How to use equity release to gift money – and avoid inheritance tax

Thousands of homeowners are facing death taxes because of the huge appreciation in property prices over the last few decades.

The value of the average home in the UK has risen from £84,620 to £286,489 since the start of the millennium, according to data from the Land Registry. The number of property millionaires, meanwhile, has shot up – with one in 40 homes now worth more than £1m.

Yet despite soaring house price growth, the nil-rate band – below which no inheritance tax is due – and the residence nil-rate band, an allowance for homeowners, remain frozen at £325,000 and £175,000 respectively, dragging thousands of families into the inheritance tax net.

Equity release lets over-55s withdraw cash from their property tax-free. So it is easy to see why many feel tempted to use this strategy to bring the size of their estates below the frozen inheritance tax thresholds.

But be warned. Equity release is a form of debt that will need to be repaid once you die or go into long-term care. It is not something to take out lightly – and not without a decent grasp of how much it could cost you in the long run.

Because of the borrowing costs, using equity release to avoid paying inheritance tax is generally only a suitable strategy for those with large estates worth more than £2m, according to David Forsdyke, of broker Knight Frank Finance.

That said, many with lower-value estates still choose to release equity to give money to their loved ones, regardless of the inheritance tax saving.

Stuart Powell, of broker Ocean Equity Release, said an increasing number of his clients are using their property wealth to gift their descendants an early inheritance, or help them onto the property ladder.

“Watching your children enjoy their inheritance before you die can be very satisfying for many homeowners over the age of 55. If this has a positive effect on their IHT bill, then great – however, the IHT bill should not drive the conversation,” he said.

Here, Telegraph Money explains how equity release can be used to gift money to loved ones, the cost of taking out a loan and how – in certain circumstances – it can be used to bring down your inheritance tax bill.

If you are considering using equity release, speak to a financial adviser.

What is equity release?

Equity release lets over-55s withdraw cash from their property as a tax-free lump sum, to be repaid either when they die or move into care.

Most homeowners take out something called a lifetime mortgage – where you retain ownership of the property.

How much you can take out depends on your age. Typically, the older you are, the more you can borrow.

The key thing to bear in mind with equity release is that interest is “rolled up” on the loan, which means the debt can grow significantly in a short space of time.

It is generally advised you take out equity release over the age of 75 or pay down the interest as you go, to stop the debt from spiralling.

How you can use equity release to gift an early inheritance

You can gift as much as you like to your children and others during your lifetime without incurring an inheritance tax liability – provided you survive the gifts by seven years.

Gifts of this nature – that do not fall into other other allowances, such as the annual allowance of £3,000 – are called Potentially Exempt Transfers (PETs).

So a homeowner could potentially unlock £400,000 of equity from their property and after seven years, no IHT would be due on the gift.

However, if they died within seven years, then the gift is considered a failed PET. The £400,000 gift will use up the taxpayer’s £325,000 nil-rate band, and inheritance tax will be due on the remaining £75,000. This is usually charged at 40pc.

However, depending on when in the seven-year period the donor passed away, taper relief may apply. This means the inheritance tax rate charged could be lower depending on when they gave the gift.

If they died within three years of the gift, then IHT is charged at 40pc. But between three and seven years, the rate falls on a sliding scale – to 32pc in the third year, 24pc in the fourth, 16th in the fifth and so on.

If the deceased still has their nil-rate band and the gift falls within this, there is no inheritance tax to pay.

Over 16,000 homeowners used equity release in the first three months of 2023, according to the Equity Release Council, a trade body. On average, as a lump sum lifetime mortgage, they withdrew £102,405.

One in five equity release borrowers took out money to gift money to family and friends, according to the equity release firm Key.

But remember, this is not free money – equity release comes with high borrowing costs. 

How much does equity release cost?

Imagine you borrow £390,000 from a £1.3m property at a rate of 6pc.

If you do not pay off the interest, then in five years’ time you will owe £526,051. Within 10 years, the bill will be £709,564.

This is because of the impact of compound interest.

Some providers will let you pay off some or all of the interest, to stop the debt from spiralling.

In this example, doing so will cost you £1,950 a month. You would need significant surplus income to cover this cost, but the debt would be smaller: worth £507,000 after five years and £624,000 after 10.

Another thing to bear in mind is that if you make no plans to pay off the interest, there is a risk that when you pass away your beneficiaries will be left to cover the final bill. 

As you can see, how high the borrowing costs are will depend on how much money you take out, the interest rate, the length of time you hold the debt for and whether or not you pay off the interest as you go.

An adviser can help you work out how much the debt could roll up.

Is now the right time?

The movements of the equity release market have mirrored those of the wider mortgage market. That is to say, it is now more expensive to borrow than it once was.

The average rate on a lifetime mortgage is currently around 6pc, up from 4.6pc last spring.

At 6pc, a £100,000 loan will grow to £134,885 in five years – whereas it would be worth £125,804 at a rate of 4.6pc.

Because of the higher interest rates, the number of homeowners using equity release in the first quarter of 2023 fell by 29pc year-on-year.

The interest rate on a lifetime mortgage has a significant impact on the size of your final bill.

Some homeowners may decide they need to release equity now, however, if you can afford to wait, it may be worth taking out a loan when the rates are lower.

Can I use equity release to avoid inheritance tax? 

The borrowing costs associated with equity release mean that it is only worth using this strategy with the intention of reducing inheritance tax if you have a large estate.

Mr Forsdyke said: “If we’re talking to a client with property worth less than £2m, it is unlikely there will be a massive advantage to taking out equity release to avoid inheritance tax.

“That’s because up to £2m, you get the residence nil-rate band. But for houses worth more than this, that allowance starts to taper.”

How it works

Knight Frank has drawn up this example to show how equity release can be used to save inheritance tax.

Imagine an elderly homeowner has an estate worth more than £4m, including a £2m property. Over the last seven years, they have given away more than £325,000 to their beneficiaries – so they have used up their nil-rate band.

The elderly homeowner takes out a £500,000 lifetime mortgage at a rate of 6pc. They have enough sufficient surplus income to cover the interest of £2,500 a month – preventing it from rolling up.

She then gifts the £500,000 to her sons, who use it to pay down their own mortgages, which have a 5pc rate. Seven years pass, by which time the borrower has spent £210,000 in interest.

However, the £500,000 gift is now free from IHT, saving them £200,000 in inheritance tax (40pc of the gift).

On top of this, the gift has saved the beneficiaries £175,000 in mortgage interest. Overall, the family is £165,000 better off.

As the example demonstrates, it can be difficult to calculate whether the beneficiary will be better off as a result of the gift – because it depends on how they spend the money.

Mr Forsdyke also warned that the inheritance tax saving “could be wiped out” if the homeowner leaves the interest to compound for 10 years.

The key rules to remember

These are the main things to bear in mind when considering taking out equity release to gift an inheritance or avoid inheritance tax:

• The loan itself will need to be repaid when you die, therefore reducing the value of your estate for inheritance tax purposes. However, this could also leave your beneficiaries with less to inherit.
• Most lenders nowadays will let you pay off the interest, and it is worth doing this if you can afford it.
• It may also be worth repaying the debt early. Many products come with early repayment charges. However, nowadays some reduce this to 0pc after a few years.