Inheritance tax (IHT) is one of the most controversial taxes. People often question why the taxman takes money from the hard-earned funds in someone’s estate after they die. Throughout their lifetime they will be expected to pay many taxes, including income tax, VAT on purchases and stamp duty on property, so is it really fair to get taxed again upon death?
In most cases the biggest financial asset in an estate will be the family home and new rules, introduced in 2017 now mean you could have less or no IHT to pay when inheriting your parent’s house.
How does inheritance tax work?
IHT is a charge owed to the taxman on the value of the estate someone leaves when they die. It is paid from funds within the estate and managed by the executors, typically people named in the will to deal with the assets that have been left.
An estate is made up of a person’s possessions. This includes physical assets such as property and furniture and their financial affairs including any investments, savings and pensions. The value is worked out based on what all the remaining assets are worth minus any debts such as loans or mortgages.
IHT is charged on anything above the value of what is known as the nil-rate band, this is currently set at £325,000. The IHT rate is 40% but can be reduced to 36% if 10% or more of the estate is left to charity. There is nothing to pay if the whole estate is below the £325,000 threshold or if everything is left to a spouse, civil partner a charity or a community amateur sports club.
Executors must pay any inheritance tax owed within six months of the date of death, which gives the required time to ensure that assets can be valued.
Do I pay inheritance tax on property?
One of the highest value assets in someone’s estate is likely to be their property. The average property value in the UK is £231,185, which could easily push an estate above the £325,000 threshold when combined with other assets.
However, the government introduced an extra allowance in April 2017 called the Residence Nil-Rate Band (RNRB) which takes some of the value of a main residence out of the value of the estate for IHT and could essentially mean there is nothing to pay.
The RNRB is £175,000 for the 2020/21 tax year and will rise with inflation each year thereafter.
This effectively gives an individual estate an IHT threshold of £500,000 before any tax needs to be paid. It can only be used on one home in the estate and must be somewhere the person lived in the UK.
An estate can also claim for the RNRB if the person who died had downsized and moved to a home of a lower value on or after 8 July 2015. The rules surrounding this are complicated but basically the executors would need to work out how much of the RNRB was given up by moving to a lower value property.
Husbands, wives and civil partners can already pass on property to eachother with no inheritance tax to pay, as we explain below, but the RNRB lets you leave your main residence to your children (including adopted, foster or stepchildren) or grandchildren as long as your estate is worth less than £2m.
The RNRB will gradually reduce, or taper away, for estates worth more than £2m, even if a home is left to direct descendants. It reduces by £1 for every £2 that the estate is worth more than the £2m taper threshold. For example, if someone died in the current tax year with the RNRB of £175,000 but their overall estate was worth £2.1m, their residence allowance would reduce by £50,000. If the estate was worth £2.35m, the full £175,000 allowance would totally disappear.
Can you inherit a property tax free?
The RNRB helps direct descendants inherit a property worth up to £2m tax-free. Direct descendants are defined as children, grandchildren or great-grandchildren and their spouses or step, adopted or foster children or those who were under the guardianship of the deceased. This means siblings, nephews and nieces and other relatives such as cousins are excluded from this allowance.
The inheritance rules are different for married couples as they can pass their assets to each other without any IHT. This means a husband, wife or civil partner can inherit a property tax-free from their deceased spouse.
Additionally, a spouse’s nil-rate band threshold, currently £325,000 also passes to the surviving partner as does their RNRB of £175,000 if they leave everything to them, making a total of £500,000. The remaining spouse will have their own IHT thresholds of the nil rate band and RNRB that are added to this, effectively allowing their estate to be worth £1,000,000 when they die before there is any IHT to pay.
If the residential property being used for RNRB is worth more than £2m the taper will also apply even if it is being passed to a husband or wife. The deceased partner’s RNRB that they pass on will be reduced depending on the taper.
Can you give away a property tax-free?
Another IHT planning option is for someone to pass on their home before they die. Passing on a home can take it out of your assets and reduce the value of your estate once you die but there are strict rules under what is known as the seven-year rule.
There is normally no IHT to pay if you pass on a home and move out and live in another for seven years. You need to pay the market rent and your share of the bills if you want to carry on living in it otherwise you will be treated as the beneficial owner and it will remain as part of your estate.
If you die within seven years of giving it away your home will be treated as a “potentially exempt transfer” and forms part of your estate within the nil-rate band of currently £325,000.
The value of any gifts above the £325,000 threshold would be charged a rate depending on how long ago it was given and tapers down the longer ago the gift was.
There is a 40% charge on the value of a gift above the £325,000 threshold, dropping to 32% for three to four years, 24% for four to five, 16% for five to six years and 8% for six to seven years.
This is charged alongside any IHT due on other assets worth more than the £325,000 threshold.
Inheritance tax paid on gifts
|Years between gift and death||Inheritance Tax paid|
|less than 3||40%|
|3 to 4||32%|
|4 to 5||24%|
|5 to 6||16%|
|6 to 7||8%|
|7 or more||0%|
Summary - Inheritance tax property rates
Each individual estate has its own £325,000 allowance and RNRB if a residential home was owned before IHT is payable. As explained, the Residence Nil-Rate Band (RNRB) is currently £175,000 giving individuals a £500,000 threshold in total and married couples £1,000,000 that can be passed on to descendants before any IHT is owed.
The RNRB will increase in line with inflation from 2021 but remember it is tapered for properties worth £2m or more.
This essentially means most people will not have to pay inheritance tax on a property or in most cases none at all. However, there is always the risk that these rules change so you shouldn’t solely rely on the RNRB to reduce an IHT bill. It is best to be prepared and ensure there is a financial plan in place that may include giving gifts.
You can find out more about the IHT rules surrounding gifts in our article 'Inheritance tax (IHT) taper relief on gifts explained'.
There are other tools that can minimise or mitigate IHT. You could place assets in trust, which effectively takes them out of your estate and shields them from IHT or you could take out a life insurance policy that pays out to cover the costs of an IHT bill when the person dies.
Read our guide on the '10 best ways to avoid inheritance tax'.
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