfect illustration of why all taxes need simplification if the government is to achieve its aim of collecting all that is due. People cannot report what they don’t know about. HMRC’s solution for those beneficiaries caught out by POAT upon the death of a loved one who cannot afford to pay it is to instead shift the onus onto the IHT gift with reservation of benefit rules. A timely reminder, if needed, that specialist tax advice is always essential.