How does Inheritance Tax work?

Inheritance Tax taxes the things of value you leave behind when you die.
People you have given things to can also be charged Inheritance Tax on gifts you made during the last seven years of your life.

When you die the value of the things you own are added up and any debts are deducted. Any gifts you have made in the last seven years that are not tax-free are added to the sum.The nil-rate band is set against this total and used up against the earlier gifts before the later. Your estate is treated as the last gift you make. Inheritance tax then has to be paid on any part of the estate that is not covered by the nil rate band (£325,000 for 2010-11).

Inheritance Tax has to be paid before your money and belongings can be distributed to the people in your will.

No Will

Remember, you really need to make a will

Without one, your partner will not automatically inherit anything from you. See our Wills leaflet (490 KB) for more details.

Bill and Sarah

Bill and Sarah lived together for 14 years. The house was in Bill’s name but he’d left it to Sarah in his will. When he died in November 2007, the house was valued at £320,000.

Two years before he died his sister had run into money problems and he’d given her a lump sum to sort out all her debts. This had to be taken into account in Bill’s estate and, along with a bit of savings and his car, brought the total up to £343,000.

The first £300,000 (the nil-rate band for 2007-8) was not taxed. But the remaining £43,000 was taxed at the rate of 40%. Sarah was left with an Inheritance Tax bill of £17,200. At 2010-11 rates, the amount of tax payable would still be substantial: the first £325,000 (the nil-rate band now) is not taxed, but the remaining £18,000 is taxed at 40%, which means tax of £7,200.

Exemptions

There are, however, a number of ways that you can give money to friends or family members, either in your lifetime or when you die, without having to pay Inheritance Tax on it.

Things you give away more than seven years before you die

Most gifts to people you make while you are alive are treated as being exempt from Inheritance Tax (what tax advisers call ‘potentially exempt transfers’ or PETs). But, if you die within seven years of making any gifts, they are reassessed as if they had been taxable after all. This may push up the tax bill on the things you leave when you die. If you don’t die within seven years, you're home free.

If you do die within seven years, the people you gave those gifts to might also have to pay Inheritance Tax on them. But they will have less tax to pay if you died between three and seven years after giving the gift than if you died sooner after giving the gift. If they cannot or will not pay, the estate will have to pay instead.

Other exemptions

There are also ways you can give money and property away without being subject to Inheritance Tax, even if you die tomorrow. The main ones are:

Anything you give to your husband, wife, or civil partner. This is where unmarried couples really lose out and why Inheritance Tax planning is particularly important. Some couples even consider getting married for this reason.

The first £3,000 of gifts you make in each tax year. If you didn’t use all of this allowance last year, you can use it this year. It can't be carried over for more than one year.

Small gifts of £250 or less. These are always exempt as long as the total you’ve given to any one person in any year is £250 or less (this cannot be combined with any gifts you made under the exemption above).

Gifts to family and friends when they get married or enter a civil partnership - £5,000 is exempt if it is your child getting married/civil partnered, £2,500 if it is your grandchild, and £1,000 for anybody else.

Gifts for the upkeep of your family, including for example, your children, husband, wife, civil partner, or ex-husband/wife/civil partner, but not an unmarried partner.

All gifts to UK-established charities, housing associations, or amateur sports clubs.

Gifts to political parties (generally those represented in parliament with at least 2 MPs).

The gifts you make out of your income on a regular basis. For example, if you pay your maintenance to a former unmarried partner, or if you give your brother £100 every month, that won't be counted. It can also include premiums for life insurance that will benefit someone else. These payments have to be out of your income, not from your savings.

The spouse, charity, and political party exemptions are also available when you die. This means you don’t have to give your money away now, you could do it in your will.

Even if no exemptions apply, most gifts you make before you die are tax-free at the time you make them because they are either PETs or fall within the nil-rate band.

John's Story

I’ve been living with Gillian since the early 70s and we have three children together. We never got married, partly because we didn’t want the state to be involved in our personal life, and we’ve always been very happy with the situation. But now we have hit a problem.

Our home in north London is worth quite a lot of money. If one of us died, the other would have to pay a huge Inheritance Tax bill and might have to sell our home. We've looked into all the different ways of tax planning but, because of our particular circumstances, nothing will work for us. Our solicitor has advised us that there is only one way of avoiding an Inheritance Tax bill - getting married!

We never wanted the state to interfere in our personal affairs and I feel unhappy that it is now. However, I’m a pragmatist. I could stay firm and not get married but that would hardly keep us warm when the tax bill lands on the doormat.

Reliefs

There are also ‘reliefs’ which reduce the amount of tax you have to pay on certain things:

Business Property Relief (BPR) – if you own property, machinery or other assets used for a business, the value of them can be reduced by 50 or 100% when working out Inheritance Tax. This includes a 100% reduction in the value of gifts of unincorporated businesses and unquoted shares (which includes AIM shares), though there are some restrictions on qualifying business.

Agricultural Property Relief (APR) – sometimes called Farm Relief – If you own farmland that has vacant possession (or can obtain it within 24 months) the value of the land can be discounted for Inheritance Tax purposes. This also applies to farmhouses and cottages as long as they are used for agricultural purposes. The value of other let agricultural land and property can be reduced by 50%.

Forestry land – might also qualify for BPR or APR. If not, the timber (but not the land) might qualify for a special woodland relief. This is a complex area - get advice.