The looming spectre of inheritance tax (IHT) has prompted many Australians to re-evaluate their financial affairs, with some even considering drastic measures to reduce their potential tax liabilities. This concern has been amplified by recent discussions and potential changes surrounding estate planning.
One individual, Kam Dhillon, a 40-year-old from West London, found himself scrutinising his finances more closely after the birth of his first child nearly five years ago. Married for 14 years, Kam and his wife have accumulated an estate valued at approximately £1.6 million. Their assets include two properties: one jointly owned and a buy-to-let property registered solely in Kam’s name.
The couple’s primary concern centres on their son’s future IHT bill. They’ve pondered a rather unconventional approach: could a divorce, undertaken purely for financial planning reasons rather than marital discord, actually lower the inheritance tax their son would eventually have to pay? The logic behind this query stems from the idea that a divorce would effectively split their estate, leaving their son to inherit one property at a time upon the passing of each parent, potentially reducing the immediate tax burden.
To address this intriguing question, an expert in financial advice was consulted to determine if a divorce, motivated by technical tax considerations, could indeed offer a solution to mitigate their son’s future IHT liability.
Understanding Inheritance Tax in Australia
Inheritance tax, in essence, is a levy applied to an individual’s estate upon their death, before any assets can be distributed to beneficiaries. An estate typically encompasses all of a person’s financial assets, including money, property, and personal possessions. In some jurisdictions, even pension pots are included in this calculation from a certain date.
Crucially, IHT is not levied if the total value of the estate falls below a specific threshold. This threshold is often referred to as the ‘nil rate band’. Furthermore, assets left to a surviving spouse or civil partner are generally exempt from IHT.
Many countries also offer additional allowances. For instance, if a person’s primary residence is passed on to direct descendants, such as children or grandchildren, an additional threshold, known as the ‘residence nil-rate band’, may apply, further increasing the tax-free allowance. The exact amount of this additional allowance can depend on the value of the main home.
For married couples or those in a civil partnership, there’s often a provision allowing the transfer of any unused tax-free allowance to the surviving partner. This can significantly increase the overall tax-free limit for a couple, potentially up to £1 million or more when combining both nil rate bands and residence nil-rate bands.
When IHT does apply, any portion of the estate exceeding these combined thresholds is typically taxed at a standard rate, often around 40 per cent.
The Divorce Dilemma: A Financial Advisor’s Perspective
Hayden Fisher, a financial adviser at Shackleton Advisers, weighed in on Kam’s situation, offering a clear assessment from a purely IHT planning standpoint. He stated that, in Kam’s case, pursuing a divorce solely to reduce IHT would be “counterproductive.”
Fisher explained the current financial picture. Assuming no significant gifts have been made in the preceding seven years, Kam’s estate of £1.6 million, when offset against the potential £1 million in combined allowances for a married couple, leaves a taxable estate of £600,000. At a 40 per cent tax rate, this would result in a potential IHT liability of £240,000.
It’s important to understand the rules surrounding gifts and their impact on IHT. Generally, for a gift to be considered IHT-free, the donor must survive for seven years after making the gift. If the donor passes away within this seven-year period, the tax due on the gift depends on when it was made. Gifts made within three years of death are taxed at the full 40 per cent rate, while those made between three and seven years prior are subject to a sliding scale, known as “taper relief,” ranging from 8 to 32 per cent.
Fisher elaborated on why divorce would be detrimental in this scenario. The key issue is the loss of the transferable IHT allowances between spouses. By divorcing, Kam and his wife would no longer be able to transfer their respective nil-rate bands and residence nil-rate bands to each other upon death, thereby reducing the overall tax-free threshold available to their combined estate.
Fisher also touched upon the buy-to-let property owned solely by Kam. He noted that while its sole ownership might seem significant, it wouldn’t directly impact the residence nil-rate band as their main home is jointly owned. Therefore, no immediate IHT saving would be realised from this arrangement. He advised considering the long-term intentions for this property, its sole ownership status, and potential capital gains tax implications upon its eventual disposal or transfer. Crucially, the destination of this property upon Kam’s death would also need careful consideration.
Capital gains tax (CGT) is a tax levied on the profit made when an asset that has increased in value is disposed of. This disposal can include selling the asset, gifting it, or transferring ownership to another party.
The Paramount Importance of Wills
Beyond the specific question of divorce, Fisher highlighted a potentially more significant oversight: the apparent absence of wills for both Kam and his wife. He stressed that a well-drafted will is the cornerstone of any effective IHT planning strategy.
In the absence of a will, the laws of intestacy would dictate the distribution of assets. Under these laws, a surviving spouse would typically inherit a set amount of any solely owned assets, with the remainder being divided equally between the spouse and any children.
Given Kam’s son is approaching five years old, his inherited share would likely be placed in trust for him. This inherited portion would also count towards the deceased’s IHT allowances.
Fisher cautioned that the disposition of the buy-to-let property upon death would require careful planning. He also pointed out that the IHT landscape can change significantly if the couple’s combined assets approach the £2 million mark, as the residence nil-rate band is gradually reduced for estates exceeding this value.
In conclusion, Fisher strongly recommended that Kam and his wife review and establish their wills as a matter of urgency. The lack of up-to-date wills could lead to substantial complications. His overarching advice was clear: “getting divorced solely for the purposes of IHT mitigation is likely to be counterproductive.”
