Money Tip #120 – How keeping a mortgage can cut your inheritance tax (IHT) bill
Increasingly, people over 50 in particular, are choosing to take out mortgages in order to avoid inheritance tax.
How it works
Each individual has an IHT-free threshold of £325,000. That means that you can pass up to £325,000 of assets on to the next generation before IHT (at 40%) is applied to the excess. For a husband and wife their combined IHT-free allowance becomes £650,000. A mortgage on the other hand is classed as a debt against an estate which is then deducted from its value before it is assessed for IHT purposes. This potentially gives rise to people using their mortgage to avoid IHT.
I'll illustrate this with an example.
Let's say you have a house worth £400,000, with no mortgage, which you wish to pass on. If you were to die then £325,000 would be passed on under the terms of your will, IHT free. The remaining £75,000 would be taxed at 40%. So after the tax man has taken all he is allowed to, your beneficiaries would receive a total of £370,000.
Now, if you had the same scenario but this time you took out a mortgage of £75,000 on the property which you simply gifted away then the IHT calculation would be quite different. Upon your death the mortgage lender would get their £75,000 back from the sale proceeds. Your estate would then be worth £325,000 as a result, meaning it can pass to your beneficiaries free of IHT. The tax man would then look at the £75,000 which you had gifted away and see if he can tax that. But as long as you lived for 7 years after making the gift then this too would be IHT free. So meaning that in total you had passed £400,000 on to your beneficiaries tax free! That’s £30,000 more than scenario 1.
So you can see it is possible to use a mortgage to avoid IHT by either keeping an existing loan or by extending it.
As with anything there are downsides to using your mortgage to save IHT.
- You will need to find a lender willing to give you a mortgage. And for pensioners, who are the most likely group to consider the above, they will need to find someone who will offer a mortgage based on their retirement income.
- While interest rates remain low and the value of the mortgage as a percentage of the value of your home is low – then the cost of an interest only mortgage could be attractive. However, as soon as interest rates rise then your monthly mortgage payments will too, unless you are on a fixed rate deal. If interest rates soar a pensioner could find themselves unable to keep a roof over their heads.
- Obviously if you live to a ripe old age then the total cost of the mortgage repayments could offset the IHT savings.
- Saving IHT is one thing – but doing it at the expense of your own lifestyle now is another.
As ever, if you are interested in exploring the above idea further then seek independent financial advice.
Other ways to cut your IHT bill
There are a number of other ways to cut your IHT bill. Read my article – 15 ways to cut your inheritance tax bill.
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