Someone dies and their property passes on to a spouse or family member. But paying tax might not be so straightforward.
In the UK, the value of the property is included in the deceased person’s estate, and so Inheritance Tax (IHT) might have to be paid on it.
What actually is Inheritance Tax, though? And how is it calculated?
Let’s find out.
What is Inheritance Tax?
Simply put, Inheritance Tax is a tax applied to the estate of someone who has died. It includes all property, possessions, and money, and the standard rate is 40%.
A key point to remember is that IHT is only charged on the part of a person’s estate that’s above the tax-free threshold (currently £325,000).
Who pays Inheritance Tax?
The first thing to establish is whether or not the deceased left a will. If they did, it’s usually the executor of said will who pays IHT, and if not, then it’s the administrator of the estate.
IHT can actually be paid using funds that are inherited. Alternatively, you can raise money by selling some of the assets included in the estate.
The most common way to pay IHT is through the Direct Payment Scheme (DPS), which enables the inheritor to make use of any kind of bank or building society account the person may have left behind.
There are also things like life insurance policies to consider, with these remaining in effect until the policyholder’s death, so long as the premiums are paid.
Payments from one of these could be subject to IHT, though – unless the policy is written in Trust, in which case tax will more than likely be avoided.
From April 2027, IHT due on pension benefits will be paid directly by the pension administrator.
How much is Inheritance Tax?
First and foremost, if the total value of an estate is below the £325,000 threshold (known as the nil band rate), then there’s generally no tax to be paid.
This is also the case if a person leaves everything above the threshold to their spouse or civil partner, or to some type of exempt beneficiary like a charity.
Most notably, if you pass your home down to your children or grandchildren, the nil rate band increases from £325,000 to £500,000.
The standard IHT rate is 40% and applies to the part of the estate above the £325,000 threshold.
Can the amount of Inheritance Tax be reduced?
This can actually be done in a number of ways.
For example, you can leave a legacy to a charity, put your assets into a trust, or leave your estate to your spouse or civil partner.
You can also give away up to £3,000 a year in gifts or pay into a pension instead of a savings account, although the latter won’t be possible from April 2027.
Can I avoid paying Inheritance Tax?
Forget reducing the amount of IHT. Can you avoid paying it entirely? In short, yes. Before we get into it, though, we should define what is meant by a ‘gift’ according to HMRC.
HMRC defines a gift as “anything that has a value, such as money, property or possessions”.
Now, if a property is given away as a ‘gift,’ Inheritance Tax won’t apply – that is, on one condition: the homeowner must vacate the premises and live elsewhere for a minimum of seven years.
If you wanted to keep living in the property, you’d have to pay rent and cover the cost of household bills for seven years (noticing a pattern here?).
Okay, but what happens if someone gifts away their property, follows protocol and moves out, and then they die before the seven years are up? Well, in that case, the property would be considered a gift, and the normal 7-year rule would apply.
Possessions up to the value of £3,000 can actually be gifted each tax year (6 April – 5 April) without them being added to the value of your overall estate, and this can obviously help you avoid paying IT (depending on the size of the estate, of course).
Again, the basic rate is 40%, and this applies if the property in question was gifted within three years of the homeowner’s death.
If, on the other hand, the property was gifted three to seven years prior to the homeowner’s death, then it’s taxed according to what HMRC call the ‘taper relief.’ This is a kind of sliding scale which outlines the tax percentage that must be paid based on exactly when something was gifted (or the timescale).
It’s important to remember that taper relief only comes into effect if the total value of gifts made in the seven years before the person’s death is above the tax-free threshold (£325,000).
The current IHT rates are as follows
- 3 – 4 years = 32%
- 4 – 5 years = 24%
- 5 – 6 years = 16%
- 6 – 7 years = 8%
- 7 or more = 0%
What happens after inheritance?
Even after Inheritance Tax is paid, you still might not be off the hook. Different forms of tax can sometimes come into play, depending on what an individual inherits (and how much it’s worth).
For example, if you were to start renting out a property you inherited, you would probably have to pay Income Tax, as you would be earning a regular income from it.
To take it even further, if someone were to sell their inheritance for more than it was worth when the original homeowner died, they would be required to pay Capital Gains Tax, with the exact amount depending on whether they paid Income Tax at the basic or higher rate.
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