Tax and estate planning considerations
When acquiring UK property, aside from seeking legal support on conveyancing, US purchasers should seek advice on the broader tax and legal implications. As with any substantial acquisition or investment, there will always be traps for the unwary. Where US purchasers are concerned, the traps can be more common and more dangerous. Taking advice from the outset will enable pro-active planning and help to avoid costly future mitigation.
Exposure to UK inheritance tax
The acquisition of UK real estate by a non-UK domiciliary will always come with an increased exposure to UK inheritance tax (IHT). The value of UK property in a person’s estate will be subject to IHT at a flat rate of 40% on death if and to the extent that it exceeds the deceased’s available ‘nil rate band’ amount of up to £325,000. This may come as a shock to clients from the US, where the amount that can pass free of Federal estate tax is currently $12.92m!
In the past, non-UK domiciled individuals (who are only exposed to IHT on UK assets) would have been advised to acquire UK real estate through a non-UK registered holding company, which would serve as a “situs blocker” and protected the value of the property from IHT. However, following the introduction of anti-avoidance legislation in April 2017, shares in a non-UK registered company will now be treated as UK assets for IHT purposes (so will be exposed to IHT, regardless of the deceased owner’s domicile) if and to the extent that their value reflects the value of underlying UK residential property.
Taking out a mortgage
The options for mitigating this IHT exposure are now very limited. In most cases, the only option will be to purchase the property with the benefit of a commercial mortgage, which should be deductible against the value of the property for IHT purposes. Of course, this comes at the cost of paying interest to the lender, and whether this is worthwhile will vary from case to case.
Where US persons are taking out mortgages to fund purchases, there are some extra considerations to be taken into account. As explained by James Rose, a private banker at Coutts & Co:
'For US people, getting a UK mortgage can present a number of issues. Many banks will struggle to lend to people whose income isn’t denominated in GBP and will want to see the income being received into a UK bank account. These issues are further amplified for HNW individuals, who are often not salaried individuals but instead have complex income streams. In these circumstances, it may be better to find a lender who can adopt a more pragmatic approach and potentially consider the client’s wider asset base to support the application.
'Furthermore, while many US clients may want to consider taking an Interest-Only mortgage for tax planning purposes, a number of changes to mortgage regulations over the last decade mean that few banks are willing to offer these any more. Nonetheless, US clients should be careful about taking a “flexible” mortgage product (such as those which you repay and redraw) and should seek specific tax advice as these products can have unintended US tax consequences as well. Overall, it is worth looking for a Private Bank or specialist mortgage lender who can take into account more complex client circumstances as well as engaging with a tax adviser who understands both countries tax regimes.'
Borrowing from individuals (e.g. friends or family) or non-UK resident trusts offers less IHT protection when viewed holistically because, although the debt should be deductible from the borrower’s estate for IHT purposes (subject to various legislative conditions being met), the benefit of the debt will be subject to IHT in the lender’s hands. This was another of the changes introduced in April 2017.
Given the limited scope for IHT planning and increasing cost of mortgages driven by higher interest rates, many clients will choose to accept the IHT burden and, instead, take out life insurance to cover the liability that will arise on their death. If they do this, they should be advised to take out the policy through a life insurance trust (or assign the benefit of the policy to a trust) to prevent the proceeds themselves being subject to IHT.
On a positive note, Christiaan van den Hout of Vie International explains that:
'US-connected clients are likely to have access to the US life insurance market, which can sometimes offer more appealing solutions than the UK market. Beyond delivering a robust and fully compliant arrangement for US/UK purposes, the larger US domestic life insurance market can offer a number of enhanced benefits including more sophisticated underwriting, flexible products, more robust legal guarantees and superior pricing. It is not uncommon to see discounts of 20-50% on life insurance products sourced in the US versus the UK when considering permanent (‘whole of life’) and short 10-year term policies.
'US persons will automatically qualify for the US life insurance market as will non-US persons who can demonstrate sufficient US nexus. In the UK, the level of cover available is typically commensurate with the tax liability on UK situs assets. The US does not have this same restriction; once US nexus is demonstrated, a larger amount of insurance can be obtained based on the client’s total worldwide assets, including wealth held in offshore entities such as companies and trusts.
'Further, for some non-UK domiciled individuals who claim the remittance basis of taxation, remitting foreign income or gains into the UK to fund a UK life insurance policy may incur tax charges that ultimately require grossing up the premium figure. For these individuals, remitting the same offshore funds into the US to pay the premiums on a US policy does not incur the same tax charge.'
But US citizens and residents will also need to ensure that the trusts they create will take the form of US irrevocable life insurance trusts (“ILITs”).Dina Kapur Sanna of Day Pitney LLP comments that:
'Assuming the ILIT is properly drafted and administered, at the death of the donor-insured, the insurance proceeds will not be includable in the insured's taxable estate and will also be exempt from income taxes.
'If an insurance policy is transferred to the trust or purchased by the trust and is completely owned by the trust, cash gifts can be made to the trust each year to pay the premiums without the ownership of the insurance being attributed to the insured. This can keep the full death benefit of the policy out of the estate of both the insured and the surviving spouse; provided, however, if the policy is transferred to the trust, there is a 3-year survival requirement for the proceeds to escape estate tax on the death of the donor.
'The gifts to the trust can be designed to qualify for the $17,000 annual gift tax exclusion through what are sometimes called "Crummey" withdrawal powers exercisable by the beneficiaries (usually the spouse and children, or in the case of a two-life policy, by children and more remote descendants).'
'It should be noted that, if life insurance is taken out with the express purpose of paying off a mortgage, the ILIT will not protect it from US estate tax. The ILIT must be independent of the residential purchase and the death benefit must be paid to the beneficiaries (not the bank) after the death of the insured.
Clients who acquire UK real estate should also be advised to consider putting in place a UK will. For married couples, the UK will should be structured in a way that allows access to the spouse exemption from IHT, so the tax liability can be deferred until the second death. While this can potentially be achieved in a foreign will, the added benefit of having a UK will in place is to facilitate the administration of the UK estate on death.
In particular, to obtain probate of a foreign (e.g. US) will in the UK, the Probate Registry will require an affidavit of foreign law (provided by US counsel) confirming the validity of the will as a matter of local law and who is entitled to administer the estate. This gives rise to an additional administrative hurdle (and associated costs) for the executors that would not arise if there was a local will in place. Having said that, if primary probate is granted in the US, the Probate Registry will generally accept a court-exemplified copy of the US will to probate in the UK without an affidavit. But this option has its own disadvantages, including the inevitable delay in administering the UK assets.
Capital gains tax on the family home
For UK capital gains tax (CGT) purposes, gains realised on the disposal of a person's main home benefit from 100% relief, assuming the property has been that person's main home throughout the period of ownership. This is not the case for US income tax purposes, where only the first $250,000 will be exempt and the balance will be subject to tax. This US tax overlay can cause the UK relief to be wasted.
Therefore, in the case of a couple with one US spouse and one non-US spouse, it will generally be most tax efficient for the main home to be owned solely by the non-US spouse. But where the US spouse is funding the acquisition of the property, it’s not that simple! Due to the absence of an unlimited spousal exemption from US gift tax on gifts to non-US citizen spouses, the gift itself could have adverse US transfer tax consequences. To address this, the US spouse might consider making annual gifts of fractional interests in the property to the non-US spouse. Under current rules, the US spouse can make gifts of up to $175,000 to the non-US spouse each year free of US Federal gift tax. These regular gifts can add up over time to improve the CGT position.
When acquiring UK property, US purchasers should seek advice on the broader tax and legal implications. In this report, Forsters’ partners along with specialists in the industry, share their insights on the current UK market for US buyers and how best to navigate the specific risks for US-connected clients.
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