Runaway house prices over the past 10 years have produced an inheritance tax headache for millions whose properties now take them over the threshold.

Unlike income tax, there is no incremental scale for IHT. If your estate is worth up to £275,000, you will pay no tax. Anything over that amount and you will pay 40 per cent on it – for example a £300,000 house would incur IHT of £10,000. 

More people are being caught every year, according to the latest IHT report by Grant Thornton with research from Lombard Street. In the 2005-2006 tax year, Revenue & Customs received £3.4bn in IHT compared with just £1.68bn in 1997/98.

“Each year, more and more people fall into the IHT net. This is largely owing to house price inflation and overall growth in individual wealth,” says Ian Johnson, head of private client services at Grant Thornton. “Both have outpaced available IHT reliefs that tend to increase in line with the retail prices index.” He says house prices rose 142 per cent between 1997 and 2006 compared with an increase in the IHT threshold of just 28 per cent.

As well as failing to raise the IHT level, Gordon Brown, the chancellor, has also closed loopholes in tax planning and overseen the stricter enforcement of existing legislation. New rules on pre-owned assets have sought to clamp down on people giving away assets to heirs while still benefiting from them.

Although there are now fewer ways to reduce the tax paid on estates, some legitimate options are still available.

Homeowners can cut IHT bills by taking some of the value of their property in cash during their lifetime. Through an equity release scheme, a homeowner can sell all or part of his or her house to the company offering the scheme, taking that share of the property out of the estate. On death, the mortgage debt with accrued interest is then deducted from the value of the estate.

There are two different equity release schemes and around 40 plans in total. Reversion plans enable a percentage of the home to be sold to a company in exchange for a lump sum, while the resident keeps a lifetime tenancy. A one-third share of a £210,000 home, for instance, which is worth £70,000 on paper will typically fetch about £40,000 from the loan company, depending on the owner’s life expectancy.

Second, lifetime mortgage plans advance a tax-free lump sum with interest charged daily and “rolled up” until the property is sold and the debt repaid. On lifetime mortgages, which are currently available at around 6 per cent, the amount of the outstanding loan will keep rising until the eventual sale of the house repays the loan.

“The advantage of doing this is that you can draw an income from your property while continuing to live in it without falling foul of the Revenue,” says Chas Roy-Chowdhury at the Association of Chartered Certified Accountants. “However, it is an expensive way of avoiding paying tax and homeowners will have to be careful to structure it correctly.”

A scheme offered from an Isle of Man-based fund and run by Close Brothers and Equity Release Services can mitigate IHT on the home through the use of equity release and a single-premium whole of life policy.

It works by transferring the investor’s house into a home reversion scheme. In return the investor receives a lump sum and is able to live in the house until death. The lump sum is then invested in a single premium bond written by Isle of Man Assurance on the investor’s life. This bond will invest in the property wealth manager fund, which holds the properties of all investors using the product.

By giving units in the wealth manager fund to children, grandchildren and other beneficiaries the investor makes a potentially exempt transfer. This means if the investor lives for another seven years there will be no IHT to pay on these units.

“This is simply another version of the typical equity release scheme offered in the UK but because it’s done offshore the company will not have to pay capital gains tax when they eventually sell the house,” says David Williams, tax consultant at Smith & Williamson. “This means that the provider does not have to factor in additional tax charges.”

Any inheritance by a spouse is not subject to IHT, and from next month the exemption will also cover same-sex couples who are registered as civil partners. It will not cover co-habiting couples.

Most people leave all their assets to their wife or husband in the knowledge there will be no IHT to pay. But that means that when the second parent dies, anything left in their estate above the nil rate band is subject to IHT. Accountants suggest making use of the nil rate band through a nil rate band discretionary will trust when the first parent dies, rather than waiting until both expire.

To set up a will trust, the property must be owned as tenants in common, not the more usual joint tenants which is the way most married couples hold the family home. Each partner then writes a will leaving their half- share of the property to the children or grandchildren or other beneficiaries.

Both partners also complete an “Expression of Wishes” document which says that the deceased person would like the surviving partner to remain in the property for the rest of their life. To avoid a challenge by the Revenue, the wills must not give the surviving spouse an absolute right to remain living in the property until they die. If this is written into the will, the Revenue will argue that there is an “interest in possession” and IHT will not be avoided.

This is a version of the nil rate band discretionary will trust. But rather than place half the family home in trust, a debt is created, with the surviving spouse buying out the deceased partner’s half of the property. This IOU is placed in the trust and is repaid from the sale of the home on the death of the second partner. As the trust owns a debt, rather than an asset, there is no problem with how the benefits are divided between the beneficiaries. It also ensures both partner’s nil rate bands are used.

“We prefer this type of arrangement because it does not go against Revenue rules and is therefore less likely to be contested,” says Mike Warburton, senior tax partner at Grant Thornton. “When the homeowners die the loan is repaid from their estate. If both spouses make full use of the nil rate band, they can escape paying tax on £550,000 of their assets.”

Neil Edwards, tax planning manager at Clerical Medical warns that any tax planning scheme needs a lot of thought. “The Revenue is taking a very close interest in all the different tax avoidance schemes that are around. You could find that if you don’t structure it correctly you will have paid the high fees to set it up but the surviving relative still has to pay IHT because it falls foul of Revenue rules.”