We can and frequently do help clients to mitigate Stamp Duty on purchase of a home or commercial premises. But when it comes to avoiding the Inheritance Tax (IHT) payable on the home on death, many clients seem to think there’s little they can do. With the rise in property prices and Inheritance Tax thresholds at £325,000 per person once the home is added to the estate many people find that Inheritance Tax will be due on death. This tax is gratefully received by HMRC, so much so they’ve put in place legislation to protect this source of tax revenue.
All is not lost however, with careful planning and expert advice there are perfectly legitimate ways you can protect the family home and mitigate Inheritance Tax.
1. Planning through lifetime gifts
Giving the family home to children and then continuing to live in it sounds like a good plan. However the ‘gift with reservation rules’ mean that if the donor receives any benefit from the property after the gift (like still living there) then on death the home is simply added into their estate as though the gift never took place. If you manage to circumnavigate these rules, HMRC always have the ‘Pre Owned Asset Tax’ rules to fall back on. Between the two, giving assets away in your lifetime and then still receiving a benefit from the asset will probably not work for Inheritance Tax planning.
What can work is if having gifted the house to the children the parents pay a market rent to them. The problem then is that the children will then pay tax on this income. The effectiveness of this route therefore depends on the marginal tax rates of the children and the parents.
Other forms of lifetime planning include selling the property and buying a smaller one and giving the surplus equity away in your lifetime. You do need to take advice on whether a lifetime Inheritance Tax charge would apply to the gift. Alternatively if the property is also the principal private residence of the children, depending upon the circumstances this may also avoid IHT.
There are also equity release schemes around, these are effectively lifetime mortgages, typically available to those of advanced years with a great deal of equity in their house. However such schemes only work for Inheritance Tax planning if the money released from the lifetime mortgage is actually gifted out of the estate or is invested in an IHT efficient investment. There are other traps to fall into with these plans so care is needed if considering this course of action.
2. Planning through the will
Giving property away to your spouse will avoid inheritance tax, although the tax is paid on the second death. However, once property is passed to anyone other than a spouse (such as children) then the property is included in the estate and IHT will apply once the estate value exceeds the nil rate band threshold (currently £325,000).
Much of the need for nil rate band trust planning has been removed with the introduction of the transferable nil rate band introduced in the 2007 budget. This effectively gives an IHT nil rate band total of £650,000 per married couple. However for those with children from another marriage or where there is a large age difference between husband and wife there is still great value in nil rate band trusts.
3. Planning through life insurance
Often the simplest form of planning for inheritance tax is to take out life insurance to cover the liability. The policy makes tax-free cash available to meet the inheritance tax bill meaning there is no need for a forced sale of assets to pay inheritance tax, which is normally due within 6 months.
Policies written in trust mean beneficiaries can be changed as required and the payout is out of the estate for inheritance tax purposes.
Premium payments are gifts and represent an excellent way of using the annual exemption and normal expenditure out of income exemption.
Claims tend to be settled quickly as there is no need for a grant of representation provided there is a surviving trustee to make the claim, and children can take over premium payments (after the death of a parent) if the premiums cause an unacceptable reduction in the net spendable income of the house owners.
Such policies are virtually challenge free by HMRC and so will work to provide a fund to pay the Inheritance Tax.
This is a complex area of tax planning and you should take advice and those taking a DIY approach do so at their peril. Inheritance Tax is tax none of us will ever pay on our own assets, as it will be left to our heirs. Unless you want to leave your children with a tax liability it is important to get the planning right.
Andy Parker
Chartered Accountant and Chartered Financial Planner