I want to leave my second home to my grandchildren: What’s the most tax efficient way to do it?

I am 77 years of age and divorced. I purchased a flat in 1999 for £90,000, and the approximate value now is £240,000. 

I don’t use it as my main home and currently rent it out, so capital gains tax will be due if I sell.

I would like to benefit my two grandchildren with this flat and wondered what would be the best advice for doing this.

I could leave it to them in my will, which will incur inheritance tax as I have another property that I live in worth £600,000 plus a share portfolio of approximately £200,000.

I could sell the flat now and give the grandchildren the money, hoping I live a further seven years so inheritance tax won’t be due. 

Alternatively, I could put it in some sort of trust fund. Are trust funds complicated and would this work? V.B

Harvey Dorset of This is Money replies: Whichever way you pass this property on to your grandchildren, someone is likely to need to pay a tax bill. 

However, you have several different options and there are pros and cons of each. 

Selling the property now would, as you say, make you liable to pay capital gains tax on the property’s increase in value.

The changes made to capital gains tax in the Autumn Budget luckily did not see an increase in tax rates for those with second homes and buy-to-lets, with rates for investments and other assets equalised with the already-higher property rates.

Capital gains tax is not chargeable on death, so you could leave the flat to your grandchildren in this way – but doing so would increase your estate’s inheritance tax liability.

Inheritance tax is currently charged at 40 per cent on anything over the tax-free allowance of £325,000. 

A residence nil-rate band of £175,000 is also available to you on your £600,000 home, if you pass it on to your children. 

This means your total tax-free threshold would effectively be £500,000.  

However, the value of your estate is well over this threshold, and could leave a hefty tax bill, as Bradley Clark explains below.

This is without accounting for the value of any pensions you have, as these are being brought into the inheritance tax scope from April 2027.

This is Money spoke to two financial advisers to find out what options are open to you to ensure your grandchildren can benefit from your flat.

Bradley Clark, financial planner at Hargreaves Lansdown, replies: It’s useful to begin by understanding the potential tax liability. 

You own a main residence worth £600,000, a second property worth £240,000 and a share portfolio worth £200,000. Combined, your estate is currently worth £1.04million.

Assuming you have an inheritance tax-free nil rate band of £325,000 and a residence nil rate band of £175,000, your assets that could be subject to IHT are worth £540,000. At 40 per cent tax, this is a potential IHT tax liability of £216,000 on your death, leaving £824,000 to pass on to your beneficiaries.

The simplest solution to meet your objective of giving your flat IHT free to your grandchildren, is to retain the property and pass it on to them via your will after you die. 

Capital gains tax (CGT) is not chargeable on an asset when it is transferred on death. It would also give you more flexibility should you need the asset or its income during your lifetime.

The value of the flat will fall within your IHT-free nil rate band and so can be passed on tax-free as your estate’s IHT liability will be paid from other assets.

Alternatively, you could give the flat to your grandchildren now. Capital gains tax will be charged on the gain in the region of £35,000. 

From an IHT perspective, if you pass away within seven years there will be no IHT liability on the gift itself. 

However, it will have an impact on the rest of your estate because value of the flat would use up part of your nil-rate band. After seven years, the value of the gift is completely clear of IHT.

If your grandchildren are under the age of 18 and too young to own property, you could gift the flat to a trust with them as beneficiaries now. 

This has the benefit of starting the seven-year clock ticking, but introduces complexity and doesn’t really improve the tax position markedly.

Before making any gifts to beneficiaries it is important to consider what assets and income you may need during your lifetime. 

If you rent the flat out, how would losing that money impact your income both now and in the event that you needed expensive care later in life?

Categorise your assets and income into three pots. 

Firstly, what assets and income will you definitely need, what might you need, and what will you definitely not need? It’s assets and income in this third category which you can gift or spend. 

For example, gifts into junior Isas or junior Sipps for your grandchildren are popular ways of building tax-free nest eggs. 

Gifts of less than £3,000 a year are IHT free, and you can also gift surplus income without IHT charge.

To mitigate the potential IHT liability of £216,000 on your estate, you could explore life insurance which would pay out on your death to pay the tax and improve the size of legacies to your beneficiaries.

George Agan, independent financial planner at Flying Colours, replies: Inheritance tax bands have stayed the same since 2009 and are not due to increase until 2030. 

The threshold remaining static means that far more people now fall into the inheritance tax (IHT) net, so I can fully understand your desire to do what you can to optimise the inheritance for your grandchildren.

With IHT it’s important to make a full assessment of your own needs first, and make sure you’ve achieved financial security in retirement before you start thinking about tax planning. 

Getting this balance right is very tricky, especially when property values make up a large amount of the estate.

Your estate appears to be above the current nil-rate band of £325,000. The main residence nil-rate band (up to £175,000) provides a potential £500,000 in nil-rate bands assuming a main residence is passed to direct descendants.

While gifting the property could potentially reduce inheritance tax exposure if you survive seven years, this needs careful consideration as:

· You would likely trigger an immediate CGT liability

· You would lose control and access to the asset or proceeds

· The seven-year rule requires sufficient longevity for inheritance tax benefits

As an alternative, trusts can be considered, but great care needs to be taken.

Establishing trusts to transfer investment properties is a complex area and beyond the scope of what I could succinctly summarise here. 

There are multiple tax interactions with trusts, and any decision to establish one should not be taken lightly. I highly recommend taking specialist advice.

Another thing to consider would be taking out life insurance, which would pay out on your death to cover any inheritance tax charge on the flat.

The feasibility of insurance will depend on your current state of health and the cost of the policy. However, a whole-of-life policy, if secured with guaranteed premiums (premiums that will not change as you age), could be a solution. 

This could be worth considering if the cost of this policy to cover the inheritance tax is less than your net rental income.

It is typically advisable to write the policy in trust, so it remains outside of the estate when payable. Of course, your rental income is not guaranteed, so a full assessment of your position needs to be considered on affordability.

Given the complexities involved – tax implications, interaction with your wider estate, and your own financial security. 

There are no simple answers sadly, so I would recommend getting advice specific to you.