Tax trap to avoid when transferring property to children to avoid creditors

Here's a salutory lesson for those contemplating the transfer of a family home to children to take advantage of record fall in house prices and the current 1% rate of stamp duty on such transfers.  A client of mine - who didn't take tax advice from us - did this and triggered a tax liability of €73,500.  What happened? you might ask.

The steps in transferring a family home to children are quite straightforward.   In this case, my client and his wife gifted the family home worth c€1.2m to their two children.  On the advice of their lawyer a right of residence for the parents was included in the contract.  This measure is designed to protect the parents from one or both children deciding to change the locks.  It also had a tax benefit for the children.

Let's examine the tax treatment of the transaction - as understood by the client.

1. The disposal of the property by the parents to their children triggers tax (capital gains tax).  That said, no liability arises as the property has been the principal private residence (ie family home) throughout the period of ownership.  This is correct.
2. The receipt of a half-share of the family home by each child is a taxable gift and this must be valued for tax purposes to determine what, if any, tax arises for the children.  As the parents retain a right of residence this must be taken into account in valuing this gift.  This is also correct.
3. The value of the gift taken by each child is calculated as follows.  A) Take the value of the property, ie €1.2m.  B) Deduct from the value of the property the value of the "right of residence".  This is calculated by a formula in tax law and is not important.  In this case the right of residence was valued at €660k therefore the value of the gift taken is €540k (i.e. €1.2m less €660k.) C) Divide this figure by 2 - as there are two children - to calculate the value of the gift taken by each child, ie €270k.  If this amounts exceeds €333k (the class threshold for tax-free gifts by a parent to a child) the excess is subject to gift tax at 25%.  Clearly the value of the benefit taken by each child does not exceed €333k therefore no such liability arises.  This is were my client is wrong.

As structured, a tax liability arises for the children of €73,500.  Let's look at where this liability comes from.

There are no rules in gift/inheritance tax law to determine the value on a right of residence.  It is generally understood that Revenue will, by concession, value such right at 10% of the market value of the property for each parent (I call this the "10% rule").  The value of the gift taken by both children is actually €960k (i.e. €1.2m less 20% (for right of residence)).  This is signficantly higher than the amount expected by my client.  The value of the taxable benefit taken by the children is €295k (i.e. €960 less €666k (the tax-free thresholds of €333k for each child)) which at 25% triggers gift tax of €73,500 (or €36k each).

What is the solution?

Fortunately, there are two possible solutions to this problem.  We made a slight alteration to the wording of the contract to enable the client to benefit from a Revenue concession so that the interest retained by him and his wife is valued at more than 10%. 

We redrafted the relevant legal papwork to ensure that no liabiltiy to gift tax arises for the children.  We saved the client €73,500 in gift tax, put his mind at ease and avoided a potential legal dispute between the parties.

The lesson when Estate Planning or implementing Asset Protection is to take tax advice and to ensure that your tax advisor is involved in the drafting and reviewing of all legal paperwork.  As this case shows, the omission of just one word can have significant consequences.

For more information on Estate Planning contact Derek Andrews at Andrews Tax Consulting by email derek@andrewstax.ie or phone + 353 (0)1 631 6075.