Rocketing house prices have turned Inheritance Tax into a charge affecting the larger population. Johanna Gornitzki examines the ways this tax can be avoided
Due to increasing property prices in the UK, Inheritance Tax (IHT), which was once seen as a tax for the rich, has brought many more people into the IHT net. With the average house in London balancing on the edge of the IHT threshold, currently £275,000, finding ways to avoid this liability has become more crucial than ever.
The rules surrounding IHT seem rather straightforward. IHT is payable upon death when the combined total value of someone's estate exceeds the IHT threshold. Any assets over that limit will be taxed at 40%. Although this sounds uncomplicated, many consumers do not know that gifts made during someone's lifetime, as well as pension savings or any other money tucked away, could be included when calculating the total amount of assets. Anecdotally, many people are also blissfully unaware that their estate may be liable to IHT and few know what steps they can take to avoid this.
Financial planning
Although it is difficult to avoid IHT completely once acquired assets are above the IHT limit, there are plenty of ways to mitigate this burden. First of all, there are a number of gifts that are entirely exempt from this tax including gifts to charities, political parties and museums. Transfers between husband and wife are also exempt, as long as UK domiciled; and normal expenditure out of income, such as maintenance, can also be made without incurring any IHT, as long as these costs do not affect the person's usual standard of living.
There is also an annual gift exemption of up to £3,000 per year, which can be carried forward one year. Moreover, outright gifts of up to £250 per individual per tax year can also be made (with no limit to the number of recipients) and wedding gifts up to a certain amount depending on the relation to the married couple, are also not liable to IHT.
In addition to this, there are certain types of gifts that are seen as potentially exempt transfers (PETs). A PET made more than seven years before a person dies becomes an exempt transfer. However, if death occurs within that seven-year period then it becomes taxable, albeit depending on the person's total assets. If the individual survives between three and seven years, then any tax payable will become reduced by tapering relief, which lessens the full value taxable by 20% each year.
Certain types of properties including business, agricultural and woodland are also relieved from the tax. However, financial planning is crucial as these are complex areas and seeking advice is therefore key. That said, when it comes to IHT-related issues advice should be sought to clarify the different exemptions and illustrate the number of steps that can be taken to minimise any unwanted tax bills.
The first thing to look at when trying to protect a client's inheritance is to ensure that he or she has got a valid will in place. The reason for this is because if someone dies intestate, that individual's assets would not necessarily go to the people he or she would have wished. "This could have horrendous consequences," says Andrew Pennie, head of intermediary investment proposition at Abbey for Intermediaries.
Drawing up a will could also mitigate an IHT bill. This could be done by stating that the nil rate band allowance of the first spouse to pass away should be transferred into a will trust. This could make a huge difference, says Matt Pitcher, financial consultant at Towry Law, as putting items in trust effectively means they are taken outside of a person's estate for IHT purposes. "People should think about amending their wills so that some money will be passed to a will trust. If people would only do that, inheritance tax would not be an issue for most people," he explains.
Take the example of a married couple, with each spouse having assets of £500,000. When the husband dies, he leaves his assets to his wife leaving her with a total sum of £1,000,000. On her death, IHT will therefore be payable on that sum excluding £275,000, which is protected by her nil rate band allowance. As IHT is 40%, the inheritance bill would amount to £290,000. However, if each spouse had left their nil rate band allowance in a nil rate band trust, IHT would only have been payable on £450,000. This would have resulted in a £180,000 IHT bill - saving them a whopping £110,000.
If most of a married couple's assets are tied into their property, which is likely to be the case for the majority, then the couple has to make sure the ownership of the resident is changed to tenancy in common instead of joint ownership. By doing so, the share of the first spouse to pass away can still be put into a will trust.
Besides ensuring that clients have valid wills, and having taken advantages of the opportunities will trusts offer, other trusts should also be considered. By doing so, the amount of IHT could be lessened or even eradicated. There are a number of trusts that have proven particularly popular when it comes to IHT avoidance. Loan trust is one of them. This allows the settlor to lend money to the trustee or trustees. As it is a loan, it effectively means that the settlor can claim it back at any time, a flexibility that is typically disallowed when putting assets into a trust.
Discounted gift trust is another popular IHT tool. The person establishing the fund basically gives their money away to the trust, which then pays the person a life income.
If an IFA has taken all necessary steps to avoid IHT and still finds that the client will be left with a tax bill, then a whole of life (WOL) trust could be set up, leaving the payout to cover the IHT charge. Brian Sceats, marketing and communications manager at Lincoln Financial Group, explains: "A whole of life plan can help effectively pay the estimated Inheritance Tax bill. In simple terms, with a whole of life plan, the Inheritance Tax bill is estimated and a policy is normally set up, paying out on a joint life second death basis to cover it."
Closing loopholes
This could be crucial since any IHT bill has to be paid before the inheritance is released. "This means that some people will be forced to take out a bridging loan to pay the tax before they can touch the assets," says Pitcher. "A whole of life plan put into a trust could pay this bill and it is also very effective as it will release the money very quickly," he adds.
However, before advising clients to put their assets into trust, advisers have to be aware of a charge known as the pre-owned assets tax (Poat), which was introduced by the Government in April earlier this year.
This tax will mainly hit people who have given away assets under a trust arrangement, while still enjoying them. For example, those still living in a property that has been put into a trust. One trust in particular has been caught out by these new rules. This is the main residence trust and, according to Pitcher, individuals with their property in this type of trust can only avoid any unwanted tax charges by going down one route - downsizing.
"You have two options here. You can either unwind the scheme or you can start paying rent to your children, which will then be liable to Income Tax. Either way, you will become liable to further tax. Therefore, the only way to avoid this is to downsize," says Pitcher.
Another area worth keeping an eye on is the pension industry. In April 2006, a whole new set of pension rules will be coming into effect. One of the suggested changes is to introduce a new way of withdrawing pensions known as an alternatively secured pension (ASP). This option will give customers more flexibility when it comes to withdrawing their pension, creating a perfect IHT avoidance vehicle.
However, the Inland Revenue (IR) has discovered this loophole and has put forward a proposal suggesting that this alternative may become liable to IHT. While nothing has been decided yet, Pitcher is quite certain the IR will go ahead with the proposal. "I think they panicked when they realised alternative secured pensions could be used as an Inheritance Tax tool, and I definitely think they will do something to ensure this will not be the case," he says.
Looking ahead, Pitcher believes the Government is likely to continue to clamp down on loopholes, in particular tax avoidance on property. "I would not be surprised if they decided to close the will trust loophole. However, while this is bad news for consumers, it will offer great business opportunities for advisers," he says.
Regardless of whether this takes place, there are plenty of opportunities to come for intermediaries advising on IHT planning, because while current IR estimates suggest that only 5% of the population have been caught in the IHT net, this is likely to change over the coming years when the real impact of increasing house prices will be felt, as the owners of these properties will begin to pass them on to their children. Then the only problem for advisers will be how to cope with this new workload.
COVER NOTES
- More people are likely to become affected by IHT as house prices continue to rise
- By writing a will or setting up a trust most tax charges can either be avoided or mitigated.
