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The Basics of Inheritance Tax

Inheritance tax (IHT) is starting to be more of a concern to many people.

Most estates (the assets you leave when you die) are still not charged with inheritance tax, as the total value is not high enough, but more estates are being dragged into the IHT net because of property prices. However, with sensible planning a lot can be done to mitigate the effects of IHT.

Who is liable to Inheritance Tax?

UK domiciled individuals are caught by IHT on assets they own anywhere in the world and non-UK domiciled individuals only pay UK inheritance tax on assets that are situated in the UK, but they may have to pay foreign inheritance tax on non-UK assets in other countries.

Exempt transfers

There are a lot of gifts that are exempt from IHT, the more common ones being...

  • Small gifts to any person in a tax year not exceeding £250;
  • Gifts in consideration of marriage; £5,000 if made by a parent of one of the couple; £2,500 by a grandparent and £1000 by anyone else;
  • Gifts that are part of your normal expenditure out of income and which don't reduce your net income below that required to maintain your normal standard of living;
  • Annual transfers up to £3,000. Any unused amount may also be carried forward for one year only;
  • Gifts to charities and registered community amateur sports clubs;
  • Gifts to political parties;
  • Maintenance payments to ex-partners.

How IHT is calculated

There are two types of gifts or transfers that can be made during your lifetime:

  • Those immediately chargeable to IHT (or would be if not covered by an exemption), which are known as chargeable lifetime transfers; and
  • Those that are exempt from IHT unless you die within 7 years of the gift, (known as Potentially exempt transfers or PETS).

A running total is kept of chargeable lifetime transfers and no tax is payable on these or your wealth at death until you exceed the IHT threshold. This is frozen at £325,000. The value of gifts or assets up to this threshold is commonly known as the nil rate band.

The excess above the nil rate band is taxed at 40% on death, although chargeable lifetime transfers are taxed at 20%.

There is a reduction in the rate of inheritance tax from 40% to 36% on an estate where 10% or more of the net value of the estate is given to charity.

Any liabilities you have on death as well as funeral costs are deducted in arriving at your estate to tax.

Husband and Wife (or civil partners)

No inheritance tax is payable on gifts between spouses or civil partners as long as both parties are domiciled in the UK. This is often used as a basic method of IHT avoidance. If the gift is a transfer to a foreign domiciled spouse it is only exempt up to £150,000.

Spouses and civil partners can make full use of the nil rate band belonging to each spouse. That gives a total inheritance tax exemption for a married couple of £650,000. The rules allow any unused part of the nil rate band on the death of the first spouse or civil partner to be passed to the surviving spouse or civil partner for use on their death.

Say Fred died with an estate worth £500,000. If he wasn't married, his executors will be required pay IHT at 40% on £175,000 (£500,000 - £325,000) amounting to £70,000. If Fred was married, and his wife did not use her nil rate band when she died previously, he now has the benefit of two nil rate bands totaling £650,000. Now Fred's executors will pay no IHT at all on his estate of £500,000.

The amount of the nil rate band that can be transferred is the proportion of the nil rate band that was unused on the death of the first spouse or civil partner. For example if on the first death, 50% of a 325K nil rate band was unused, if on the second death the nil rate band is 350K at that time, then 50% x £350K = £175K is available for use in addition to their own nil rate band.

There is a maximum of an amount equal to the nil rate band in force at the time of the second death that can be used in addition. Therefore, it doesn't matter how many ex-spouses or civil partners there are, it is not possible to have a total nil rate band of over £650K in 2017/18.

Main residence nil rate band

The residence nil rate band (RNRB) is available where a ‘qualifying residence’ is passed onto ‘direct descendants’ upon deaths on or after 6 April 2017. It is given in addition to the existing nil rate band (currently £325,000).

A 'direct descendant' includes children, step children, adopted children, foster children, lineal descendants and also one’s spouse/ civil partner.

A ‘qualifying residence’ is one where a person held an interest and had occupied the property as their residence at some point. Where a person has more than one property, an election can be made so that the exemption is offset. There is no requirement for the property to be the main residence at death.

The available exemption for the tax year 2024/25 is £175,000

There is a tapered withdrawal of the additional nil-rate band for estates with a net value of more than £2 million. This will be at a withdrawal rate of £1 for every £2 over this threshold.

Potentially Exempt Transfers

Most transfers to individuals are PETS and so are only subject to IHT if you die within 7 years of making the gift. Even at that stage IHT is only payable if the value of the transfer is over the IHT threshold when it is added to the estate at death plus other lifetime transfers made in the previous 7 years.

So giving your assets away and hoping to live 7 years is the most basic form of IHT planning, although does of course mean you have lost control of your assets. There is no need to report the gifts when made, but the recipient of the gift should do so within a year of the donor's death.

The amount of IHT due on the gift is tapered away for gifts made between 3 and 7 years before death.

Chargeable transfers

Gifts made to most trusts and companies are chargeable transfers. These can produce an IHT charge at the time the gift is made at the rate of 20%, if the total cumulative value of these transfers exceeds the IHT threshold.

Gifts with Reservation

Giving away an asset such as your home does not automatically exempt you from inheritance tax should you live 7 years after the gift. While you are still living in the property rent free it is treated as a gift with reservation and the gift is ignored for IHT purposes. However the gift is recognised for capital gains tax purposes, so you can end up with the worst of both taxes; a property legally in the hands of someone else but treated as yours for IHT while you live there. You can avoid the gift with reservation rules if you pay a market rent for occupying the property.

Pre-Owned Assets Tax (POAT)

The pre-owned assets tax was introduced from 6 April 2005 to charge income tax on the benefit of using an asset for free which you had previously owned at some point since 17 March 1986. It can apply to the use of property or to valuable objects, such as paintings, but also where the asset has been purchased with cash you have given to the owner of the asset. The charge only bites if the benefit of using the asset is valued at more than £5,000 per year. If the asset is included in your estate under the gift with reservation rules, the POAT charge does not apply. You can elect for the asset to be included in your estate and potentially be liable to IHT to avoid an annual POAT charge.

Payment of IHT?

On death IHT is payable 6 months after the end of the month in which the death occurs. The personal representatives of a deceased's estate has to pay any tax they are liable for at the time of probate, even if it is before then.

The IHT due on certain qualifying assets including land and business interests can be paid in equal yearly instalments over 10 years.

Business Property Relief

This is a valuable relief for business owners, allowing up to 100% of business interests to be removed from IHT when the asset has been owned by the donor throughout the previous 2 years. Shares in unquoted trading companies generally qualify for 100% business property relief. Other property used by your business may qualify for 50% business property relief.

Life Assurance

If you have a life assurance policy and the payout goes into your estate it will form part of your estate for IHT purposes. However, if the policy is written in trust for the beneficiaries it is possible to avoid this and it is simple to do.

Policies can also be taken out to cover the IHT due on death.

Using trusts to avoid inheritance tax

Trusts do require expert advice to be set-up, but they can allow you to give money away to avoid IHT whilst still keeping a certain amount of control.

How we can help you

We can advise you on your potential exposure to inheritance tax and on the planning you can put in place to minimise it.

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