Interactive Investor

Downsizing? Things to know about a property windfall

4th July 2023 11:04

by Faith Glasgow from interactive investor

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Cash from a property sale needs handling with care. Faith Glasgow explains what you need to know in terms of potential tax liabilities and minimising the taxman’s take.

Downsizing - a row of houses 600

Have you sold your family home in order to move to a less expensive part of the country, or downsize? Are you staring at a five or six-figure sum in your bank account and wondering what on earth is the best thing to do with it?

It’s a pretty good problem to have, of course – but the fact remains that large windfalls need careful attention if you’re going to manage them tax-efficiently. So, what do you need to know about the money you’ve released in terms of potential tax liabilities, and how could you consider using it so as to minimise the taxman’s take?

Are the sale proceeds taxable?

First things first. If you have sold your main home, in most cases there is no capital gains tax (CGT) to pay on the capital released. However, as Carla Morris, a financial planner at RBC Brewin Dolphin, points out, there are a few exceptions to the rule.

“In some circumstances you may have to pay CGT when you sell your main home - for example, if youve sub-let part of it (having a lodger doesnt count), or if the home includes more than 5,000 square meters of land and additional buildings,” she warns.

CGT might also be due if part of the property is exclusively your business premises, or if you have another home that could also be considered your main home, or if you are a property developer and bought it purely to make a capital gain.

Morris emphasises: “These points may be open to interpretation, so if you’re in any doubt it’s sensible to seek advice.”

What about inheritance tax?

The proceeds from your property sale, like the property itself before you sold it, remain part of your estate and therefore could be liable for inheritance tax (IHT) when you die.

Each partner has a £325,000 nil rate band (NRB) before IHT liability kicks in, and the residential nil rate band (RNRB) of £175,000 per person rules give property owners additional protection from IHT.

These mean that if you stay in your family home until you both die, then as a married couple or civil partners you could leave your house worth up to £1 million to direct descendants on the second death, without any liability to IHT.

In principle, moving to a cheaper home would mean that the cash proceeds were no longer protected from IHT by the RNRB because they were no longer tied up in a property. However, the government is keen not to penalise people for downsizing, as Morris explains.

As long as the new property costs at least £350,000 and the couple followed the RNRB rules, the estate will benefit from the full amount of RNRB,” she says. “If they sold a £500,000 home and bought a property for, say, £250,000, the estate may be able to claim a ‘downsizing addition’ on the second death to make up for the amount of RNRB that has been lost (£100,000 in this case).

The downsizing addition rules also apply if no new property is bought - for example if the sellers move into rented accommodation or a care home.

To qualify, the downsizing must have taken place since 7 July 2015, the former home must have qualified for the RNRB if it had been held until the owners died, and at least some of the estate must go to ‘direct descendants’ (children, grandchildren, great-grandchildren). 

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Can I gift some of the proceeds to my kids?

Perhaps you have moved partly to free up cash to pass to your children, to help them get a toe on the property ladder themselves.

If that’s the case, the good news is that you are free to gift any amount you want to them, and no tax is payable at the time you make the gift. However, as Tom Kimche, a client adviser on Netwealth’s advisory team, explains, the money will be counted as a 'potentially exempt transfer’ by HMRC.

“This means that if you were to die tomorrow or in five years’ time, the gift would still count as part of your estate for IHT purposes; it falls totally outside of the estate after seven years, as long as you survive that time.” If you die more than three years through the seven-year period, the rate of IHT applied is tapered accordingly.

As an alternative, if you’re concerned about the idea of passing money on to younger family members who may be unable to properly manage it themselves - whether because of their age, health, capacity level or lack of experience with money - a trust can be used to retain control over how the gift is used and when the recipients have access to it.

Kimche adds: “The beneficiaries’ access to the trust could be defined by you as the settlor of the trust, so for example access could be dependent on them reaching a certain age, or for school fees, or to purchase their own home.”

What’s the most tax-efficient way to invest the money?

How you invest the money will depend on how much risk you’re comfortable with and how soon you’ll need to access the funds.

As Morris observes: “If you're not planning on touching your investments anytime soon, you likely can take more risk and try out less liquid investments than if you're planning to use your funds in a couple of years to buy another property, for example.”

She suggests that in the latter case there’s generally more incentive to play safe with your investments, as you won't have as much time to ride out any market ups and downs and recoup capital losses.

Bearing that caveat in mind, the two most obvious routes for your money so as to keep it free of capital gains or income tax as it grows are to invest via a self-invested personal pension (SIPP) or an ISA. But when large sums are at stake, this can be tricky.

Your £20,000 ISA allowance and that of your partner are obvious starting points. The annual pension allowance, meanwhile, has risen to £60,000, although you cannot pay in more than the value of your taxable earnings this tax year.

Provided you use up this year’s pension allowance, you may also be able to ‘carry forward’ unused allocations from the past three years. (And your partner may have similar pension bandwidth to utilise.)

But if you are retired and have already flexibly accessed your pension, then the maximum amount you can contribute into your pension pot each year is cut to £10,000.

The pension route has advantages if you are concerned about estate planning, as your pension (unlike your ISA) does not count as part of your estate when you die and can therefore be passed on free of IHT at that point. However, there may be other tax consequences for the beneficiaries. 

If youve exhausted the ISA and SIPP possibilities, says Morris, a general investment account (GIA) could be another good choice. “However, if your money makes gains above the annual capital gains tax threshold (currently £6,000), then there’ll be capital gains tax to consider, as well as tax on dividend income.”

Kimche points out that there may be other options worth considering. “You could also invest on behalf of children or other family members, for example into Junior ISAs, Junior SIPPs, or a Junior GIA using a bare trust,” he suggests. 

“Making use of these allowances now is not only tax-efficient but also gives them a head start in investing and the benefit of compounding growth over a much longer period of time than if they started investing as adults.”

Dealing with substantial windfalls can be complex, particularly if you’re thinking about estate planning, so it’s sensible to take professional advice in such circumstances.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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