The number of households caught by inheritance tax, once aimed at only the very wealthy, has almost doubled in the past five years, new research reveals.

Inheritance tax (IHT) is charged at 40% on the value of a person’s estate over £300,000. Soaring house prices have pushed millions of ordinary homeowners into the net.

In the past five years, the number of homes valued above the threshold has risen from 1.3m to 2.3m, according to Halifax. By 2020, it estimates more than 4m households will be caught, and most do nothing to cut the bill.

The government, keen to pull in cash, has reversed many popular IHT schemes during its 10 years in office. Tens of thousands of families who set up home-loan trusts to escape the tax were affected by a crack-down on preowned assets in 2005.

A tax to discourage the use of certain types of trusts was also announced last year, and last week it announced it would be paying closer attention to gifts made during your lifetime.

But there are still ways to escape and a few simple steps could mean your heirs pay nothing. Here we show you how.

1. Update your will

IHT is not payable when an estate passes from a husband to a wife or vice versa.

However, if you want as much as possible to end up in the hands of your children and grandchildren, you need to ensure both spouses make use of their individual nil-rate bands.

Nil-rate band discretionary will trusts can be employed by married couples, or those in civil partnerships, to use both their IHT allowances.

Take a husband and wife with a £600,000 home. When the husband dies, his wife will have no IHT to pay as transfers between spouses are tax-free. When the wife dies, though, her estate will be taxed at 40% on assets above £300,000 – a bill of £120,000.

A will trust, however, uses both the husband and wife’s nil-rate bands so the entire £600,000 property is free from tax.

A recent landmark court case has highlighted the need to set up a scheme properly. Stephanie Phizackerley faced a tax bill of £60,000 after being told the trust her parents had set up was useless. Unusually, her mother, who had not worked, died first, rendering the trust invalid.

If done properly, this one piece of planning, which can save up to £120,000 in tax, should be enough to wipe out most people’s IHT bill. But if you still have a problem here are other steps to take, starting with the simplest and least risky.

2. Give assets away

Gifting is one of the easiest ways of slashing your bill. Each year you can give away £3,000 free of IHT, or £6,000 if you did not make a gift of this kind in the previous tax year.

A married couple giving for the first time could therefore hand over £12,000 to their children in one year. After that the maximum for a couple is £6,000.

You can also legitimately avoid IHT by giving £250 to any number of people every year, but you cannot combine it with the above exemption.

Parents can give £5,000 to each of their children as a wedding or civil partnership gift. Grandparents can give £2,500 and anyone else £1,000. Gifts of any size to political parties and charities are tax free.

If a gift is regular, comes out of your income and does not affect your standard of living, any amount of money can be given away and ignored for IHT.

3. Live for seven years

It is possible to make further tax-free gifts – potentially exempt transfers (Pets) – but you have to survive for seven years after making the gift.

Always make a note of such gifts to pass on to your executor, as the Revenue will be paying closer attention in future.

If you die within seven years and the gifts are valued at more than £300,000, apply taper relief. The tax reduces on a sliding scale if a gift was made between three and seven years earlier.

Say you give your daughter £400,000. After deducting the £300,000 allowance, you are left with a chargeable gain of £100,000. If the gift was made five years before your death, she would pay a rate of 16% on the gain, £16,000.

If you cannot apply taper relief, you usually add the gift to other assets and pay 40% tax on the sum above the £300,000 threshold.

For example, if the gift is worth £200,000 and the rest of your estate is valued at £500,000, you pay 40% tax on £400,000.

You can give away most assets, including cash and shares. However, it has to be an outright gift from which you can no longer benefit.

This excludes giving away your family home. If you hand it to your children and continue to live there, you have to pay a market rent, which can wipe out the tax benefits.

4. Consider loan schemes if you want to keep control

Loan trusts are designed for people who cannot give away assets as they need to live off the income, but want future investment growth to be IHT-free.

You make a payment to a trust, which is treated as an interest-free loan to the trustees. The trust then repays your loan capital in instalments, giving you an income. When you die, any outstanding loan forms part of your estate, but all investment growth is free from tax.

The underlying investments for these schemes are generally insurance bonds that are paid with the basic rate of tax already deducted. Higher-rate taxpayers can take an income of 5% a year for 20 years with no immediate tax to pay. If you loaned £100,000 to the trust and drew an income of 5% or £5,000 a year, you would have withdrawn all your capital after 20 years.

If you died before you had withdrawn all the original capital, any outstanding loan would form part of your estate and be liable for tax.

The schemes are often expensive to set up: as much as £5,000. Many also pay high commission to advisers so you need to be sure this is what you require.

You can set up most schemes using a bare trust, where the beneficiaries are fixed and become entitled to the assets at 18. If you want the trustees to retain greater control you can also set up a flexible trust, but there could be a 6% tax charge every 10 years on assets over £300,000.

5. Try gift trusts

If you need to draw an income but do not think you will need the capital, look at discounted gift trusts. You make a gift into a single-premium insurance bond for your children, fixing how much income you will draw until your death. If you survive for seven years the bond does not count as part of your estate.

Even if you die within the seven years, your heirs may get a discount because your right to draw an income from the gift reduces its value. The extent of the reduction depends on your health, gender, level of income and age. The older you are when you take out a scheme the smaller the discount.

6. Take AIM

As you get older many of the options for avoiding IHT disappear. But one way that is proving popular with the overseventies is to buy shares quoted on AIM.

Most AIM shares become free from inheritance tax once you have held them for two years because they qualify for “business property” relief. It is not for the fainthearted, though, because AIM stocks can be very volatile: the market is down 10% over the past two months against a 2% fall by the FTSE All-Share.

However, the value of your portfolio would have to fall by 40% or more before you would lose the IHT benefits. This is not inconceivable, but advisers say many clients are prepared to take the risk. Shares in businesses that engage in “substantial” nontrading activities, such as property, finance and mining, are not generally eligible.

About a dozen fund managers and stockbrokers will select a portfolio for you. The minimum investment ranges from £30,000 to £100,000. Collins Stewart, one of the cheapest, charges an entry fee of 3% and an annual charge of 1.5% on top of dealing costs.

7. Buy a forest

Money invested in a commercial forest becomes free of IHT after you have owned it for two years as it qualifies for business property relief. Commercial woodlands are defined as property where timber from the forest will be actively marketed and sold.

You can buy a forest through an agent or investment manager, such as UPM Tilhill, John Clegg, Fountains or Forestry Investment Management. Most plots will set you back £100,000 or more. Larger plots can top £1m.

8. Become a farmer

Families can escape IHT by purchasing actively farmed land. If you farm the land yourself you will qualify for 100% relief on the land after two years. The same is true if you sign a contract with a farmer to do the work for you, as long as you share in the profits and losses. However, if you let the land to a farmer, you qualify for relief only after seven years.

Whether a farmhouse escapes IHT is a grey area. In 2005 land-tribunal judges said they should be exempt only if the owners or their spouses had farmed the land on a day-to-day basis. Life-style farmers not involved in the daily running could be barred.

9. Borrow more money

If it is simply the value of your home that is pushing you into the IHT net, an equity-release loan might help.

There are two main types. With a home-reversion plan, you sell part of your property in exchange for a one-off lump sum, which you can give away, or a regular income. With this type of scheme you know exactly how much your heirs will get.

With the alternative, a lifetime mortgage or roll-up scheme, you take out a mortgage on part of the value of your home, usually in return for a cash lump sum.

Interest is “rolled up” and the loan is repaid only when you die or when the house is sold. The amount you owe can therefore grow quickly and swallow up your heirs’ inheritance.

10. Take action even after death

A deed of variation allows you to change ownership of the house you live in after your spouse’s death so your heirs have less IHT to pay when you die. If a portion of the home is transferred into a discretionary trust, when you die assets held in the trust do not count towards your estate.

RECORD ALL YOUR GIFTS

Accountants have warned that the taxman is to get tough on families who avoid inheritance tax (IHT) by making gifts to friends or relatives before they die.

The Revenue has set its sights on potentially exempt transfers (Pets), which legitimately become exempt from IHT as long as they are made more than seven years before the donor dies. If you die within the seven years there may be some tax to pay.

The Revenue is concerned people are not accurately declaring gifts and therefore, wittingly or unwittingly, are not paying tax due on assets given away less than seven years before death. Your estate’s executor is required to declare all gifts made prior to your death.

The taxman warned that where information about a gift is unclear or incomplete it will investigate. If it discovers a gift has not been disclosed properly there could be penalties and interest charges, as well as a bill for unpaid tax. It said: “From now until March 31 2008 ... we will be paying particularly close attention to lifetime transfers. In appropriate cases we will open an inquiry and ask you for further information to satisfy ourselves that all gifts have been included.”

We answer your questions.

I am giving away assets to sort out my estate. What should I be doing?

When you give away money or assets, write down what you have given, to whom and when. Keep these records with a copy of your will. Tell your executor where they can find these papers. The executor of the estate should use the information provided to fill in the IHT declaration. If necessary, seek professional help.

Does this apply to all gifts?

Yes, to be safe. The Revenue is most concerned about Pets – gifts over and above your annual allowance of £3,000 that become exempt from IHT only if you live for another seven years. Make a note of the date of the gift so your executors can prove to the Revenue you lived for the required amount of time.

Accountants said it is also worth recording gifts that fall within your annual allowance, such as cash presents at Christmas and birthdays or if you lend someone money and later agree to wipe out the debt.

What happens in a Revenue investigation?

It could trawl through all areas of your personal finances, including bank statements and pension plans, to look for big withdrawals which may have been used to make gifts.

Will I be fined?

The Revenue said: “We are simply trying to highlight the common mistakes made when filling in IHT returns. We are only likely to impose penalties if information was knowingly not disclosed. If it was an obvious mistake there is unlikely to be a fine.”

MEET THE DEADLINE

- If you want the Revenue to calculate your 2006-7 tax bill, you have one week to submit a paper return. The online deadline is January 31.

- Meet the September 30 deadline and any mistakes will be the Revenue’s fault – as long as you provide the right information.