How to avoid inheritance tax

Last updated: 30 December 2021

If you were making a list of things you’d rather not think about, I’d imagine that near the top of that list would be “my own death” and “passing over a huge chunk of money to the government”. (Although “what exactly is in a Big Mac” would probably be up there too.)

These two nasty topics unfortunately come together in the notion of Inheritance Tax: the idea that when you die – having paid tax on your income, your profits and even your purchases throughout your entire life – HMRC for some reason feels that it’s entitled to 40% of everything that’s left at the end.

So if you’ve built up a total equity base of £1.3 million (impressive to be sure, but remember that this includes your home, all the investment properties you’ve acquired during your lifetime as well as cash and shares), after taking account of the £325,000 allowance, your heirs would be writing HMRC a cheque for £400,000. Yikes.

Much as it’s not the most enjoyable topic to think about, it is one of the most financially rewarding. Inheritance Tax is sometimes dubbed “the voluntary tax”, because by planning in advance there’s a large amount you can do to protect your assets and make sure they get passed on in their entirety to your children and grandchildren.

The key phrase there is “planning in advance” – because while there are lots of options, you need to take action and set everything up correctly in plenty of time.

So in this article, I’ll attempt to give you a nice gentle introduction to a less-than-pleasant topic – and convince you that your family could profit enormously from giving it some further thought.

Passing on cash and the family home

Before we get on to your investment properties, it’s worth taking a moment to talk about the other assets that you might have as part of your estate when you shuffle off this mortal coil.

In addition to any investment properties, you’re likely to have some quantity of cash (and maybe shares) as well as the home you live in. If you die without having made any specific plans to mitigate the impact of Inheritance Tax, 40% of the value of these assets over £325,000 will find its way into HMRC’s coffers.

This is an excellent example of where a bit of advance planning can save large amounts of tax: if you’re planning on passing everything on to your children and/or grandchildren anyway, why not start early? There are many occasions during life where HMRC allows sums of money to be passed on without any tax implications: for example, up to £3,000 can be given in each year, as well as “small gifts” of up to £250 whenever you want and up to £5,000 ahead of a child’s wedding.

Then there’s the family home, which could be the single most valuable asset you own. A common wheeze for people to think up is “gifting” the home to the children but continuing to live there themselves. However, this won’t have the desired effect: if you’re still enjoying the benefit of the property, it still forms part of your estate for Inheritance Tax purposes. The only exception would be if you were paying the children a commercial level of rent in return for living there.

There are a few other options – like selling up and having cash to pass on instead (which will be exempt from Inheritance Tax as long as you survive for 7 years after making the gift), or taking out additional borrowing against the property to reduce the equity, and using the borrowed funds to buy other assets that can be sheltered from Inheritance Tax.

Whichever route you go down, it’s clear that it involves investing time in careful planning and money in expert advice – but that planning could save huge amounts of tax.

Passing on investment properties

Let’s now turn to how to avoid inheritance tax when it comes to passing on investment properties, which is probably what brought you here in the first place.

Of course, if investment properties form part of your estate when you die, the equity in those properties will form part of the value of your estate – meaning that your heirs will have to pay Inheritance Tax of 40% on any amount over the (current) threshold of £325,000.

This is far from ideal, of course – not least because if you’re passing on little cash but a lot of equity, your heirs might have to sell the properties just to pay the tax bill. That will deprive them of future capital growth and rental income, not to mention the fact that you might be thoughtless enough to die at a point in the cycle when it’s not a good time to sell.

Why not just gift the properties during your lifetime, as long as you’re confident (or as confident as you can be) that you’ll survive for 7 years so there will be no Inheritance Tax to pay? You could do, but this is where Capital Gains Tax comes into the picture: even if you give the property away for nothing, you will still have to pay Capital Gains Tax on the difference between the price when you bought it and its market value at the point you give it away.

This leaves you with two far-from-ideal options: wait and fret on your deathbed about the amount of money that’s going to be lost to HMRC when you’re gone, or take a big Capital Gains Tax hit now to avoid your family having a potentially even bigger Inheritance Tax hit later.

If you hold the property in your own name, that’s about the size of it. But if the properties are instead owned within a company, other options become available…

Property in a company

In my recent article on whether you should buy property within a limited company, I mentioned Business Property Relief: a relief that completely removes the spectre of Inheritance Tax from “a business or an interest in a business”.

So instead of passing on properties, you can just pass on shares in the business that owns the properties. Bingo – no Inheritance Tax due.

Or…not. Because honestly, do you really think HMRC would make it that easy?

The flaw here is that “investment” companies – so in our case, one which just holds properties and collects rent – can’t claim business property relief. So unfortunately, Inheritance Tax will still apply to shares of the business that you pass on.

One way around this is to steer the company towards an activity that does qualify for business property relief. The HMRC guidelines say that you can’t claim business property relief on a business that is “wholly or mainly” involved in making or holding investments…so what if the “main” activity of your company became property development?

The guidelines don’t state what “mainly” precisely means, but you could argue that if over 50% of your profits or turnover came from developing property, you’ve actually got a development company rather than an investment company on your hands – so the whole thing, including the properties you’re just quietly holding, qualifies for business property relief.

Dive in deeper…

We’ve really just touched on a few of the important factors in how to avoid inheritance tax – a topic that might not be the most pleasant to think about, but has potentially huge consequences for what happens to your family after you’re gone.

Just by reading this article instead of passing it over for something more exciting, you’re already on the right track: Inheritance Tax can be largely voluntary if you think about it in plenty of time. There are all kinds of strategies you can adopt to reduce your liability, but many of these strategies disappear if you refuse to think about the topic until the last minute.

For now though, congratulations on spending this time confronting such distasteful issues as death and taxes. So go on – why don’t you Google “what’s in a Big Mac? ” while you’re on a roll…