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How to save £5m in tax Buying abroad Give it away
Death and taxes may be life's great inevitabilities, but while we'll glibly acknowledge this truism, too few of us stop to ponder their implications in an era where trading up through our booming property market will make paper millionaires of many of us.
Accountant Ronnie Ludwig, whose firm Saffery Champness advise many of Scotland's wealthiest people, says that it isn't just the super rich who have to worry about the implications of your property suddenly making you liable for millions in tax. If house prices continue to rise in anything like the way they have done in the last few years, many ordinary, professional urban twenty and thirty somethings should be thinking about steps they can take to minimise their liability. And saving £5 million over your lifetime is in no way outlandish, argues Ludwig.
To illustrate, Ludwig uses an example of a super successful couple with high earnings throughout their career. Mary Smith is a lawyer aged 24 with a one-bedroom flat in Haymarket, Edinburgh, bought in 1999 for £80,000 with a 10% deposit. William Brown is a doctor aged 25. He owns a one-bedroom flat in Stockbridge, Edinburgh, bought in 1999 for £100,000 with a deposit of £10,000.
They marry in 2003, and sell Mary's flat in Haymarket for £120,000 and William's flat in Stockbridge for £150,000. This gives them a pot of £108,000 from their equity and deposits to invest in a three-bedroom semi in the New Town with a purchase price of £454,000, meaning that after fees they need a mortgage of £354,000, affordable as they earn £50,000 and £60,000 per annum respectively.
They have savings of £20,000 and both have modest pension funds worth around £50,000 each. In 2006 they start a family and decide to look for a bigger house with a garden.
By this time they both earn £100,000 per annum. They sell their New Town semi for £600,000, giving them a personal fund of £250,000 to invest in a new family home. They fall in love with a four-bedroom detached house in Murrayfield which costs them £900,000, equating to a £650,000 mortgage after they add their own funds to the mix.
By 2012 both children are at a private school in Edinburgh and, borrowing against some of the equity in their home, the parents decide to buy a holiday home on the French Cote d' Azur for £450,000.
By 2025 William and Mary are entering their fifties and are earning £350,000 and £375,000 respectively. After his gap year their son John goes to university. The couple decide to buy their son a two-bedroom flat near Kelvingrove Park in Glasgow for £330,000. John will rent out the spare room in the flat purchased with a buy-to-let mortgage.
A year later their daughter Jane enrolls at St Andrews. This time the parents act as guarantors on a student mortgage on a one-bedroom flat costing £285,000.
In 2031 aged 55 and 56 respectively, Mary and William begin to prepare for their retirement by downsizing into a modern penthouse flat costing £3m. They sell up their family home in Murrayfield, now worth £6.7m, and retire at 60, spending their time between their Edinburgh penthouse and their home in France.
They both die in 2051 aged just 70 and 71 and split all the assets between their two children through their wills.
When the sums are totted up, excluding any inheritances they may have received during their lifetimes, the Browns will have amassed a personal fortune of almost £6.7m and a property portfolio worth £25.3m split between their student flat, the property in France and their principal residence, the Edinburgh penthouse. While this is the result of an optimistic view of the property market, assuming an 8% rise in prices per annum, it is not impossible.
With inflation currently growing at around 3% per annum, Ludwig calculates that the exempt allowance for inheritance tax by 2051 will represent something in the region of £1m. But the Browns' estate could be looking at paying at least £12 million in inheritance tax - a figure, Ludwig says, which could be significantly reduced with some simple advance planning. "The couple could reduce their final inheritance tax bill by at least £5m and possibly a lot more if tax efficient investment advice has been taken during their lifetimes," he says.
"They are not atypical, and £5m is a massive amount of money at any point in history."
In terms of their life progression, the Browns hit their first major decision when they add their holiday property to their prime principal residence in Edinburgh. Ludwig says: "Strange though it may seem the worst thing they could do is purchase their overseas property with their personal reserves of cash.
"With a UK mortgage designed for buying abroad or one of the excellent local Euro calculated products, they can take advantage of a number of tax breaks and avoid crossing the thresholds for French wealth tax.
"It seems perverse, but being in debt to a mortgage can actually save you money. The borrowings would reduce your tax liability in France as the mortgage is deductible from the value of your property for calculating wealth tax, currently charged annually on property worth in excess of 732,000 (£502,000) at rates ranging between 0.55% and 1.8%. You must contemplate the spectre of rising liability as your asset grows in value."
According to Ludwig, another benefit of taking out a mortgage is that any profits you might make from letting out your property are reduced for tax purposes by the amount of the mortgage interest you pay.
Buying for children
It's a similar scenario when it comes to buying John and Jane's student flats. Again, the parents should resist the temptation to buy the flats with cash. They should instead act as guarantors on student mortgages on both properties (rather than just Jane's) to avoid capital gains tax and, ultimately, inheritance tax when the students graduate, sell up and move on. As John and Jane's principal private residences, held in their own names, these flats would be exempt from capital gains tax on profits when they are finally sold. The proceeds of the sale would be in the children's hands as would any future growth in value.
Ludwig also recommends that the couple make lifetime gifts to their children, especially on their retirement. Unlimited cash gifts can be made direct to the children and even gifts of assets pregnant with a capital gain can be made into a discretionary trust by each parent every seven years, up to the then limit of the IHT exemption threshold. These gifts are made on the assumption that the donor will live seven years after the date of the gift (the donor could take out an insurance policy to cover any tax liability should he or she fail to live beyond that seven year threshold) and that the gain is held over into the trust. On this basis, parents can gift substantial chunks of their estate tax free to safeguard their children's financial futures.
Another consideration is for the couple to bypass each other with a proportion of their estates on first death. Tax efficient Flexible Will Trusts can be used so that the surviving spouse never runs short of cash. Getting the balance right is the difficult bit, but the object of the exercise should always be to transfer as much capital wealth down to the next generation, or even to grandchildren, as can be sensibly done without leaving the older generation short of money in later life.Copyright The Scotsman
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