It might have started out as a tax on the wealthy, but with house prices recovering, a growing number of people are being caught in the expensive inheritance tax (IHT) net. The taxman's IHT receipts have climbed for the third year in a row, according to official figures, and many homeowners are now being forced to prioritise reducing their tax liabilities.
The IHT threshold has been frozen since 2009 which has meant property prices have a major effect on rises and falls in the level of IHT being paid to the government. Revenues reached their highest level of £3.8bn during the housing market peak of 2007-08, before falling back when the market crashed. For the tax year ended April 2013, IHT income was £3.1bn, according to the Office for National Statistics, up from £2.9bn the previous year.
Paying any tax on assets left to loved ones is always going to be unpopular, but now that house prices are creeping back up again, estate planning should once again be a prominent part of a long-term financial strategy.
Nigel Green, the founder of the independent financial adviser (IFA) deVere, says: "People are being pulled into the IHT net for a number of reasons, not least because the threshold at which IHT is charged was frozen at £325,000 for individuals and £650,000 for couples until 2019, and property prices are increasing and household savings are recovering."
Assets beyond the IHT threshold – also known as the nil rate band – are taxed at 40 per cent (or 36 per cent if you leave at least 10 per cent to charity), but the good news is that assets left to a spouse or civil partner are exempt. As of 2007, couples can also pass their unused allowances to one another, effectively doubling a family's allowance to £650,000. For example, Mr and Mrs Smith have assets totalling £600,000 and Mr Smith dies first, leaving £200,000 to his children. The remaining £125,000 of his allowance would pass to Mrs Smith, giving her a new allowance of £450,000 – upon her death, IHT would be payable only on assets above this.
When it comes to your property, mitigating the IHT burden can actually start from the moment you buy your own home, if you can hold the property as "tenants in common" with your spouse, as opposed to joint tenants.
Tony Byrne of Wealth and Tax Management, an IFA based in Milton Keynes, explains: "On the first death of a married couple half of the property is transferred into trust. The remaining half is owned by the survivor and this means a half of the property is free from IHT in the survivor's estate and the survivor has the right to live in the property for the rest of his/her life. If the survivor is a beneficiary of the trust, capital gains tax is saved too."
The most obvious way to reduce potential IHT is to give money away before you die, and there are a number of useful exemptions. First of all, you can give £3,000 away every year, which can be carried forward to the next tax year, permitting up to £6,000 to be gifted at once. You are permitted to give an unlimited number of small gifts of up to £250 per person without worrying about IHT, as well as larger gifts to a couple on their marriage.
If you are planning to be particularly generous to loved ones, start planning early because beyond these allowances, money given away in the seven years before you die will usually be counted as part of your estate and therefore subject to IHT. The exception to this is if you make gifts from excess income (your pension or income) – this money is always exempt provided it does not affect your normal standard of living.
If your wealth is tied up in your property, you may want to consider downsizing to release the cash and start making gifts to reduce your taxable estate.
Equity release is another way to free up some capital, which can then be passed on to heirs with no tax to pay – provided you survive for at least seven years. This involves a company buying your property in exchange for a cash payment while allowing you to carry on living there, but your estate will be reduced, either because you have to sell your home below market value, or because there is new mortgage debt to clear when it is sold.
Beware of making "gifts with reservation" – gifts that you continue to benefit from. As an example, if you give your home to your children and continue to live there rent free, it will not be exempt from IHT, whether you live for seven years afterwards or not.
Even if you are paying full market rent, remember that once gifted, the property is no longer yours, so not only do you lose control, your children as the new owners will have to pay income tax on the rent that you pay. You could sell your home, give that money to your children and then move into a granny annexe in their home but again, there could be income tax implications if you don't pay market rent.
A "whole of life" insurance policy is one of the simplest ways to protect your estate against an IHT bill – the idea is to take out enough to cover the IHT bill and, because the policy is written under trust, it won't count towards your estate when the tax is being calculated. This can be fairly pricey and technically these premiums are treated by the taxman as a lifetime gift, but they usually come under one of the tax-free exemptions.
Getting more complicated, talk to an adviser about investments which qualify for business property relief and sit outside of your estate for IHT purposes for two years after the initial investment.
Claire Walsh of the IFA Pavilion Financial Services says: "These are proving very attractive to clients who wish to retain control of their money, particularly as these investments can also generate an on-going income. It is a very under-utilised investment opportunity of which people are generally unaware without speaking to a financial adviser."
Exemptions and reliefs
Anything you leave to a spouse or civil partner who has their permanent home in the UK.
Any gifts you make to a "qualifying" charity during your lifetime or in your will.
Potentially exempt transfers (PETs) – as long as you survive for seven years after making a gift, it is exempt.
You can give away up to £3,000 each year, either as a single gift or as several gifts.
Small gifts of up to £250 to as many individuals as you like, tax-free.
Wedding and civil partnership gifts. Parents can each give £5,000, grandparents and great-grandparents £2,500.
If you own a business, farm, woodland or National Heritage property, some IHT relief may be available upon your death.