The Postcode Lottery

Inheritance tax (IHT) was originally intended as a tax on the wealthiest, but last year the Revenue claimed £5.2 billion in IHT, 60% more than five years ago.  One of the reasons for this is the rise in property prices, with property hotspots like London bearing the biggest financial burden, and an IHT threshold that has not increased since 2009.

Let’s take the example of Alice who is single and has no children.  She owns a flat in London worth £500,000 and has savings of £100,000.  She wishes to leave her estate to her niece Berry.  She is shocked to learn that on her death £110,000 of IHT would be payable (£600,000 – the IHT threshold of £325,000 = £275,000 x 40%).  Whilst her options are limited there are things she can do to reduce her IHT liability.

1.  Lifetime Giving

As Alice is planning on passing her assets to Berry anyway, could she start to do this in her lifetime?  She could give £3,000 a year without any IHT implications.  There are also exemptions in relation to wedding/civil partnership gifts and gifts in relation to normal expenditure out of income.  If Alice wanted to make a larger gift (perhaps from her savings or by downsizing and having more cash to pass on) she could do so and provided she survives the gift by 7 years it would fall out of account for IHT purposes in her estate.

Alice could borrow against the property, for example by way of equity release and use those funds to make lifetime gifts to reduce the value of her estate.  Equity release is not without its risks and Alice would need to take financial advice.

Whilst Alice could gift her flat to Berry in her lifetime, if she wanted to continue to live there, then as well as surviving the gift by 7 years, she would need to pay a market rent to Berry for it to be outside of her estate for IHT purposes.  There are also practical concerns such as Alice’s ability to continue to live there if Berry dies before Alice, gets divorced or becomes bankrupt.  There are also stamp duty and capital gains tax implications.

As my colleague Samuel Hardy highlighted in his recent blog probate court fees are expected to rise and instead of being a flat fee will vary depending on the size of your estate.  Under the new rules Alice’s executors would have to pay a probate court fee of £2,500 if her estate was worth £600,000.  But if she made lifetime gifts so as to reduce the value of her estate to just below £500,000 then the probate court fee would be reduced by £1,750 to £750.

2.  Investing in IHT free assets

Alice could invest in assets which are exempt from IHT, such as business property relief (BPR) qualifying investments.  BPR assets can include shares in qualifying companies listed on the Alternative Investment Market (AIM).  AIM listed shares can be held in an ISA meaning that as well as being IHT exempt they also have the ISA benefits of tax free income and capital growth.  Alice would need to hold the shares for a minimum of 2 years in order for them to qualify for the relief.  By investing in BPR assets Alice holds on to her wealth, while planning for IHT, rather than giving it away.  There are however risks, AIM listed shares are likely to be more volatile and less liquid.

Alice heard that she could borrow funds against the property (say £100,000) and use those funds to invest in BPR qualifying assets and therefore avoid IHT on £200,000, but that is not the case.  There are IHT anti-avoidance rules which mean that you have to deduct the debt from the BPR assets so negating any tax advantage.

3.  Pensions

Pensions do not form part of your estate for IHT purposes.  If Alice wanted to reduce her IHT liability she could top up her pension.  If Alice died under the age of 75 the recipient of her pension, Berry, would not be taxed at all.  If, however, Alice died over the age of 75 Berry would have to pay income tax on the money, but not IHT.

4.  Life Insurance

Alice could take out a life insurance policy and write the death benefits in trust, so that on her death the policy could be used to pay the IHT.  Taking out an insurance policy does not avoid the IHT liability, but instead of Berry paying £110,000, Alice is planning for the IHT liability by paying the policy premiums during her lifetime.

The insurance company is likely to require Alice to have a medical assessment.  Depending on Alice’s health and age the premiums could be quite high.

5.  Charities

As Alice supports various charities, she could leave a legacy to them under her Will.  Legacies to charities in the UK and Europe are exempt from IHT.

Furthermore, if she were to leave at least 10% of her “net chargeable estate” to charity so £27,500 (being £600,000 less £325,000 = £275,000 x 10%) then not only is the gift to charity free of IHT, but her estate would benefit from a reduced rate of IHT of 36% rather than 40%.  So £89,100 would go to HMRC, £27,500 to the charity and £483,400 to Berry.  As opposed to £110,000 to HMRC and £490,000 to Berry if no charitable gift was made.  By making the charitable gift, Berry’s inheritance is only reduced by £6,600, but the charity gets £27,500 and it is the Revenue that takes the hit of £20,900.

By planning in advance there are things you can do to reduce or even eliminate your IHT liability and ensure that your assets pass to those you love.