How to reduce inheritance tax on residential property
Inheritance tax raises a huge amount of money for the government and last year, a record-breaking £7 billion was collected, a rise of £1 billion from the previous tax year which was largely due to the increase in property prices. It’s easy to see why the government favours this method of taxation, but you’d be hard-pressed to find anyone who relishes the prospect of paying 40% tax on assets they’d rather pass to their loved ones when they die.
For the average person in the UK, property is their most valuable asset; one of the best ways to reduce inheritance tax liability is to plan ahead and look at ways of reducing the IHT burden on their home.
Give property to a spouse or civil partner
Transfers between UK-domiciled spouses or civil partners are exempt from inheritance tax so property can be passed on first death inheritance tax-free. However, if a property is still held on the second death, without planning, inheritance tax could apply to the whole estate of the second spouse or civil partner to die.
One way of making sure that your beneficiaries get to keep more of your estate is to downsize and release equity from your main residence. You can then give this money to your children or other family members and if you survive for seven years from the date of the gift, the amount will be exempt from IHT.
If you die before the seven years have passed, then the gifted money will be liable for IHT, however, it operates on a sliding scale, which is as follows:
- 3 – 4 years – 32%
- 4 – 5 years – 24%
- 5 – 6 years – 16%
- 6 – 7 years – 8%
- 7+ years – 0%
Giving money away is the best way of mitigating IHT, but before you do so, it is worth working out how much you can afford to give away. It can be a difficult balancing act because nobody can predict if and when they may fall ill and perhaps need long-term care which is expensive.
You can also give your property away in your lifetime and continue to live there, although you will have to pay market rent and that must be proved upon your death. So for example, if you gift 10% of your property to your children, you must pay 10% of the current market rent, and so on. The rent must be reviewed on a regular basis as it would with any rental property.
In fact, if you gift your home and continue to benefit in any way, HMRC will view it as part of your estate. A staggering £608 million has been claimed from people who have gifted their homes and broken the rules since 2017, so if this is something you are considering, you need to make sure you have taken all the necessary steps to avoid the pitfalls.
If there is a mortgage on your home when you gift it, the recipient may be liable for stamp duty and if you gift a property that hasn’t always been your main home, you may have to pay capital gains tax if the value of it has increased since purchase.
Gifts to charity are IHT-free
Any money or assets that you give to charity are exempt from IHT and if you give at least 10% of your net estate to charity on your death, the rest of your taxable estate will be taxed at 36% saving you 4%. You might decide that you’d rather give money or assets to a cause closer to your heart than the government so it is well worth considering this option when planning how your estate should be distributed when you’ve died.
Residence nil rate band
Any estate worth less than £325,000 doesn’t need to pay inheritance tax (provided the deceased hasn’t made any gifts in the seven years preceding their death, which may use up some or all of their inheritance tax nil rate band) and if you are passing your main residence onto direct descendants such as your children or grandchildren, there is a further £175,000 exemption known as the residence nil-rate band (RNRB), which has been frozen until 2028 – it was originally in place until 2026, but the government extended it as part of the 2022 autumn statement.
If you are married or in a civil partnership, each person is eligible for the exemption. When one person dies, the surviving spouse can pass the unused portion of their RNRB to their spouse, so for example, there could be a £1 million exemption on the estate of the second person to die if the main residence is being passed onto direct descendants. Anything over that amount will usually be taxed at the 40% rate.
A property usually qualifies for the RNRB if you have lived in it at some point, so for example, if you have a large portfolio of properties, any that you haven’t lived in wouldn’t qualify for the exemption. It doesn’t have to be the property you were living in at the time of your death – so for example, if you were in a care home at the time and your home was being let, it could still qualify for the RNRB.
If you own more than one property that could qualify for the RNRB, you will have to nominate just one of them and if your net estate is worth more than £2 million then your RNRB band is tapered by £1 for every £2 over the threshold.
How to reduce inheritance tax on property
Rather than handing over property to an individual, a trust allows the property to be held until a later date. This can potentially save IHT on death because it will reduce the size of your estate. However, there could still be tax implications. Trusts are subject to their own regulatory regimes, so you would need to seek specialist advice in view of any potential stamp duty land tax, capital gains tax and lifetime IHT.
All trusts have to be registered with HMRC’s Trust Registration Service, and any changes or updates to the trust must be reported to HMRC.
If you put a property into a trust during your lifetime, which you don’t retain a benefit in and you pay any necessary taxes and survive for seven years, then the property isn’t usually considered part of your estate and therefore wouldn’t be liable to IHT on death.
Anything above the £325,000 nil rate band paid into a lifetime trust would be subject to lifetime IHT at 20% on the excess amount even though you are still living. However, the nil rate band resets itself every seven years so if you have a considerable amount of excess money that you don’t need during your lifetime, trusts are a good way to reduce your IHT bill.
Trusts are complicated and invariably come with a lot of admin, so it is always best to seek professional advice.
Immediate post-death trust
These are types of trust that are written into a will and are a means by which you can provide future security for certain individuals whilst also ensuring that your estate ultimately passes to your chosen beneficiaries. They are commonly used between couples where there are concerns about the surviving spouse remarrying, cohabiting, or entering into a civil partnership. They can also be of benefit when there are blended families, for example, second marriages and children from different relationships. The person who is given the life interest (the life tenant) is entitled to receive the income from the assets in the trust and can be given the right to live in the property owned by the trust. When the trust comes to an end (usually when the life tenant dies) the capital passes to the ultimate beneficiaries.
Estates worth more than £2 million
With estates worth more than £2 million that have a reduced RNRB, it is the net estate that is used when applying the taper threshold. In other words, the value of all the assets the deceased owned at the time of death including any interests in trusts minus liabilities such as mortgages, etc. Any gifts, even if they were given before seven years have elapsed, won’t be included in the calculation because they weren’t owned by the deceased at the time of death.
When an individual estate is worth more than £2.35 million, and a couple’s estate is worth more than £2.7 million, the RNRB will be completely extinguished due to the tapering of it. Therefore, careful IHT planning is advised. Because gifts are not included in the tapering calculations, a lifetime gift can be made to reduce the value of the estate to below the £2 million threshold.
Business property and IHT
As long as certain conditions are met Business Property Relief (BPR) is available on the value of business property at 50% or 100%, therefore reducing the amount of inheritance tax payable by an estate. However, BPR is not taken into account for the purposes of valuing an estate for RNRB. Therefore, if a business property is part of an estate, it could result in the tapering of the RNRB if the total value of the estate, including business property, exceeds £2 million. One way around this could be to place the business property in a discretionary trust during your lifetime, therefore potentially placing the assets outside of your estate.
Residence nil-rate band and downsizing
What happens if the deceased had downsized before their death or perhaps sold their property to pay for care home provision, meaning they don’t have a home that qualifies for RNRB?
In this instance, the estate could be eligible to claim a downsizing addition to make up for the lost RNRB. This may be possible if the sold home would have qualified for RNRB and if direct descendants such as children and grandchildren, inherit part of the estate. However, the rules regarding the downsizing addition are complex so specialist advice is recommended.
There are ways in which you can reduce the inheritance tax on a property and as many of them are complex and can have other tax implications, it is always best to seek expert advice. With sound planning before you die, you can do much to reduce the amount of IHT your estate will have to pay.