The press currently seem to be fixated on the rights and wrongs of inheritance tax (IHT). One of their latest claims is that older people can use a mortgage to make use of a “loophole” in the IHT rules. Is this something you should consider?
What’s a tax loophole?
Before we get into the nitty-gritty of the inheritance tax (IHT) rules it’s important to understand what a tax loophole is. This is an unintended consequence of the rules either because the legislation was poorly written or a tax expert spots a side effect of the rules that could not reasonably have been foreseen by those who wrote the legislation.
Is there a risk of using loopholes?
Loopholes come in all different shapes and sizes. As a rule of thumb, unless HMRC is making a fuss about one and claiming it doesn’t work, it’s safe to use.
Tip: If you’re thinking of using a tax loophole, do some research first. Read what HMRC has to say about it, if anything, and speak to your accountant or tax advisor to get their take on it.
Can a mortgage be an IHT loophole?
The apparent loophole recently mentioned in the media involves older individuals or couples mortgaging their home and giving the proceeds away. This isn’t a loophole! It’s simply making use of basic IHT rules. It might therefore work to reduce your IHT. However, before charging off to the bank to mortgage your home or other property you should consider all the consequences.
How does the non-loophole work?
You probably know that when you die if your estate is valuable enough it will have to pay IHT on the excess above various thresholds (see The next step). The value of your estate for IHT purposes is the total value of all your assets less the total of any debts you have. A loan, whether or not secured by a mortgage, is a debt that reduces your estate’s value and therefore potentially the IHT. Simply taking a loan won’t save IHT because the cash you borrowed is now in your bank account or invested elsewhere, which means overall your assets are worth the same as before the loan. To save IHT you need to give away some or all of the money you borrowed, presumably to the beneficiaries named in your will.
Trap. After you’ve given the money away, you need to survive seven years for the gift to escape IHT completely.
Example. Ian is a widower. When his partner dies she left all her assets including a share of the marital home to Ian. His estate is worth £1,200,000. This is £200,000 in excess of the IHT nil rate bands his estate is entitled to his children. If he died today, his estate would owe IHT £80,000 (£200,000 x 40%). To reduce this he borrows £200,000 and gives it to his children. If he survives seven years from the date of the gifts their value will be excluded from his estate for IHT purposes which, everything else being equal, will save the £80,000 IHT. However, interest payments on the loan will eat into this saving.
Tip: If there’s little or no chance that your estate will exceed the total IHT nil rate bands and exemptions you’re entitled to, which could be up to £1 million, there’s no point in considering reducing the value of your estate with a mortgage to avoid IHT. You’ll be incurring mortgage costs for no tax advantage.
While the arrangement is just the normal IHT rules in action rather than a loophole, borrowing and giving away the proceeds might save IHT. However, this isn’t worth considering if there’s little or no chance that your estate will exceed the point at which IHT is payable. Often this can be as much as £1 million.
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