How Does Inheritance Tax Work?

Inheritance Tax can feel daunting, but the basic principles are straightforward. It's a tax on your estate when you die — but only if the value exceeds certain thresholds, and there are several reliefs and exemptions that can reduce or eliminate the bill. Understanding how it works is essential whether you're planning your own affairs or dealing with someone else's estate.

What is Inheritance Tax?

Inheritance Tax is charged on the estate of someone who has died. Your estate includes your property, money, and possessions.

There's normally no Inheritance Tax to pay if:

• The value of your estate is below £325,000
• You leave everything above £325,000 to your spouse, civil partner, a charity, or a community amateur sports club

Even if your estate is below the threshold, you may still need to report its value to HMRC.

Inheritance Tax rates

The standard rate of Inheritance Tax is 40%. It's only charged on the portion of your estate above the tax-free threshold.

Example: If your estate is worth £500,000 and your threshold is £325,000, Inheritance Tax is charged on £175,000 (the difference). The tax bill would be £70,000 (40% of £175,000).

There's a reduced rate of 36% available if you leave 10% or more of your estate's net value (total value minus debts) to charity in your will.

The £325,000 threshold

The basic tax-free threshold is £325,000. This is known as the nil-rate band (the amount on which nil tax is charged).

If you're married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be transferred to your partner when you die. This means couples can potentially pass on up to £650,000 tax-free.

The residence nil-rate band

If you own your home (or a share in it), your tax-free threshold can increase to £500,000 if you leave it to your children, grandchildren, stepchildren, adopted children, or foster children — but only if your estate is worth less than £2 million.

This additional £175,000 threshold (on top of the basic £325,000) is called the residence nil-rate band.

If you leave your home to your spouse or civil partner, there's no Inheritance Tax to pay regardless of its value.

Who pays the tax?

Inheritance Tax is paid to HMRC using funds from the estate. The person dealing with the estate — called the executor if there's a will — is responsible for paying the tax.

Your beneficiaries (the people who inherit from you) don't normally pay tax on what they inherit. However, they may have related taxes to pay later, such as income tax on rental income from an inherited property, or Capital Gains Tax if they sell an asset.

The 7-year rule on gifts

Gifts you make during your lifetime can be subject to Inheritance Tax if you die within 7 years of making them.

If you give away more than £325,000 and die within 7 years, the person who received the gift may have to pay Inheritance Tax. The amount of tax depends on when the gift was made — this is known as taper relief, which reduces the tax charged on gifts made between 3 and 7 years before death.

Tax-free gifts you can make

You can give away certain amounts each year without them counting towards Inheritance Tax:

Annual exemption: You can give away £3,000 in total each tax year. You can give this to one person or split it between several people. If you don't use your full £3,000 allowance, you can carry it forward to the next tax year — but only for one year.

Small gift allowance: You can give as many gifts of up to £250 per person as you like each tax year, as long as you haven't used another allowance on the same person.

Wedding or civil partnership gifts: You can give tax-free gifts when someone gets married or enters a civil partnership (though the source material was cut off on this point).

Birthday and Christmas gifts made from your regular income are also exempt from Inheritance Tax.

Gifts between spouses or civil partners are always exempt from Inheritance Tax (as long as they live in the UK permanently). You can give your spouse or civil partner as much as you like during your lifetime with no tax consequences.

Gifts to charities and political parties are also exempt.

What counts as a gift?

A gift can be:

• Money
• Household and personal goods (furniture, jewellery, antiques)
• Property, land, or buildings
• Stocks and shares

A gift also includes losing money when you sell something for less than it's worth. For example, if you sell your house to your child for £200,000 when it's worth £300,000, the £100,000 difference counts as a gift.

Anything you leave in your will doesn't count as a gift — it's part of your estate.

Giving away your home

If you give away your home and move out completely, there's normally no Inheritance Tax to pay if you live for another 7 years.

If you want to continue living in your property after giving it away, you must either:

• Pay rent to the new owner at the market rate for similar local properties, and pay your share of the bills
• Give away only part of your property and have the new owners live there with you (in which case you don't need to pay rent)

If you don't follow these rules, it counts as a "gift with reservation" — meaning you've given something away but still benefit from it. This will be added back to the value of your estate when you die.

If you die within 7 years of giving away your home, the 7-year rule applies and it may be subject to Inheritance Tax. Note that the 7-year rule does not apply to gifts with reservation.

Business and agricultural reliefs

Some assets can be passed on free of Inheritance Tax or with a reduced bill. Business Relief allows certain business assets and shares in unlisted companies to qualify for relief.

If your estate includes a farm or woodland, Agricultural Relief may be available — contact HMRC's Inheritance Tax helpline for guidance on this.

Getting help

If you have questions about Inheritance Tax, you can contact HMRC's Inheritance Tax helpline. Note that HMRC cannot give advice on how to reduce your tax bill — for that, you'll need to speak to a solicitor or tax adviser.

Sources

• How Inheritance Tax works: thresholds, rules and allowances

This article provides general guidance based on current HMRC rules. For advice specific to your situation, speak to your accountant.