Inheritance tax has been in the spotlight for much of the past year, ever since Labour announced changes to how estate planning will operate – with some willing to take drastic action to lower their bill.
One such person who is re-examining his finances is Kam Dhillon who admits news of inheritance tax (IHT) changes made him review his situation, especially after welcoming his first child nearly five years ago.
Yet the couple want to know if getting a divorce would help mitigate their son’s future IHT bill.
Kam, 40 from West London, has been happily married to his wife for 14 years with the couple’s total estate currently valued at £1.6m.
Kam said: “We have two properties, one that we both own jointly and one buy-to-let that is only in my name.
“My wife and I wondered, if we were to get a divorce, would my son pay less IHT as my wife would have one property and I would have one, so when one of us passes away he would only inherit one property at a time?”
The i Paper spoke to an expert to find out if getting a divorce – for a technical reason rather than lack of love – could lower their son’s IHT bill in future.
How does inheritance tax work?
IHT is paid on someone’s estate when they die, before anything can be passed on.
A person’s estate includes their money, property, possessions and from 2027 this will include the deceased’s pension pots.
IHT is not applied if the estate is worth less than £325,000, known as the nil rate band, or if the estate is left to a person’s wife, husband or civil partner.
If a person’s main home is left to direct descendants, including children (biological or adopted) and grandchildren the IHT threshold might increase by £175,000 – this is known as the resident nil-rate band – depending on the value of the home.
If the person who dies is married or in a civil partnership, any unused tax-free allowance from their estate can be passed to their surviving partner.
This means for a married couple, their tax-free limit could be up to £1m, when you add both of their £325,000 nil rate bands and £175,000 resident nil-rate bands together.
If IHT applies, anything above the IHT threshold is taxed at 40 per cent.
Would getting a divorce help any IHT implications?
Hayden Fisher, financial adviser at Shackleton Advisers, said looking at the situation from a purely IHT planning perspective, getting divorced in Kam’s case would be “counterproductive”.
He said: “Assuming that no gifts have been made in the previous seven years, given the estate value of £1.6m, if we subtract the £1m in allowances, we are left with a sum of £600,000 on which IHT would potentially be chargeable at a rate of 40 per cent.
“This would imply an IHT liability of £240,000 as things stand.”
Under current IHT rules, those making gifts must live seven years after the gift is made to make the asset IHT free.
If a person dies within seven years of giving a gift and there’s IHT to pay on it, the amount of tax due after their death depends on when they gave it.
Gifts given within three years before a person’s death are taxed at 40 per cent, while gifts given after three years but before seven years are taxed on a sliding scale known as “taper relief” between 8 and 32 per cent.
According to Fisher, in Kam’s case getting a divorce would be a hinderance given the IHT allowances (£325,000 plus £175,000) would no longer be able to be transferred from him to his wife or vice versa when one of them dies.
Fisher added: “There is a suggestion that the buy-to-let property being owned in a sole name may have an impact on IHT. Given that the reader and his wife own their main residence jointly, it would not impact the residence nil-rate band, and as such, there would be no immediate IHT saving.
“It would be worth thinking about the intention for this property in the longer term, and whether sole ownership is appropriate. This will depend on several factors, and there will likely be some future capital gains tax considerations. They should also consider who this property would pass to on the reader’s death.”
Capital gains tax is a tax on the profit when you dispose of an asset that has increased in value.
Disposing an asset includes selling it, giving it away as a gift or transferring it to someone else.
Importance of wills
According to Fisher, the bigger issue here is the suggestion that Kam nor his wife have a will in place.
He said: “First and foremost, it should be emphasised that a correctly drafted will is the foundation of any IHT planning strategy. If there is no will in place, then the laws of intestacy would apply, meaning that, by default, the surviving spouse would inherit £322,000 of any solely owned assets, with the remainder being split equally between the spouse and the son.”
As Kam’s son is turning five soon, his share would need to be held in a trust for him and the share of assets would use part of the deceased’s IHT allowances.
The position with the buy-to-let property on death would need to be carefully thought out, according to Fisher and the position may change if and when the couple’s assets approach the £2m mark.
This is because the residence nil-rate band is tapered away for estates valued at over £2m.
“I would suggest that the couple should review their wills as a matter of urgency; not having up-to-date wills in place could cause a big issue if this is not addressed. In conclusion, my view is that getting divorced solely for the purposes of IHT mitigation is likely be counterproductive,” Fisher added.
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