Your property will usually be counted as part of your estate for inheritance tax purposes. Given that the average property in the UK currently is valued at £293,000 (based on the UK House Prince Index for August 2024), your house will often form a significant portion of your estate.
Taken together with your other assets, your property valuation can sometimes push you over the inheritance tax threshold leaving your family with a potential inheritance tax bill. That said, there are ways to avoid paying inheritance tax on your property. We explore some methods below.
What is inheritance tax?
Inheritance tax (IHT) is a tax charged on a person's estate following their death. The usual inheritance tax rate is 40% but this only applies on the value of your estate above the inheritance tax threshold which is currently £325,000 per person. If you have a home which you are leaving to your direct descendants, you can also benefit from the residence nil-rate band (RNRB) which is an additional £175,000.
In addition, if you're married or in a civil partnership, you can pass everything on to your partner without paying any inheritance tax. They can also inherit your unused inheritance tax allowance and residence nil-rate band which means that after they die, they can pass on up to £1,000,000 tax-free.
Therefore, if you're married or have a civil partner and own your home, you only need to worry about inheritance tax if you believe your estate is likely to be valued at over £1,000,000, or if you have made a number of significant gifts to other people. If so, there are ways to mitigate your inheritance tax burden.
When does the residence nil-rate band apply?
The residence nil-rate band is set at £175,000 and is an additional allowance which applies if you want to pass on your main property to a direct descendant. A direct descendant is typically defined as a child, grand-child, or great-grandchild. However, stepchildren, adopted children, and foster children also count as direct descendants. That said, if you do not have children, then this additional allowance won't apply as you won't be able to leave your home to a direct descendant.
If you do have children and you die before your spouse or civil partner, they can inherit your unused residence nil-rate allowance which means the two of you could pass on an extra £350,000 to your children without paying inheritance tax.
However, if your home is worth less than £350,000 then your RNRB will be reduced as well. So, for example, if you're leaving behind a flat valued at £150,000, then your RNRB will be £150,000 rather than £350,000. In addition, if your estate is worth more than £2,000,000, your RNRB will be reduced at a rate of £1 for every £2 above the £2million threshold.
That said, the residence nil rate band can be a good way to pass on your home to your children without having to worry about inheritance tax implications in many cases. It's a generous allowance that, if you're married or in a civil partnership, can add up to more than the average house price in the UK right now.
For many, just making use of the RNRB in addition to their existing inheritance tax nil-rate threshold will be enough to avoid any kind of inheritance tax without having to take any additional measures to mitigate their tax burden. You can find out more about this topic in our residence nil-rate band article.
Can you gift a property to avoid inheritance tax?
Some people believe they can simply gift their house to their children to avoid inheritance tax. The idea is that if the house is in your children's names, then it won't be part of your estate for inheritance tax purposes. Gifting a house to your children can be classed as a potentially exempt transfer (PET) and free from IHT if you fully transfer ownership of your home to your child and survive for 7 years after the fact. This means the house won't count towards your estate for inheritance tax purposes and therefore you will reduce your bill.
However, this only works in specific circumstances. To start with, if you gift your children your home, they will own it. This means they can ask you to move out and sell the house immediately. Relationship fallout happens, so it's important to consider this before going down this route.
In addition, there are rules around gifting the home to your children if you hope to avoid inheritance tax in the future.
Avoiding the "gift with reservation of benefits" trap
You can't continue living in the house you've gifted to your children for free as then the gift will be classed as a gift with reservation. This means that, as you're still deriving a benefit from the property, it will count towards your estate for inheritance tax purposes even if you don't technically own it anymore.
If you plan to live in the property, you can avoid this by paying market-rate rent for the property to your children. This means that if similar properties in the area cost £1,000 per month to rent, then you should be paying this amount to your children each month in rent. This could trigger an income tax liability for your children as the money they receive in rent will count as income.
However, gifting your property could work well in some circumstances. For example, if you're planning on retiring abroad and only visiting your children in your old home on rare occasions, this won't count as a "gift with reservation" as you'll have your own property elsewhere and you won't be living in the home you've gifted.
As such, gifting a property could work in some limited circumstances, but for many people who hope to continue living in their home, it might not be the best idea unless they're prepared to pay market rent for their property to their children or are planning on retiring elsewhere.
Can you use a trust to avoid inheritance tax on your property?
You can use a trust to avoid inheritance tax on your property because assets placed in a trust do not usually count towards your estate for inheritance tax purposes. In some circumstances, trusts can be a good idea. Bare trusts, for example, work well if you want to pass on assets to younger grandchildren but want someone else (the trustees) to look after the assets until they turn 18. For the purposes of inheritance tax, bare trusts work very similarly to gifting.
Trusts, however, are complex legal structures which often come with their own taxes and charges. Discretionary trusts, for example, come with their own inheritance tax charges. This includes a reduced 20% inheritance tax charge on the portion of the value of the property which exceeds your inheritance tax allowance when you first put it in a trust, as well as a 6% 10-year anniversary charge on the value of the trust above the inheritance tax threshold available to the trust.
In addition, if you place your home in a discretionary trust, the residence nil rate band (RNRB) won't apply as the RNRB only applies if a direct descendant inherits the property. Within a discretionary trust, you have "potential beneficiaries" who do not directly inherit the assets. There are ways around this, but they typically giving the asset directly to the beneficiary who also needs to be a direct descendant and this can negate the point of the trust in the first place.
As such, while trusts can be a good option in certain circumstances, they are complex structures and as such, you'll need to seek legal and financial advice particularly when it comes to using trusts to reduce your inheritance tax bill. In short, they can sometimes be used to mitigate your tax burden but they're not always the best choice depending on your circumstances. You can find out more about trusts in our article on using a trust to reduce inheritance tax.
Gifting, trusts, and care home fees
Before you decide to put your home in a trust or give it away, you should think about how you're going to fund your care in your later years if you need it. If you ask for help with your care fees from the council, you may be expected to pay for your own care in full if you have assets valued at over £23,250 in England.
Gifting a property or putting it in a trust is sometimes done pre-emptively in order to shield the value of the property from potential care costs down the line. And sometimes people give away their property before they suspect they'll need care in the first place. However, in some circumstances, this can backfire.
When assessing your application, the council can take a look at any gifts you've made in the past. If it decides you've given away your home (either by gifting it or putting it in a trust) in order to avoid paying for your care fees, this could be classed as deliberate deprivation of assets and you could be on the hook for the fees anyway.
Some people believe that as long as you transfer your assets at least 7 years before you need care, then it won't count as deprivation of assets. But, the council can technically go back as far as they like when assessing your claim and, if they can evidence the fact that you've deprived yourself intentionally, you may be asked to cover your own fees.
To do this, the local authority typically needs to show you deprived yourself "deliberately" which typically means you reasonably expected you'd need care in the future but you gave away the asset anyway.
Only you know your situation and only you can gauge whether you're likely to need care in the future. But, before you gift or put your home in a trust for inheritance tax purposes, it's worth working out how you'd fund care if you reasonably believe you might need it in the future.
Bear in mind that your home will not be included in any means test if you go into a care home on a short-term or temporary basis. Also, you move into a care home permanently, your home will not be included if - for example - your partner still lives there. More information can be found in our article on paying for later life care.
Can you use equity release to avoid inheritance tax?
Equity release arrangements will reduce your estate which means you can lower or eliminate your inheritance tax bill by using an equity release arrangement. That said, they are not usually the best way to reduce your tax liability as they involve borrowing against your property or selling your property to an equity release provider. Often, the deal you get will be below market value as well.
For instance, with a lifetime mortgage, which is the most common type of equity release, you can typically release up to 60% of the value of your home in the form of a loan. But, this 60% figure is only available to older applicants. Someone in their mid-50s for instance will typically only find deals that allow you to borrow up to 25% of the value of your home. You don't have to pay off this loan or any associated interest until after you die and you can continue living with your home.
But the catch is that compound interest will add up over your lifetime resulting in a bill that can sometimes wipe out the value of the entire property and any price appreciation that has happened over time. Your family will then need to pay off this bill from the proceeds of the sale of the home (unless they have other means) often meaning they can't keep the property anyway.
As such, while equity release will technically reduce your estate and your inheritance tax bill, in most circumstances, it's only worth considering if you need to raise cash for other reasons. If your sole purpose for considering equity release is to reduce your tax inheritance burden, there are other options to consider first. That said, if you want to explore this option, we have an article on understanding equity release to help you wrap your head around the concept.
Avoiding inheritance tax on a property
Avoiding inheritance tax on a property is possible for most people. Those who wish to leave their property to their direct descendants can benefit from the additional residence nil-rate band, which, if used with a spouse or civil partner, could mean leaving a £1,000,000 inheritance tax-free.
For others, there are other options, such as gifting the property, putting it in a trust or opting for an equity release arrangement. However, all of these options come with their own downsides and caveats which means they're not right for everyone. As such, it's always worth speaking to a financial adviser before you decide on the best way to protect your property from inheritance tax. You can book a free, no-obligation inheritance tax consultation with a qualified financial adviser* to discuss your options.
