Equity Release Tax Trap Leaves Families Worse Off

Many homeowners consider equity release a smart way of avoiding inheritance tax, but opting to take the money rather than leave a debt-free home doesn’t always pay off.

Rising interest rates have tipped thousands of families into the inheritance tax (IHT) net.

House prices and the cost of borrowing money have steadily increased over the past two years, but the thresholds for paying IHT have remained the same since 2009.

Chancellor Jeremy Hunt has already decided to keep the current thresholds until 2028 while families hand over record amounts of IHT to HM Revenue & Customs (HMRC).

In the first six months of the 2023-24 financial year, HMRC collected £3.2 billion of IHT – £300 million more than during the same period last year. In June, £800 million of IHT was paid – a record for a single month.

Reducing IHT With Equity Release

Some families plot to reduce the amount of IHT they pay with equity release.

Equity release allows older homeowners to borrow against the value of their home while rolling up any loan repayments until they leave the property.

This ploy reduces the deceased’s net worth as they are credited with the home value but debited for the money borrowed on equity release. But there is a tax trap.

Equity release has always had a higher interest rate than a standard mortgage, so loans are expensive. Rolled-up interest can soon grow to more than the tax saved by entering the equity release contract.

For a homeowner with an estate that has nudged over the tax-free threshold of £1 million, taking an equity release of £100,000 reduces the estate’s net worth to below the tax-free limit and could save £40,000 in taxes.

Beating The IHT Trap

This tactic was fine while interest rates were lower, but the current equity release rate is 7.08 per cent, adding £98,000 interest to the borrowing over ten years. Opting for equity release would cost the estate £58,000 more than the IHT potentially awaiting the estate.

To avoid the tax loss, the equity release loan should come to around £57,000, which would roll up the interest over ten years to about £40,000.

Calculating the amount of interest an equity release loan costs is difficult, as the rate depends on age, credit history, health and property value.

The best time to consider equity release is when interest rates are low, and property prices are climbing. The current state of the housing market suggests lenders will make lower loan offers at higher interest rates.

How IHT works

IHT is a tax paid on the value of someone’s estate once they have died.

No tax is paid if the estate’s value is less than £325,000 or if the amount over £325,000 is left to a spouse, civil partner or charity.

How much IHT is paid depends on the value of the deceased person’s estate, including their home and contents, money, cars, shares and a business. These are someone’s assets.

You also need to account for any money owed by the deceased. These are someone’s debts.

Add up the value of the assets and subtract the debts to discover the net worth.

The IHT rate is 40 per cent and is only charged on the estate value above £325,000.

Extra IHT Reliefs

If the deceased owned or had a share in the home, the IHT threshold is increased by £175,000 to £500,000. To claim this extra relief, the home must be left to the deceased’s children, and the estate must be worth less than £2 million.

The tax-free threshold is tapered or reduced for estates worth more than £2 million. The residence nil-rate band (£175,000) is diminished by £1 for every £2 the estate is valued over £2 million until the relief is zero.

Tapering means once an estate is worth more than £2.35 million, the residence nil-rate band disappears.

If the home passes to a spouse or civil partner, there is no IHT to pay.

If the estate is worth less than the tax thresholds, any unused relief is passed to the surviving spouse or civil partner.

Doubling up reliefs like this gives a potential IHT tax-free threshold of £1 million for a married couple or civil partners. Any claim for relief must be made within 24 months from the end of the month the person died.

Equity Release And IHT FAQ

What is equity release?

Equity release is a special borrowing arrangement for older people to unlock the value of their homes. Equity release terms vary, but the most popular borrowing is a lifetime mortgage. The package comes with rolled-up interest payments, allowing homeowners to take the cash without any repayments until they die or leave the property.

What are the age limits for equity release?

Equity release is aimed at borrowers aged 65 or older, with no upper age limit.

How much can I borrow on equity release?

A typical equity release offer is up to 60 per cent of a home’s value. The final amount depends on age, health, credit score and property value.

How much can I borrow on equity release?

A typical equity release offer is up to 60 per cent of a home’s value. The final amount depends on age, health, credit score and property value.

How much does equity release cost?

Equity release rates have reached a record high of around 7 per cent.

Can I take equity release if I have a mortgage?

A typical equity release lender will let you borrow if you have a mortgage, but you must repay the mortgage as part of the deal.

What does IHT stand for?

IHT stands for Inheritance Tax.

What is IHT?

IHT is a tax on the wealth a person leaves behind when they die.

What happens if I give away my money when I’m still alive?

Gifts of money or property while living are considered potentially exempt transfers (PETs) under IHT rules. The tax reduces over seven years until no is due on the gift.

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