The true impact of the pandemic on the commercial property market remains, for the time being, unquantifiable. It is clear, however, that property valuations have dropped and may drop further in the short-term as we discover how to live and work in a post-pandemic world.
On the face of it, this seems to mitigate a problem for those who may have been worried about a hefty inheritance tax (IHT) bill on holdings in property investment companies. Lower valuations should mean less tax to pay. It seems likely, however, that in all but a handful of situations, property prices will rise again and investors – or more specifically, their heirs - will face the same problem.
In normal circumstances, property investment companies do not qualify for relief from IHT, so the full value of the shares is exposed to IHT on the death of a shareholder. It may be possible, however, to ‘lock in’ these lower valuations for IHT purposes even if, in the longer-term, property prices ultimately recover. The idea was mentioned briefly in our article on tax rises.
Separate share classes
The key is to create new ‘growth’ share classes in the investment company. These shares are gifted to children or other beneficiaries who then become entitled to any growth in the underlying property portfolio. This growth is taken out of the parent’s estate for IHT purposes, thereby locking in the lower valuations we see today.
In a typical example, the parents hold 100% of shares in an investment company with a commercial property portfolio worth, say, £10m. In the wake of the pandemic, the value of the property portfolio could have dropped to £8m. The family expects the value of the portfolio to recover, but it is likely to take time.
The shares held by the parents are reclassified into ‘A’ shares and ‘B’ shares. The ‘A’ shares are held by the parents with the right to capital capped at, say, £9m. The ‘B’ shares are gifted to the children. They have no right to the capital until it exceeds £9m. After that point, they receive anything extra. This extra might come from a combination of recoveries in asset values, and/or retained after-tax profits. These shares are also non-voting, so the parents retain control of the company throughout.
The ‘switch’ point (or hurdle) is £1m higher than the current value in the example above. This means that the ‘hope value’ of the growth shares is relatively low (the shares will not be ‘in the money’ until capital values rise). The lack of voting rights also suppresses the share value. The combination of these two facts allows the shares to be gifted to children without triggering punitive taxes. There will be some tax, but it will be relatively low.
If the value of the property portfolio returns to £10m and rents remain the same, then over a five-year period £1m of capital value flows into the children's shares, giving an IHT saving of £400,000.
If the parents do not need the rental income, it is also possible to roll this up in the company. Assuming rental income of £400,000 per year over five years, this adds another £2m of value to the children's shares – potentially a further £800,000 IHT saving. Other variations to this planning can realise further reductions in IHT exposure.
In this way, it is possible to use the lower valuations today to mitigate IHT bills over the longer-term. If you are interested in this or any other tax structuring options, please talk to one of our team using the contact details below.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.