Inheritance tax

Inheritance tax (IHT) used to be known as the “voluntary tax” because if you planned ahead you could avoid it. But an increasing number of people are being caught in the IHT net because of the sharp increase in the value of their homes. Revenue & Customs took in £2.92bn in IHT last year compared with £1.68bn in 1997-1998. The IHT threshold has been lifted by 28 per cent over the past eight years while house prices have risen 142 per cent.

What is IHT exactly?

It is a tax applied to estates worth £275,000 or more though this level is adjusted annually and goes up to £300,000 in 2007-2008. Unlike income tax, IHT is not incremental so tax is levied at 40 per cent regardless of how much money you are leaving behind. Nearly 2.5m UK homes are worth more than £275,000 although the Revenue points out that only 6 per cent of estates are caught by IHT.

Are there any exemptions?

Yes. The most important one is the marriage allowance that applies to spouses and, since the recent law change, couples registered under a civil partnership. But this exemption does not apply to co-habiting couples and when the second partner in a marriage dies, there is no exemption for assets passed on to children.

I believe that I can pass on my property tax free if I hand it over seven years or more before I die?

You can but the Revenue has clamped down on what it saw as an abuse of this by excluding “pre-owned” assets. This was when someone “gave” their home to their children but continued living there tax free. From last April, gifting now requires the donor to pay a commercial rent for their use of the property or any other asset.

I am keen to avoid IHT but concerned that if I hand over my assets to my children too soon they may not use them wisely. Is there anything I can do?

You can make your gift through a trust where the trustees will ensure that your children do not squander their inheritance or that divorce does not lead its loss.

Are there any other tax breaks?

One of the most important areas of exemption is known as business property relief. This was established to allow small businesses, typically family-owned, to continue trading without having to sell off assets to meet IHT. You do not have to run your own business to benefit. Relief is available to anyone holding unquoted company shares, providing they have been held for two years.

Shares listed on Aim and Ofex also qualify as do those bought under the Enterprise Investment Scheme. Under business property relief, if you own fully-listed shares that give control of the company, your IHT bill on these can be halved. But before you stuff your portfolio full of these shares, be aware that smaller companies are more vulnerable to setbacks and that it can be difficult to sell shares in smaller companies.

Some venture capital trust managers are structuring their schemes to give investors both the VCT tax breaks and exemption from IHT. They do this by holding the Aim stocks for three years – the qualifying period for VCT reliefs – and then distributing value to investors in the form of Aim shares. If these are held for a further two years the IHT tax breaks kick in.

I live in the country and have heard there is special IHT relief for farms. Is this true?

There is IHT exemption for farm-
houses but they have to form part of a working farm. The house must also be “of a character appropriate to the property, ie, proportionate in size and nature to the requirements of the farming activities”, according to Revenue guidelines. No account will be taken of the value the house might have as a desirable country residence.

Continuing the rural theme, I hear that woodland also enjoys exemptions. How does that work?

Commercially-managed woodland owned for two years is exempt. But managing woodland requires professional skills and is a long-term venture with trees typically taking 30 years to reach maturity. You may need to hire in professional management, which will incur costs. If this does not appeal you can invest through special woodland funds managed by advisers such as Forestry Investment Management. Such funds also allow you to spread your risk.

Is that the lot?

No. You are allowed to make a gift of up to £3,000 a year without incurring IHT. You can carry forward into the following year any unused allowance so you could give up to £6,000 in the year you start giving. The taxman even has a soft spot for those about to marry and allows IHT-exempt wedding gifts of £5,000 for each child, including adopted children and stepchildren, and the person your child is marrying. For grandchildren and great-grandchildren and their prospective partners, the allowance is £2,500 each.

I have read that charitable donations can also escape inheritance tax. Is that so?

Yes. Gifts to UK-based charities, housing associations and political parties are covered by this rule. National museums, universities and the National Trust can benefit from your generosity without exposing you to IHT.