Inheritance tax loophole squeezing more families as property values soar

Five years ago, 2,200 families faced the surprise of an inheritance tax bill triggered by a rule, but projections indicate that by 2028, more than 5,000 estates will be affected as a consequence of escalating property values and the government’s persistent freeze on inheritance tax thresholds.

The Telegraph has been urging the government to eliminate inheritance tax before the upcoming general election. Over the past decade, annual revenue from inheritance tax has doubled, surpassing £7 billion, as more families are compelled to pay the 40% charge due to soaring asset prices and stagnant tax thresholds.

Inheritance tax affects only those with estates exceeding the nil-rate band of £325,000. Unfortunately, this allowance hasn’t been adjusted since 2009, despite the significant increase in house prices and inflation. As a result, more families are falling under the scope of this divisive tax.

For homeowners passing their primary residence to their children, there is an additional but frozen £175,000 allowance called the residence nil-rate band. This allows married couples and civil partners to jointly pass on up to £1 million free of inheritance tax. However, it’s not widely known that wealthier couples may not qualify for the full tax relief. When an estate is valued over £2 million at death, the residence nil-rate band begins to diminish. In cases where a couple’s estate is substantial, both partners can lose their nil-rate bands, potentially incurring an additional £140,000 in tax.

According to analysis by the investment firm Quilter, by 2028, around 5,400 families will be impacted by this complex rule each year if the thresholds remain unchanged. Over this period, more than 20,000 families could face unexpected tax bills.

The complex aspect of the residence nil-rate band is that it starts to taper when the estate’s total value exceeds £2 million. For every £2 over this threshold, the band reduces by £1 until it reaches zero. For many couples, the residence nil-rate band will disappear once the estate exceeds £2.7 million, mainly because the first spouse typically leaves everything to the surviving spouse, rendering the residence nil-rate band unused. Preserving these bands could save a family £140,000 (40% of £350,000).

For individuals with pensionable earnings, maximising contributions to reduce the estate’s size is recommended, as pensions are not subject to inheritance tax, thus helping to preserve the residence nil-rate band. Shaun Robson of investment firm Killik & Co emphasises the importance of reducing the taxable estate below the £2 million threshold while ensuring that individuals have sufficient income or capital to maintain their current lifestyle throughout their lives.