Taking the first step on the housing ladder has become a daunting prospect for the younger generation.
House price growth continues to outstrip wage rises and, following the 2008 market crash, lenders have tightened affordability checks and their risk appetite, meaning first-time buyers must also come up with a substantial cash deposit.
This has meant that parents regularly find themselves in the position of offering a helping hand to their children by way of a cash sum – the oft quoted “Bank of Mum and Dad”. It is estimated that £6.3 billion will be provided by the Bank of Mum and Dad in one form or another this year.
The question that arises at this point, and which we are often asked by clients, is whether this ‘helping hand’ should be by way of gift or loan, or whether the parents or benefactor should take a share in the property to be purchased. Different options have different consequences, particularly when it comes to tax.
There are several advantages to giving a loan, not least that you get your money back (at least in principle!). A loan, as opposed to a gift, also provides protection for the funds. For instance, a child may use the money to buy a property in which they live with a partner. If there is a breakdown in that relationship, there is no risk of losing the value of the funds you provided. That is also a risk associated with gifting cash. However, that risk can be minimised if the child and their partner are willing to enter into a Cohabitation Agreement.
On some occasions, parents may choose to give a loan initially, but at a later time ‘forgive’ that loan. It would, at that date, convert to a gift. If the loan is still outstanding at the date of the parent’s death, it will be an asset in their estate. This may have inheritance tax implications.
It is essential that any loan is properly documented; failure to do so can have devastating consequences, highlighted recently in the press in articles pointing to a rapid rise in the number of cases brought to court by parents trying to retrieve funds from their children.
In one notable case, a couple spent £380,000 in legal fees trying to prevent an estranged daughter-in-law from “walking off “ with half of a sizeable sum they had provided to their son to purchase a house, which the couple claimed was an investment in the property and not a gift. The couple failed to convince the court, and as a result had to also pay the former daughter-in-law’s legal costs.
For a loan, the documentation could be by a simple Personal Bond or a more sophisticated Loan Agreement. A Loan Agreement would state whether the loan is interest-free; if not, whether subject to a fixed or variable rate of interest; and establish the repayment term.
You should also consider whether it would be prudent to take a security for the loan over the property to be purchased. The lender will always insist on a first ranking security and may have to consent to a second security being registered against the property.
Gifting is a popular tool in mitigating inheritance tax liability. Gifts made more than seven years before death are generally not included in the Inheritance Tax calculation. However, where a gift to an individual or to a trust is made within the seven years preceding death, it is counted back into your estate for inheritance tax purposes.
As mentioned above, a disadvantage to gifting outright is that the value of the gift may be at risk if your child’s relationship with their partner breaks down or they get themselves into financial difficulties. A Cohabitation Agreement can mitigate the risk with partners, but not creditors. A trust is a particularly useful vehicle if a parent wants to make a gift but still wishes to retain control and protect the value of the gift.
Again, clearly documenting the arrangement is important. In the case of an outright gift, a Memorandum of Gift should be made which sets out the donee (the receiver of the gift), its value and the date when it was made. This is particularly important from an inheritance tax perspective, facilitating the smooth administration of the parent’s estate on death and minimising the risk of misunderstandings between siblings or HM Revenue and Customs (HMRC). The Revenue advises that it only accepts the release of a loan by way of gift if the release is effected by deed.
On death, executors, potential beneficiaries and indeed HMRC will want to determine the status of any financial assistance given. Having a clear written narration of the financial arrangement can save both time and possible conflicts after death.
Helping children financially is an enormous benefit, giving them a significant advantage in obtaining a property or providing them with financial stability at an important time in their lives. However, it is vital to consider the means by which this is done and to document the arrangement clearly.
Given the complexities, it is always best to seek professional advice from your solicitor when considering passing wealth to your children, who can advise on the advantages and pitfalls in the options available.