Eight Common Inheritance Tax Mistakes and How to Avoid Them
5 minute read
Avoiding a handful of common errors can make a meaningful difference to your estate.
Inheritance tax is one of the most misunderstood areas of financial and legal planning in England and Wales. Many people are aware that it exists, and most have a general sense that it is something they should consider. But the gap between knowing that inheritance tax matters and understanding how it actually works is wide, and it is in that gap that some very costly errors tend to occur.
The mistakes described in this article are not unusual or obscure. They are the kinds of errors that professionals see regularly, often made by well-intentioned people who were trying to plan sensibly but who were working with incomplete information or acting without advice. Some of them are relatively simple to avoid once you are aware of them. Others require more careful planning and proper legal guidance.
If any of the situations described here sound familiar, it is worth taking them seriously. Inheritance tax planning is time-sensitive, and the options available to you narrow as time passes.
Table of Contents
Mistake 1: Leaving Planning Too Late
Timing is at the heart of most inheritance tax planning. Many of the most effective strategies for reducing an estate’s exposure to inheritance tax depend on the passage of time, and specifically on the person making the gifts surviving for a set period after making them. When planning begins too late, time-dependent strategies either cannot be used at all or are only partially effective.
The most significant example of this is the seven-year rule that applies to most lifetime gifts. When you make a gift to another individual, it is treated as a Potentially Exempt Transfer. It becomes fully outside your estate only if you survive for seven years from the date of the gift. If you die within that window, the gift is brought back into account and inheritance tax may be charged on it, with taper relief reducing the rate for gifts made between three and seven years before death.
This means that for lifetime gifting to work as a planning strategy, it needs to begin early. A person who starts making substantial gifts in their mid-sixties has a reasonable chance of surviving for the necessary seven years. A person who only turns their mind to this in their late seventies or after receiving a serious diagnosis may find that the window has effectively closed. Gifts made after a diagnosis of terminal illness are unlikely to outlast the seven-year period, and HMRC will be alert to arrangements put in place in those circumstances.
Waiting until a serious illness is diagnosed also tends to remove other options. Trust planning, restructuring business assets, and making changes to the ownership of property all typically require time, legal process, and, in some cases, valuations or professional advice that cannot be rushed. The earlier a conversation about inheritance tax planning begins, the wider the range of tools that remain available.
Key point: Many inheritance tax strategies depend on surviving for seven years after taking action. Starting planning early significantly increases the effectiveness of those strategies.
Mistake 2: Not Using the Annual Gift Allowances
A great many people who are concerned about the level of inheritance tax their estate might face are entirely unaware that there are simple, immediate, and permanent ways to begin reducing it right now. The annual gift exemptions that exist in the inheritance tax legislation are straightforward, require no trust arrangements or legal documentation, and can make a meaningful difference over time. Yet they are consistently underused.
Every individual has an annual exemption of £3,000 in each tax year. Gifts within this amount are immediately outside the estate and permanently exempt from inheritance tax. Any unused portion of this exemption can be carried forward to the following year, meaning that a person who did not use their exemption last year could give away up to £6,000 this year without any inheritance tax consequences. This sounds modest, but a couple who both use their exemptions every year will have removed £6,000 from their combined estates annually, or £60,000 over a decade, without any planning complexity at all.
Beyond the annual exemption, small gifts of up to £250 can be made to any number of individuals in the same tax year, again immediately and permanently exempt. Wedding gifts made in consideration of a marriage or civil partnership are also exempt up to set limits depending on the relationship.
Perhaps the most powerful and most overlooked exemption is the normal expenditure from income exemption. Where gifts are made regularly from surplus income (meaning income that is not needed to maintain your usual standard of living), those gifts can be immediately exempt from inheritance tax with no upper limit and no seven-year waiting period. For people with pension, rental, or investment income that they do not need for day-to-day expenses, this exemption can allow very substantial sums to be passed out of the estate over time. The key requirements are that the gifts must be regular, they must come from income rather than capital, and they must be properly documented so that the exemption can be claimed on death.
The cumulative effect of consistently using these exemptions over a period of years can be significant. An estate that is £100,000 smaller as a result of regular annual giving will pay £40,000 less in inheritance tax than it would have done otherwise.
If you would like to understand how regular giving could form part of your estate planning, our specialists can help you think through the options and ensure your will reflects your overall strategy. Get in touch for a no-obligation conversation.
Mistake 3: Giving Away the Home but Continuing to Live There
This is one of the most common inheritance tax mistakes, and it is one that can be particularly damaging because it tends to create problems on several fronts at once. The idea behind it is understandable: if your home is likely to be a significant part of your estate, and you want to reduce your estate’s exposure to inheritance tax, why not simply transfer the property to your children now?
The problem is that inheritance tax law does not treat that kind of transfer as a genuine gift. If you transfer your home to your children but continue to live in it without paying a full market rent, you are treated as having retained a benefit from the asset. This is known as a gift with reservation of benefit, and the legal consequence is that the property remains in your estate for inheritance tax purposes, as if the transfer had never taken place.
The seven-year clock that would normally start running on a gift does not apply where a reservation of benefit exists. The asset simply stays in the estate, and no inheritance tax advantage is gained. But the transfer itself may have had real costs. Transferring a property that has increased in value since it was acquired can trigger a capital gains tax liability for the person making the transfer. If the property is later occupied rent-free by the original owner, HMRC may also charge Pre-Owned Asset Tax, which is an annual income tax charge on the notional benefit of living in a property that you previously owned.
The result is that an arrangement intended to reduce tax can end up creating tax liabilities that would not otherwise have arisen, while delivering none of the inheritance tax savings that motivated it. This is what is sometimes described as the worst of both worlds.
How to Avoid This Problem
To avoid the gift-with-reservation rules, the gift must be genuine and unconditional. If you transfer your home, you must actually give up the use of it. If you wish to continue living there, you must pay full market rent to the new owners, and that rent must genuinely be paid throughout your continued occupation. A token or nominal payment will not be sufficient in HMRC’s eyes.
Paying market rent is a legitimate option for some people, though it comes with its own considerations. The rent you pay becomes rental income in your children’s hands and will be subject to income tax. The overall tax position across all taxes needs to be assessed before any arrangement of this kind is put in place.
Key point: Simply putting your home in your children’s names while continuing to live there does not remove it from your estate for inheritance tax. Legal advice is essential before attempting to plan around a property.
Mistake 4: Making Large Gifts Without Considering Capital Gains Tax
Inheritance tax and capital gains tax are two separate taxes that operate in quite different ways, but they interact in situations involving gifts, and failing to consider both of them together before making a significant gift can lead to an unexpectedly large combined tax bill.
When you give away an asset that has increased in value since you acquired it, capital gains tax may be charged on the gain at the time of the gift. This applies even though no money has changed hands. HMRC treats the transfer as if you had sold the asset at its current market value, and the resulting gain is taxable. For property (other than your main residence), the rate of capital gains tax for higher-rate taxpayers is significant, and for shares and other assets, it can also be substantial.
So if you give away a portfolio of shares or a rental property in the hope of reducing your estate for inheritance tax purposes, you may face an immediate capital gains tax liability at the point of transfer. And if you die within seven years of making the gift, the gift is brought back into your estate as a failed Potentially Exempt Transfer and inheritance tax may also apply. In that scenario, you have paid capital gains tax on the gift immediately and inheritance tax on it on your death, with no net saving.
This does not mean that gifting assets is never appropriate. In some circumstances, particularly where assets have not increased substantially in value, or where the donor has significant unused capital gains tax allowances, gifting can work well. The point is that the full tax position across both taxes needs to be assessed before any significant gift is made, not as an afterthought.
Mistake 5: Overfunding Discretionary Trusts
Trusts can be a useful tool in inheritance tax planning, but they are not a straightforward solution, and transferring too much into a discretionary trust without understanding the ongoing tax consequences is a mistake that can be costly.
A transfer into a discretionary trust is a Chargeable Lifetime Transfer, which means it is immediately subject to inheritance tax rather than being a Potentially Exempt Transfer that becomes exempt after seven years. The Nil Rate Band (currently £325,000) applies over a rolling seven-year period, so transfers up to that limit are tax-free at the time of the transfer. But any amount above the available Nil Rate Band is subject to inheritance tax at the lifetime rate of 20%, or at an effective rate of 25% if the tax is paid from the trust itself.
Beyond the initial charge, discretionary trusts are subject to ongoing inheritance tax charges. Every ten years, the trust is subject to an anniversary charge of up to 6% of its value. When assets leave the trust and are distributed to beneficiaries, exit charges apply. These charges are calculated on a proportionate basis and are not always straightforward to compute, but they can add up significantly over time, particularly in trusts holding appreciating assets such as property.
The mistake that is frequently made is transferring a large sum into a discretionary trust without fully understanding or accounting for these ongoing charges. The trust may reduce the estate on death, but if it has been subject to significant anniversary and exit charges in the meantime, the overall tax saving may be much smaller than expected, or may not exist at all.
Discretionary trusts can still be an effective part of a wider estate plan, particularly for assets that are expected to grow significantly in value, or where there are good reasons beyond tax for using a trust structure. But the decision to use one should be made with a full understanding of the tax regime that applies throughout the trust’s life.
Trust planning is a complex area where the wrong structure can create tax charges rather than avoid them. Our team can help you understand whether a trust is appropriate for your situation. Contact us to discuss your options.
Mistake 6: Assuming Joint Tenancy Solves Everything
Many couples own their home as joint tenants, which means that when one of them dies, the surviving partner automatically inherits the deceased’s share by what is known as “the right of survivorship”. The property does not pass under the will or intestacy rules. Rather, it vests in the survivor immediately and automatically. This arrangement is common and, in many cases, entirely appropriate. But it is sometimes treated as though it resolves all estate planning questions for the family home, when in fact it can create complications and remove important options.
The Remarriage and Residential Nil Rate Band Risk
One of the most significant risks associated with joint tenancy is what happens if the surviving partner remarries or enters a new civil partnership, and later leaves the property to a new spouse rather than to the children of the first relationship. In those circumstances, the Residence Nil Rate Band that was intended to benefit the children of the first relationship may be lost. The property ultimately passes to a new partner rather than to the direct descendants (who were the originally intended beneficiaries), and the inheritance tax planning assumptions that were built around the original arrangements no longer hold.
Care Fee Risk
Where both partners jointly own a property and one of them requires residential care, the estate’s value may be assessed for local authority funding purposes. Holding assets in joint tenancy means they are typically counted as part of the estate for means-testing purposes. If the property had instead been held as tenants in common, with each partner’s share held separately and potentially subject to a trust arrangement, there may be more flexibility to protect at least a portion of the estate’s value.
Loss of Intended Planning
Joint tenancy also removes the ability to use the will to control what happens to the property on the first death. Where a property is held as tenants in common, each partner owns a defined share of the property and can leave that share to whomever they choose in their will. This opens up possibilities for trust arrangements that can preserve the Residence Nil Rate Band, protect against care fees, and ensure that assets ultimately pass to the intended beneficiaries. Joint tenancy does not permit any of this: the right of survivorship operates regardless of what the will says.
For many couples, converting from a joint tenancy to a tenancy in common, and putting appropriate trust provisions in their wills, is a straightforward and sensible step. It does not necessarily mean the surviving partner loses the use of the property, since a well-drafted Will can give the survivor a lifetime interest while ensuring that the underlying share eventually passes to the intended beneficiaries.
Mistake 7: Misunderstanding Business and Agricultural Property Relief
Business Property Relief and Agricultural Property Relief are among the most valuable reliefs available under inheritance tax law, capable of reducing or eliminating the tax on qualifying assets. But they are also subject to detailed conditions, and the assumption that a particular asset qualifies when it does not can lead to a very substantial and unexpected tax bill.
The Rental Property Assumption
One of the most common misunderstandings relates to property. Business Property Relief is available for genuine trading businesses, but it does not apply to businesses that are primarily used for investment, and in this context, investment includes letting property. A person who owns a portfolio of rental properties may think of themselves as running a business, and in a practical sense, they are. But in the eyes of HMRC and the inheritance tax legislation, a property letting business is an investment activity rather than a trading activity, and it does not qualify for Business Property Relief. The full value of those properties will form part of the taxable estate.
Companies Drifting Into Investment Activity
Business Property Relief can also be lost where a trading company gradually accumulates investment assets, such as large cash reserves, investment portfolios, or properties held within the company that are not used in the trade. HMRC applies a test to assess whether the company is primarily a trading company or whether investment has become a significant part of its activity. Where investment activity has become too prominent, the relief may be restricted or denied altogether. Business owners who have not reviewed the composition of their company’s assets in recent years may be carrying a greater inheritance tax exposure than they realise.
Agricultural Relief and Development Value
Agricultural Property Relief applies to the agricultural value of qualifying land and property, but it does not apply to any additional value that may reflect any development potential. A farm that has planning permission or is located in an area where residential development is possible may be worth considerably more than its agricultural value. The relief will cover the agricultural element, but the development premium will be exposed to inheritance tax in the ordinary way.
Key point: Never assume that a business or agricultural asset qualifies for relief without checking the conditions carefully. The rules are detailed, and assumptions can be expensive.
Mistake 8: Confusing Residence With Domicile
The final mistake on this list is perhaps the most conceptually challenging, but it affects a significant number of people and can result in an entirely unexpected inheritance tax exposure.
Inheritance tax in England and Wales is based on domicile, not on tax residence. These are two different legal concepts, and conflating them is a common error. Tax residence is broadly about where you live and where you spend most of your time in a given year. Domicile is a deeper concept: it is the legal jurisdiction that you regard as your permanent home, the place you intend to return to and settle in for good.
A person who was born in the United Kingdom, lived here for most of their life, and has family and property here, will almost certainly be UK-domiciled even if they have spent recent years living abroad for work or retirement. And a person who was born outside the UK but has lived here for many years, built a life here, and has no real intention of leaving permanently, may be treated as domiciled in the UK for inheritance tax purposes under the concept of deemed domicile, even if they have never formally acquired a UK domicile in the legal sense.
The consequence of being UK-domiciled or deemed UK-domiciled is that inheritance tax applies to your worldwide assets, not just to property and assets held in the United Kingdom. If you have assets in other countries, those assets will be assessed for UK inheritance tax even if they are also subject to inheritance or estate taxes in the country where they are held. Double taxation relief may be available in some cases, but not all countries have a treaty with the UK that covers this, and the interaction of different tax systems can be complex.
Many people who live or have lived internationally make assumptions about their inheritance tax position based on their tax residence status rather than their domicile. Those assumptions can be significantly wrong, and taking advice before drawing any conclusions is strongly recommended.
If your situation involves international assets, business interests, or property planning, a properly structured will is an essential part of managing your inheritance tax position. Contact our team to discuss how we can help.
Taking the Next Step
The mistakes described in this article share a common thread. They tend to arise not from recklessness, but from incomplete information, delayed action, or a reasonable but misplaced confidence that a particular arrangement is working as intended. The good news is that most of them are avoidable, and even where a mistake has already been made, understanding it clearly is the first step towards addressing it.
Inheritance tax planning is not something that can be resolved by a single conversation or a single document. It requires a clear picture of your overall position, an understanding of how different assets are treated, and a will that is drafted to reflect both your intentions and the tax consequences of the choices you have made. If it has been some time since your will was reviewed, or if your circumstances have changed in ways that might affect your inheritance tax position, now is a good time to take a fresh look.
Frequently Asked Questions
What is the most common inheritance tax mistake?
Leaving planning too late is one of the most frequent and costly inheritance tax mistakes. Many effective strategies, including lifetime gifting, depend on surviving for seven years after taking action. Beginning planning early gives those strategies the best chance of working and preserves the widest range of options.
Can I give my house to my children to avoid inheritance tax?
Simply transferring your home to your children while continuing to live there without paying market rent will not remove it from your estate for inheritance tax purposes. HMRC treats this as a gift with reservation of benefit, meaning the property remains in your estate as if the transfer had never happened. You may also trigger capital gains tax and Pre-Owned Asset Tax. Legal advice is essential before attempting to plan around a property.
Does gifting property trigger capital gains tax?
Yes, gifting a property that has increased in value since it was acquired can trigger a capital gains tax liability at the time of the transfer, even though no money changes hands. HMRC treats the gift as if the asset had been sold at market value. If the donor also dies within seven years, inheritance tax may apply to the same gift, creating a double tax exposure.
How much can I give away each year without paying inheritance tax?
Every individual has an annual exemption of £3,000 per tax year, which is immediately outside their estate. Any unused portion can be carried forward one year. Small gifts of up to £250 per person can also be made to any number of individuals each year. Gifts made regularly from surplus income may also be exempt, with no upper limit, provided the conditions are met.
What is a gift with reservation of benefit?
A gift with reservation of benefit occurs when you transfer an asset but continue to benefit from it, such as giving your home to your children but living there rent-free. In those circumstances, the asset is treated as remaining in your estate for inheritance tax purposes, and the seven-year rule does not apply. To avoid this, you must either genuinely give up all benefits from the asset or pay the full market rent if you continue to use it.
Does joint tenancy affect inheritance tax?
Owning property as joint tenants means it passes automatically to the survivor on death, bypassing the will. While this is straightforward, it removes planning flexibility and can create risks: if the surviving partner remarries, the Residence Nil Rate Band may be lost for the children of the first relationship. Converting to tenants in common and using trust provisions in the will can preserve more options.
Does a rental property qualify for Business Property Relief?
In most cases, no. Business Property Relief is available for genuine trading businesses, but property letting is generally treated as an investment activity rather than a trade. Rental property portfolios, therefore, do not usually qualify for Business Property Relief, and their full value will be included in the taxable estate.
What is deemed domicile for inheritance tax?
Deemed domicile is a rule that treats certain long-term UK residents as if they are UK-domiciled for inheritance tax purposes, even if they have not formally acquired a UK domicile. A person who has been resident in the UK for at least fifteen of the previous twenty tax years may be deemed domiciled here. This means their worldwide assets, not just UK assets, are subject to UK inheritance tax.
Is it too late to reduce my inheritance tax bill?
It depends on your circumstances and how much time you have available to you, but it is rarely too late to take some useful steps. Even in the short term, using annual gift exemptions, reviewing your will, and structuring assets more efficiently can make a difference. The sooner you begin, however, the more options remain available to you.
Why is it important to review my will for inheritance tax purposes?
Your will determines how your estate is distributed and who bears the cost of any inheritance tax. A will that has not been reviewed recently may not reflect changes in your assets, your family situation, or the law. It may also fail to take advantage of available exemptions and reliefs, or produce unintended results where there is a mix of taxable and exempt beneficiaries. Regular reviews, particularly after significant life events or financial changes, are strongly advisable.
Disclaimer
This article is intended as general information only and does not constitute legal advice. The information refers to the law of England and Wales. Tax thresholds and legal rules are correct at the time of writing but are subject to change. We recommend that you seek professional advice regarding your own circumstances.
Bio
This article was written by Stephen Rhodes. Stephen was called to the Bar of England and Wales in 1999 and brings over 25 years of in-house experience working with solicitor firms across the Manchester area, with a specialism in Wills and Probate. He now focuses exclusively on will drafting, helping his clients ensure their loved ones are taken care of exactly as they would wish.