Don’t fall foul of this inheritance-tax trap

Inheritance tax (IHT) isn't just a problem for the wealthy. As house prices spiral out of the realm of reason, more of us can expect our children to be landed with an IHT bill on our deaths. Unfortunately, IHT is a complicated tax with a number of potentially expensive pitfalls.

For example, the "seven-year rule" in IHT legislation is well known: your estate will have to pay IHT on most gifts given by you in the seven years before your death. However, there is also a related "14-year rule" which is less widely understood, says Richard Dyson in The Daily Telegraph.

This affects those who set up certain trusts to earmark money for future generations. If the person dies within seven years, the assets held in trust become taxable. Nothing new there. But few people realise that gifts given in the seven years prior to the trust being set up will also be liable for tax. This means that IHT could apply as far back as 14 years prior to death.

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Another potential trap relates to the recently introduced family home allowance. This will allow homeowners an extra IHT-free allowance of £175,000 per person when passing on the family home to children, giving a couple a total allowance of £1m. To avoid penalising downsizers, those who move to a smaller,cheaper property will be able to carry forward the allowance that would have applied to their previous residence. So if you sell a family house worth £1m to move into a property worth less and invest the profits, your estate will still be entitled to an allowance of £1m.

But this will only be possible if you keep good records, says Naomi Rovnick in the Financial Times, detailing how much money you made and how the profits were reinvested. Otherwise your descendants won't be able to show they are entitled to the allowance.

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Lastly, be aware that HMRC doesn't look too kindly on people who give "gifts", but continue to enjoy the benefit themselves. The classic example is a parent who transfers a property to their children, but continues living there. Unless the parent pays market rent, the gift will be seen as a "gift with reservation of benefit" and they will still be caught by IHT, even if they live for more than seven years after making the gift.

In addition, the children might have to pay capital gains tax when selling the property if it was not their primary residence. It would be relatively easy to fall foul of mistakes such as these even with a relatively small and simple estate.Hence, as Dyson says, it's important to take "seriously copper-bottomed adviceif you are doing anything other thanbasic inheritance-tax planning".