Why German estate planners and tax lawyers love the tool “lifetime gift with a reserved life interest”
Any German testator who has offspring and who owns a significant estate and therefore asks their German tax lawyer about estate planning advice on how to transfer the family wealth onto the next generation without paying unneccessary German gift tax or inheritance tax, will, inter alia, be proposed to make use of the standard German estate planning tool of “vorweggenommene Erbfolge” by way of “lebzeitige Schenkung unter Nießbrauchsvorbehalt“.
Lifetime Gift of German Property
The German inheritance tax and gift tax system is very different from that in the UK. In Germany, the individual beneficiaries are taxed, not the estate. Thus, German inheritance tax experts always look at who receives how much and when. The “when” is especially important for German estate planning purposes, because German inheritance and gift tax law grants a personal tax allowance (Steuerfreibetrag, i.e. individual tax exempt amount) for each 10-year-period. In other words: A donor and donee can make use of the individual allowance every ten years. A simple example: The gift tax allowance per parent per child is EUR 400,000. So, I can gift my son EUR 400,000 today (either in cash or as any other asset having that value) without triggering any German gift tax. After 10 years have expired, I can gift the next EUR 400,000 tax free. This is why wealthy German families start transferring either property or a percentage of shares in the family business to the next generation. The goal is to make us of the German gift tax allowances as often as possible.
Gifting German Property but reserving a Life Interest
When it comes to property, including the family home, gifting to the next generation early on has the additional advantage of transferring the property while the value is relatively low compared to leaving the property upon death years or decades later. Let’s say a flat in Munich, co-owned by the parents, is worth EUR 900,000 today. If the parents transfer it to their child, each parent makes a gift wirth EUR 450,000. Because the gift tax allowance are per parent per child, the amounts of EUR 400,000 from mom and das respectively are covered by the tax exempt amount (Freibetrag). So the child only needs to pay tax on the exceeding two times Euros 50,000.
If, however, the parents in Germany do not make a lifetime gift, but wait until they (the second of them) pass away 20 or 30 years later, then the property may be worth EUR 1.5 million or even more. Then, the tax allowance (unless significantly raised by the German lawmaker, which is doubtful) will only cover a much smaller percentage of the property value. Ergo: much more German taxes to pay for the child.
Now, the downside of making such a lifetime gift, especially if it is the family home the parents still live in, is: The parents do not own it anymore. So would they fall out with their child after the gift was made, the child could sell the property and kick the parents out.
In order to prevent this outcome, German law offers the perfect tool: Gifting the property now but retaining a life interest in the form of the so called Nießbrauch (usufruct).
What is the German Niessbrauch (usufruct, right to use for life)?
Nießbrauch is defined in sections 1030 to 1067 of the German Civil Code (https://www.gesetze-im-internet.de/englisch_bgb/index.html.
The idea is that the donor makes a lifetime gift (of German property or other assets like shares in a German business) to a child, grandchild or other beneficiary, but reserves a life interest in the asset, i.e. the right to keep using it for the rest of the donor’s life (lebenslanges Nießbrauchsrecht).
This is a standard estate planning tool often used in Germany to mitigate German gift and/or inheritance tax while at the same time protecting the interests of the donors.
In the case of property, it means that the current owners (e.g. the parents) transfer the title (Eigentum) in the property to the new owner (typically their children or grandchildren). The new owner is immediately entered into the German land registry (Grundbuch) as the new proprietor (Eigentümer). However, the previous owners have reserved a right to use the property for the rest of their lives, i.e. in order to either keep living there themselves or to let it to a third party and collect the rent from these tenants.
This right to use, i.e. “enjoy the fruits” (thus usufruct), is called Nießbrauch (also sometimes written as Niessbrauch) and is also entered in the land registry to protect the donor.
The donor usually also reserves the right to revoke the gift, i.e. have the full title transferred back to the donor.
Additional tax advantage of using the Nießbrauch approach
The additional advantage of this lifetime gift with reservation of lifetime interest is that the value of the life interest is being deducted from the value of the gift at the time of the transfer. Unlike in the UK, taxes in Germany immediately trigger gift tax if the value of the gift exceeds the personal allowance of the donee. However, as the donee “only” receives a gift “with strings attached”, i.e. the Nießbrauch of the donor, the gift value is reduced by the value of the Nießbrauch.
For German tax purposes, the value of the life interest ist calculated like this: What would a third party pay rent for the flat? This times the statistical life expectancy of the donor who enjoys the life interest.
In our above example of the EUR 900,000 flat in Munich, this means: Lets say the parents transfer the co-owned flat to their child when they are both 70 years old. Then each parent makes a gift worth EUR 450,000, but minus the value of the life interest, which calculates like this. A tenant (at arms length) would pay EUR 2,000 rent per month, i.e. EUR 24,000 per year. Let us assume (to make it simple) that the parent’s statistical life expectancy is 10 years, then the value of the Nießbrauch is EUR 240,000. Thus, the gift from each parent is no longer EUR 450,000, bus EUR 450,000 minus EUR 120,000, i.e. EUR 330,000. Thus: NO GIFT TAX ANYMORE BECAUSE THE VALUE IS WITHING THE GIFT TAX ALLOWANCE OF EUR 400,000!
Why is this estate planning tool not used in the UK?
The reason why such lifetime gifts with reserved life interest for the donor are not used in the UK as estate planning tools is simple. HMRC does not accept such a lifetime gift with reserved interest as a “genuine gift”.
In the UK, if a donor retains any interest in the property then they are making a “Gift With a Reservation of Benefit.” HMRC will, for inheritance tax purposes, not recognise this as a “real genuine gift” and will consider the gifted property to be still part of the donor’s estate when the donor later passes away (even if decades later). I.e. the executors / beneficiaries must still include the gifted property in the UK IHT returns and UK IHT is being calculated based on the value of the gifted property.
Thus, in the UK, is has no tax advantage to make a lifetime gift with reservation of benefit. Even if donor and donee do not explicitly agree on such a reservation of benefit, but the donor continues to live in the property rent-free, then HMRC will not consider the transfer of title a genuine gift.
Tax planning for UK-German Families
These differences in gift and inheritance tax regimes between the UK and Germany make tax planning very difficult for international families who own property (and other assets) both in the UK and in Germany. What is a great estate planning and tax mitigation tool in Germany, does not work at all in the UK. And vice versa.
More information on German inheritance tax, estate planning and international probate:
- The Perils of German IHT and Gift Tax
- Basics of German Inheritance and Succession Law
- How to apply for a German Grant of Probate
- The Infamous German Community of Heirs – And how to avoid it
- Germans Heirs are Personally Liable for Debts of the Deceased
- International Wills and Estate Planning for British-German Families
- Can foreign Taxes be set off against UK Inheritance Tax?
The law firm Graf & Partners and its German-English litigation department was established in 2003 and has 20+ years of experience with British-German and US-German probate matters, including the representation of clients in contentious probate matters. If you wish us to advise or represent you in a German or cross border inheritance case please contact German expert lawyer Bernhard Schmeilzl, LL.M. (Leicester) at +49 941 463 7070.