A solid understanding of inheritance tax and your liabilities is the first stage in passing your wealth to the next generation. Inheritance tax is a tax on the transfer of assets, usually after your death, although it can be charged on gifts made to trusts during your lifetime.
It’s difficult to compare tax regimes, but the UK, along with the USA, has the fourth-highest standard estate and inheritance tax in the world at 40%. Emerging economies tend not to impose inheritance and estate taxes because they can be seen to inhibit wealth creation. China and India have no inheritance taxes. Meanwhile, several developed countries such as Australia, Israel and New Zealand, abolished inheritance taxes in recent decades.
Ian Dyall, head of estate planning at Tilney, says: “Part of our planning is understanding what people have done in the past in terms of making gifts, and what they need to do in the future to ensure they don’t trigger any unnecessary lifetime liabilities.”
In the UK, each person has a nil-rate band of £325,000. If you have less than £325,000 at the point of your death, you should not have a liability to pay unless gifts have effectively used that nil-rate band before you die. “If you don’t use the nil-rate band on death and you’re married or in a civil partnership, it can be transferred to your spouse. Someone may have two nil-rate bands if their spouse has previously died, their own and their spouse’s, and potentially the children would benefit from both allowances.”
Should you be a UK domicile (your permanent home is in the UK) and you have properties, timeshares or bank accounts abroad, all of that is part of your UK estate when it comes to paying inheritance tax. The only exceptions are trading companies or working farms.
A trading company is a company there to trade. It can’t be several rental properties that are effectively an investment wrapped in a corporate structure to call it a trading company. That would be seen as an investment company and wouldn’t generally qualify for relief.
Further to the standard nil-rate band, there is an additional nil-rate band of £175,000 per person to use against the value of your primary residence. If you are a part of a couple, you have £650,000 in the nil-rate band between you, plus the nil rate on your main home is another £350,000 between you, making a total of £1m.
But there are some rules attached to the additional residence relief. Dyall says: “It can only be used against a qualifying property, and that it is one used as a home by the deceased, so it cannot be a rental property unless at some point in your life it was used as your main residence.”
Secondly, the property must pass to ‘closely inherited’ individuals, such as children (including step and adopted children), grandchildren and great-grandchildren, but it does not cover nephews or nieces.
“It is also means-tested in the sense that at the time of your death, if you’re worth more than £2m, and that includes any businesses, then for every £2 you’re over that, you will lose a pound in your residence nil-rate band allowance.”
On the whole, Dyall says, property can be challenging to plan around. Theoretically, you may gift your home, providing you live for seven years after you make that gift. “For any gift to be effective – whether property, cash or other assets – it has to be an outright gift. There can’t be strings attached.”
There are two issues to deal with here. You cannot continue to live in it because it is continued use unless you pay market rent. However, the people you pay rent to would need to pay income tax on that rent. The other concern is if you give half of your house to your children and one of them divorces, your tenancy is at risk.
“If you are living with your children, as long as you share the bills, you can give them part of the property, and if you live for seven years, there’s no reservation of benefit there. But it’s a big step to be moving in with your children.”
You can gift the property to a trust, which offers beneficiaries some protection from disputes arising in a divorce or bankruptcy. “You can be a trustee, giving you some control of who benefits from what and when. But the only person who cannot benefit is yourself if you want it to be effective for inheritance tax.”
“It can be a complicated asset to hold in a trust because if you’re holding a rental property in trust, trustees have to collect rents and maintain the property from the money in the trust. Lenders don’t generally like trusts, so it can limit your mortgage options.”
“For any gift to be effective – whether property, cash or other assets – it has to be an outright gift. There can’t be strings attached” Ian Dyall, Tilney Financial Planning Ltd
Dyall says there is a four-step process to estate planning. The first thing is to look at the quick wins. Some assets such as pensions are not part of your estate. “While many people took out pensions to fund retirement in many cases, they should preserve the pension, spend other assets, and pass on the pension.”
The next step is will planning, to help you make the most of your reliefs and allowances. This is particularly important if you've remarried on the death of your first spouse and wish to use your deceased spouse’s nil-rate band.
After that, you may want to look at gifting and using trusts to protect that money. Dyall says: “COVID-19 taught us that our situation can change quickly. You saw people who had good careers or very stable businesses until COVID-19 arrived. Suddenly, the business failed, or they lost their high-flying job.
“With planning, that family could have money sitting in a trust unused unless needed, or they can pass it down to the next generation without inheritance tax if they want to. But if required, they can dip into it and see them through hard times. Trusts are underrated because they can act as a family lifeboat.”
Then the final step is to pay the tax bill but do so in an efficient way. “Often we will use life cover to fund the remaining liability. That does two things. Firstly it’s efficient, but it also gets around the cash flow issue on death because inheritance tax must be paid before probate is granted and the assets can be released, which might be the assets you need to pay the inheritance tax.”
If the money is in a trust, as a life policy for example, that could give you access to funds before probate because it sits outside the estate.
While it pays to plan for inheritance tax mitigation, Dyall says it is not something that you should set up once and forget about. Regimes can change slowly with inheritance tax, but it is wise to keep on top of changes a government might make and seek advice.
Tax rates and reliefs are dependent on individual circumstances and may change.
“If you are living with your children, as long as you share the bills, you can give them part of the property” Ian Dyall, Tilney Financial Planning Ltd