How equity release can reduce your inheritance tax bill

Equity release is regularly used to allow individuals to access capital locked in their properties to help fund their income in retirement.  However, unknown to many it can also be used to reduce inheritance tax (IHT) on your estate, potentially allowing you to pass on more of your wealth to your loved ones. 

With substantial increases in UK house prices over the years, it is inevitable that people have built up significant wealth in their properties. According to analysis by the Equity Release Council, recovering house prices in the first half of 2024 meant property equity in the UK rose to £5.7 trillion. As a result, many people will have large inheritance tax bills looming over their estates, especially in light of frozen personal tax allowances which continue to bring more people’s estates into the realm of inheritance tax liability.

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Added to this, in the Autumn Statement 2024, The Chancellor of the Exchequer announced a change to pension legislation, which will see that inherited pension funds will form part of an individual’s estate for inheritance tax purposes from 6th April 2027. Up until this point, pension funds sat outside of the estate for inheritance tax purposes and were able to be passed down generation to generation in a very tax efficient manner. From April 2027 those with significant pension funds will see the inheritance tax liability on their estate increase due to the inclusion of pensions in the inheritance tax regime. 

A Wealth Report from M&G stated that future generations are expected to inherit more than £293bn, with wealth passed to younger generations projected to double over the next 20 years, and could reach as much as £5.5 trillion by 2047 – with individuals born after the 1980s on average receiving £200,000-£400,000.

Establishing your estate plan

There are several different ways you can pass down your wealth, known as estate planning, including for those individuals with significant wealth tied up in their properties. More often than not estate planning is driven by a desire to maximise the wealth that can be passed down to loved ones, however, personal financial security should be your number one priority before considering how best to pass down your estate. Once this has been established, it is possible to identify which assets, such as property, are available to meet your estate planning objectives. 

Releasing some of the equity from your property isn’t just a solution for those needing some extra capital or cashflow. This can also be used as a tool for estate planning purposes. A lifetime mortgage and gifting arrangement allows people to reduce the value of their estate that maybe subject to inheritance tax, so that more of their hard-earned assets can pass tax efficiently to the next generation. It also means that liquid assets, such as cash and savings, remain untouched and are available to fund expenditure for the remainder of their lifetime.  

Of course, it is important to consider your overall financial situation and equity release may not be suitable for everyone.  By not servicing the interest on an equity release arrangement, the interest will compound which can be significant over time. Taking out an equity release arrangement could also potentially result in you losing means tested local authority benefits. 

What is a Lifetime Mortgage?

A common form of equity release is through a Lifetime Mortgage, which is available for homeowners aged 55 and over. A Lifetime Mortgage enables you to borrow money secured against the value of your property. Unlike a conventional mortgage, you don’t have to service the interest during your lifetime, instead the interest on your loan is ‘rolled up’ and it compounds each month or every year depending on which plan is used.  This means that the amount you owe on your Lifetime Mortgage grows every year. The outstanding balance is typically only repaid on death or permanent move into long-term care. Importantly you remain the legal owner of the property and will benefit from any increase in the property value over time. 

How equity release works in practice for IHT (inheritance tax) planning 

One way of passing on wealth during your lifetime could be to release equity from your property and make gifts to your loved ones. In one  case, we helped a gentleman use a lifetime mortgage to release and gift £3million to his children and grandchildren. His property was valued at £9million and therefore the potential inheritance tax bill saving here is over £1.2million, provided he lives for 7 years from the date at which the gift was made.  

Another example is a married couple owning a home worth £1.2 million and with other assets worth £800,000, bringing their total estate to £2 million. With no equity release, their estate could be subject to inheritance tax beyond their combined nil rate (£325,000 individually or £650,000 combined) and residence nil rate bands (£175,000 individually or £350,000 combined). However, by releasing £300,000 of equity and gifting it to their children, they reduce their estate to £1.7 million. If they survive for more than seven years after making the gift, that £300,000 will not be subject to inheritance tax – saving their beneficiaries £120,000 in tax. 

Additionally, the fixed interest that accrues on the loan will be a debt on the estate and will reduce the value of the estate further for the purpose of inheritance tax. It is worth noting that the amount of interest charged, along with potential fees linked to the arrangement of a Lifetime Mortgage can vary depending upon individual circumstances, therefore it is important to seek professional advice before entering into this type of arrangement. Also, there will in fact be an inheritance tax saving after 3 years from the money being gifted due to taper relief.  

If you die within 7 years of giving a gift and there's inheritance tax to pay, the amount of tax due depends on when you made the gift. Gifts given in the 3 years before your death over and above your nil rate inheritance tax band are taxed at 40%. Gifts given 3 to 7 years before your death over and above your nil rate inheritance tax band are taxed on a sliding scale known as 'taper relief'. 

Now not everyone will be sitting on property wealth of £9m but it does show you those with larger estates can actually mitigate the inheritance tax liability on their estate using equity release. A concept that many may not have even thought of. 

How the freeze on allowances will hit home

The current inheritance tax nil rate band (the level at which you can pass down wealth free of inheritance tax) of £325,000 per individual and residence nil rate band (the amount over your nil rate band that can be added when passing down your main residence to direct decedents) of £175,000 per individual will be frozen until at least April 2031.  

The increase to house prices along with the frozen inheritance tax allowances will see a rise in those being hit with an inheritance tax liability, especially those with significant property wealth. Furthermore, for individuals with a net estate over £2m the residence nil rate band is tapered by £1 for every £2 over this threshold. Estates (based on a married couple if an allowance isn't used on first death) with a net value of £2.7m will completely lose any benefit of the residence nil rate band allowance. This is where an equity release and gifting solution could reduce the value of a net estate below the £2m threshold and reinstate their residence nil rate band, potentially saving thousands of pounds in tax. 

What are the benefits and safeguarding features of using equity release?

The lifetime mortgage market has changed dramatically over the past decade, and many providers have introduced attractive benefits and safeguarding features on the products they offer. These include: 

• Interest rates which are fixed for life.  
• Lump sum with reserve facility – you can choose between having an initial lump sum only or you can have an initial lump sum plus a reserve facility.  You only pay interest on the initial lump sum. The reserve facility allows you easy access to further funds in the future and you don’t pay any interest on the monies in the reserve facility until you draw them down.
• No negative equity guarantee - you and your beneficiaries will never owe more than your home’s worth.
• Porting – if you decide to move home in the future, your Lifetime Mortgage can be transferred or ported to your new property, providing it meets the lender’s lending criteria.
• Downsizing protection – if you need to move to a smaller property in the future, you can repay your loan without facing any early repayment charges if your new home does not continue to meet your plan’s criteria.
• Partial capital repayments – you can repay up to 10% of the original loan amount every year if you wish to do so with no early repayment charge.
• Fixed early repayment charges – so you know how much you will be charged should you choose to pay off the loan early, subject to the provider's T&C's.

What are the downsides of using equity release?

• The initial release will increase if the interest is not serviced and be rolled up which means the amount you owe on your Lifetime Mortgage grows every year.
• Choosing equity release may affect you in the longer term. You need to be sure that the arrangement suits you both now and in the future.  For example, equity release can make it hard to move, if you decide you want to downsize later on you may not have enough equity in your home to do this.
• Interest rates on Lifetime Mortgages are generally higher than on traditional residential mortgages.
• Releasing equity from your home may affect your eligibility for state benefits, grants or allowances.
• If you release too much equity from your home you may find you do not have the money you need later in your retirement, for instance if you need to pay for long term care.
• There may be substantial early repayment charges if you decide to voluntarily repay the monies released typically within 8 to 15 years of taking out a Lifetime Mortgage. 

How we can help

The Private Office has specialist advisers for equity release.  Importantly these advisers are also Chartered Financial Planners so have expertise across all areas of financial planning which makes them well positioned to consider your overall financial situation and provide the most suitable solutions to meet your objectives. 

There are lots of other ways that you can reduce your inheritance tax bill which the advisers at TPO are knowledgeable on and will explore with you the most suitable solutions for you and your family. 

If an equity release is considered suitable, as an independent financial adviser firm, The Private Office, has the freedom to explore the whole of the equity release market and the advisers have excellent knowledge of the products available. If you’d like to arrange a free no obligation initial consultation, please get in touch.

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This article is for information only and does not constitute individual advice. 

The Financial Conduct Authority (FCA) does not regulate estate planning, tax or trust advice. This is a lifetime mortgage. To understand the features and risks, ask for a personalised illustration.