How a trick to save inheritance tax can backfire spectacularly
Gifting a property in the hope of saving tax could actually cost your heirs hundreds of thousands of pounds.
We are paying more in inheritance tax (IHT) than ever before. HMRC raked in £5.2bn from death duties this year, a £3.4bn rise compared with five years ago, and growing property wealth means more and more people will be losing out to the taxman when they die.
There are a number of ways to pay less, but the complex and little-understood rules surrounding IHT result in many being caught out.
When you die, £325,000 of your estate is safe from tax, plus a further £125,000 if you are passing your home on to a direct descendant. Anything above those thresholds will be taxed at 40pc before it can be passed to your family.
You can reduce the death duties your family will have to pay by giving them assets beforehand, thereby reducing the value of your estate. If the gift, such as a cash lump sum, is made at least seven years before you die, it will be exempt from tax.
Telegraph Money readers often ask about the benefits of giving their properties to family members before they die to avoid the clutches of the taxman, but experts have warned that certain pitfalls could result in you paying more than you save.
While it is indeed possible to give away an entire property to substantially reduce the value of your estate and therefore the amount of tax an inheritor would have to pay, the process is not as tax efficient as many would think. One little-known rule in particular can throw gifting exemptions out of the window. The rules on a “gift with reservation of benefit” (GWROB) are designed to stop people giving away assets such as properties at the same time as making use of them.
These rules mean you cannot give your home to your children and continue to live there unless you are prepared to pay the market rate of rent – a rather tall order for most people in the later stages of life. In order for the gift to qualify for IHT exemption if you continue to live in your property, you would have to pay rent at the market rate for at least seven years.
Andy Butcher of Raymond James, the wealth manager, said the rule also applied to holiday homes. If you wanted to give away your holiday property but still use it every now and then, you would have to pay a market rent for the length of your stay. Otherwise the taxman could deem the asset to be part of the overall estate.
Mr Butcher said the tax implications of the GWROB rules could be severe. For example, a widow who gave away her property in order to reduce the amount of IHT payable on her estate could inadvertently leave her son with more tax to pay than if she had done nothing at all.
If she continued to live in the house after the gift was made without paying the market rate of rent, even if she died more than seven years later, the taxman could take his 40pc cut under the GWROB rules.
Moreover, as the widow had made the gift during her lifetime, she would lose her £125,000 family home allowance, as the property would not have passed directly after death.
Following the widow’s death, the son could also be liable to pay capital gains tax if he decided to sell the property, which could well have risen significantly in value over the years since the gift was made. Capital gains tax would apply on any money made over the annual tax-free allowance, currently £11,850, at a rate of 18pc, or 28pc for higher-rate taxpayers.
Mr Butcher said some people could be leaving their families hundreds of thousands of pounds worse off if they gave away properties without a thorough understanding of IHT rules.
“Many clients ask us about gifting property and ways around this, but unless they have significant income and are comfortable paying market rate rental to the beneficiary, it is an area we encourage them to avoid,” he said.
There are other, more efficient ways to reduce your tax bill, such as giving away cash lump sums, making use of tax-efficient investing or putting assets into trust structures, Mr Butcher added. The family home allowance or “residence nil-rate band”, which came into effect on April 6 2017, entitles each individual to an additional amount on top of their existing £325,000 inheritance tax exemption.
The value of the perk, originally £100,000, increases by £25,000 a year until it reaches £175,000 in April 2020; it is currently £125,000. For a couple this means a £1m estate will eventually be able to be left tax free when their allowances are combined.
However, Chris Ball of Hoxton, another wealth adviser, said increasing property wealth meant that people would still be caught out by gifting rules, despite the new allowances.
Property wealth now accounts for 76pc of the average estate, according to Hoxton, which says most people do not understand the IHT rules. More than three quarters of parents aged 55 and over find gifting rules confusing and are concerned about making mistakes, according to research by Key, the estate planning adviser.
“House prices are going up, so more people are falling into the IHT net as property is the bulk of people’s wealth,” Mr Ball said.
“People are paying more tax and looking for ways around it. But gifting can be a real problem if people think they can gift a house and still live in it rent-free. These things can be extremely costly further down the line if you get it wrong and it’s not you who has to pay the taxman – it’s your children.”
He added that HM Revenue & Customs had been stepping up its efforts to raise tax money as the Government struggled to fund public services.
“HMRC is always going to tax the low-hanging fruit. It is easier for the taxman to go after the general public than companies,” he said.
“The Government needs more money and HMRC is becoming more aggressive on these things than it used to be, that’s for sure.”
Mr Ball said very few people would give away their property if they knew what the implications were. He said the idea of paying rent would be a serious deterrent for most.
He added that there were always ways for individuals to reduce the size of their estate by structuring their assets in a more tax-efficient way. For many, IHT should be considered a “voluntary tax” as diligent financial planning could result in significant savings, he said.
Gordon Andrews, a tax expert at the wealth manager Quilter, said the rules could be made clearer. “It’s a struggle for people. HMRC does make an effort but the complexity of these things means they are not always able to make the rules clear to everyone,” he said.
He added that, despite government efforts to make the system clearer, tax had become increasingly complex over the years and people often struggled to keep abreast of changes to the rules and thresholds involved.
Mr Andrews advised people to consider moving to a smaller, cheaper home and giving away the money left over rather than handing over the properties themselves.
‘Clients ask us about giving property away but we encourage them to avoid it’