What is inheritance tax?
Below is a short guide on how Inheritance tax (IHT) is charged on gifts and other transfers of cash or assets that you make, in your lifetime, or on your death. Assets are things you own such as your house, shares or other possessions. There are some gifts and transfers that are free from IHT and we will also look at them here. We only cover the position for individuals who are domiciled in the UK.
What is IHT, briefly?
Inheritance tax (IHT) is basically a tax on the transfer of assets that you build up during your lifetime and then pass on to others. The passing to others might be during your lifetime, as a gift, or when you die.
If you own one or more valuable assets – often the most valuable of which might be your own home – it is useful to understand what IHT is and whether it will affect you if you make a gift while you are alive, or whether any IHT will be due when you die.
We know that people find the idea of IHT on gifts while you are alive confusing, but basically IHT is payable on certain lifetime gifts because the act of giving something away diminishes the value of your estate. However, IHT need not be considered in relation to lifetime gifts unless you make a gift to a trust or you die within seven years of making the gift.
When someone dies, IHT might be payable if the value of the taxable estate on death, together with any lifetime gifts that are, or become chargeable, on death, is more than the ‘nil rate band’.
This short guide gives an overview only, so you might need to take further advice from a professional adviser. You can find a tax adviser on the Chartered Institute of Taxation website or the website of the Society of Trusts and Estates Practitioners (STEP).
It is worth noting that most people do not pay IHT.
Are any gifts exempt from IHT?
If any gift is exempt from IHT, it will not be included in the calculations when working out whether any IHT is due.
Important note: Although there may not be any IHT payable on lifetime gifts you make, the capital gains tax effect must be considered if you are disposing of chargeable capital assets (although note that cash is not a chargeable capital asset).
Broadly speaking, if you make any gifts in your lifetime and survive for seven years after making them, then their value will not be counted as part of your estate on death and will be exempt from IHT.
There are certain gifts you can make in your lifetime which are completely exempt from IHT, whether you survive seven years or not.
Small gifts to an individual
You can make outright gifts of up to £250 in value to any one person in a tax year. The total gifts to any particular individual must not be more than £250 in that year.
You cannot combine this exemption with any other exemption for lifetime gifts, such as a gift on marriage.
Annual exemption of £3,000
You can make gifts of up to £3,000 in total in any tax year and these are exempt from IHT. It does not matter how many people you make gifts to but the overall limit is £3,000.
A husband and wife (and civil partners) each have their own £3,000 exemption.
If you have not used your allowance of £3,000 for the previous year you can use that as well, but only after you have used the later year's exemption in full.
Gifts in consideration of marriage or registration of a civil partnership
You can give exempt wedding or civil partnership gifts up to the following amounts:
- Up to £5,000 to each of your children, stepchildren or adopted children or their intended husband or wife (or civil partner);
- Up to £2,500 to each grandchild or their intended husband or wife (or civil partner);
- Up to £1,000 to anyone else.
Normal expenditure out of income
Gifts that are part of your pattern of normal expenditure can exempt from IHT, but you must be able to make the transfer out of your income (after tax) without reducing your standard of living. For example, Christmas presents might fall into this category, or for instance you might decide to put an amount out of your surplus income into a savings account for a grandchild.
You might need to use some of your capital to help with the maintenance of your husband or wife (or civil partner), ex-spouse or former civil partner, children under 18 or in full-time education or a dependent relative. Such transfers are exempt from IHT.
Jack and Chloe – lifetime gifts and whether taxable
Jack and Chloe have been married for 40 years and have a son, two married daughters and five grandchildren. During 2018/19 they made no gifts at all but during 2019/20 Jack gives each of his grandchildren a gift of £250. Chloe gives £5,000 to their son as a wedding present and a further £5,000 to help in setting up his new house. Jack gives his disabled sister £4,000 to help with her nursing home costs. He also gives £1,000 out of his income every year to his brother.
None of these gifts are taxable:
- Jack's gifts to each of his grandchildren were within the £250 limit for small gifts and are tax-free.
- Chloe's wedding present to her son is also tax free.
- Chloe has also used up her 2018/19 annual allowance of £3,000, together with £2,000 which she did not use during 2017/18 in making the extra gift to her son of £5,000.
- Jack's gift to his sister is exempt as family maintenance.
- Jack's gift to his brother is normal expenditure out of income. Alternatively, it could use up £1,000 of his 2018/19 £3,000 annual allowance.
Gifts to your spouse or civil partner
If you make a gift to your spouse or civil partner, during lifetime or on death, this is exempt from IHT, provided that they are UK-domiciled – check with HM Revenue & Customs (HMRC) if you are unsure. There is more information on domicile in our migrants section.
If a spouse or civil partner is not UK-domiciled the limit for exempt gifts between spouses or civil partners is different. Up to 5 April 2013, there was a limit of £55,000 on the amount that could be transferred IHT-free to a non-domiciled spouse. From 6 April 2013, this limit is set at the level of the prevailing nil rate band (currently £325,000).
This exemption does not cover gifts you make to your unmarried partner or a partner that you are not in a registered civil partnership with.
Gifts to charities
You can make IHT exempt gifts to most UK charities or to registered community amateur sports clubs. This exemption also covers qualifying charities established in the EU and some other countries.
For more information on leaving gifts to charity see our website.
Gifts to political parties
You can make an IHT-free gift to any UK political party as long as at the last general election it had either at least two MPs in the House of Commons, or one MP and received at least 150,000 votes.
You do not need to pay any IHT on gifts you make that are exempt.
Most other non-exempt lifetime gifts you make, apart from gifts to certain kinds of trust, will be what we call potentially exempt transfers (PETs).
This type of gift will become completely free from IHT if you live for seven years, after the date you made it. If you die within seven years, the gift may become chargeable to IHT. However, you will only pay any tax if the value of your taxable estate on death, together with the value of PETs made within the last seven years, exceeds the nil rate band at date of death.
You do not need to notify HMRC about any PET when you make it and there will be no tax to pay at the time you make the gift. Over time you need to keep a record, in date order, of all the PETs that you make, until the seventh anniversary of each gift, when you should take them out of your list.
If you make a lifetime gift into some types of trust, the gift will be a chargeable lifetime transfer (CLT). You may have to pay IHT at the time of making the CLT, if its value is more than the IHT nil rate band (£325,000 in 2019/20). There is more information on the GOV.UK website.
How do I work out the IHT due on a lifetime gift, if I die within seven years?
For IHT there is a tax threshold, known as the nil rate band, and below this limit you pay no tax as the rate is set at 0%. For 2019/20 the basic threshold is £325,000. The rate is then usually 40% on anything above this amount.
If you die within seven years of having made a gift, but your total gifts to date (within the seven-year period) are less than £325,000, there will be no IHT to pay on the gift. This is because although the gift is taxable, the rate of tax is only 0%. However, the gifts use up some of the nil rate band that could have otherwise been set against the value of your estate on death, so the gifts could, overall, affect the amount of IHT you pay.
If you die within seven years of making a gift, and your total gifts to date (within the seven-year period) are more than £325,000, your executors will have some IHT to pay. They can, however, use any annual or other exemptions to reduce the value of the gifts that are included in the calculation, based on what you had available at the date of the original gift.
You can see how this works in the example of Molly below.
Any IHT that is then due can be reduced if the gift was made more than three years before the date of death. This relief is called taper relief.
The longer the time since the gift was made the less IHT you pay. The relief reduces the tax due by 20% per year, from 80% of the full charge in the period of three to four years before the death, to 20% when the gift was made between six and seven years before the death.
Example – Molly
Molly made no gifts until 5 April 2010 and then she gave away the following to her family. Each of the gifts was a PET at the time it was made:
To Kath, Molly's daughter – a picture valued at £10,000 on 5 April 2010
To John, Molly's nephew – cash of £16,000 on 5 April 2013
To Jenny, Molly's granddaughter – an antique clock valued at £9,000 on 5 April 2014
To David, Molly's husband – some land valued at £150,000 on 5 April 2015
To Brian, Molly's brother – some BT shares valued at £70,000 on 5 April 2017
Molly died on 6 April 2019. Her total estate excluding the above gifts came to £82,500.
The gift on 5 April 2010 is not taken into account as it was made more than seven years before Molly died.
The gift to her husband David is tax free.
The gifts to John and Jenny of £16,000 and £9,000 respectively are now taxable, but are also subject to annual exemptions. In the case of the gift to John, as no gifts were made in the previous year, two £3,000 annual exemptions may be used, reducing the value of the gift to £10,000.
In the case of the gift to Jenny, only one annual exemption may be used, reducing the value of the gift to £6,000. The total value of the gifts to be taken into account for these two gifts is therefore £16,000, but still below the nil rate band of £325,000.
Although the gifts to John and Jenny were made over three years before death, no taper relief is given because no tax is due on them.
The amount of the nil rate band remaining is £309,000 (£325,000 less £16,000).
This is set against the gift to Brian and then Molly’s estate.
The gift to Brian is not eligible for any taper relief as it has not passed its third anniversary. However, it will be possible to take off the annual exemption of £3,000 for the year to 5 April 2016 and £3,000 for the previous year to 5 April 2015 as these have not been used. This leaves only £64,000 of the gift taxable.
When this is added Molly’s estate on death (£82,500) it gives us a total of £146,500 which is well within the remaining nil rate band, meaning there is no IHT due.
How do I work out the IHT when someone dies?
If you give something away but then continue to use the asset or enjoy a benefit in it (a ‘gift with reservation’), you will be treated for IHT as if you had not made the gift in the first place. A good example of this is when you give away your house to your children – they live elsewhere because they have their own homes and you continue to occupy your home after you have given it away.
The gift only becomes a PET as described above when you stop having a benefit in it, so if you should die before this happens the full value of the gift will remain part of your estate.
With regard to the gift of your home, there are certain exceptions to this rule if there is an unforeseen change in your circumstances in that you become infirm and are unable to maintain yourself through either old age or illness, for example. In addition, your occupation of the house must be only what might be expected as provision for your care and maintenance by the donee (person you have given the property to). Bear in mind for this to apply the donee must be a relative.
Note, however, that the residence nil rate band, available from 6 April 2017, will mean that more people may be able to leave their family home on their death to their direct descendants free from IHT.
What is pre-owned assets tax (POAT)?
With effect from 2005/06, the government introduced a pre-owned assets tax (POAT) as an IHT anti-avoidance measure. It is an annual charge to income tax on benefits received by a former owner of certain types of assets. It applies to individuals who continue to receive benefits from certain types of assets that they once owned after 17 March 1986 but have since given away.
The POAT aims to tackle schemes which try to get around the 'gifts with reservation' (GWR) rules in IHT. The GWR rules prevent you from reducing your taxable estate by giving away property while continuing to enjoy it, such as giving your house to your children then continuing to live there.
POAT applies to three types of assets:
- household and personal goods; and
- intangible property or cash, stocks and shares and insurance products.
If you either dispose of any such assets by making a gift (or sometimes by selling them), or you contribute towards the purchase of the asset in question and then continue to receive some benefit from it, you are potentially liable to the charge. The benefit may be occupation of the land, use or possession of the asset or the ability to receive income or capital from a trust or settlement holding intangible property.
The scope of the POAT is very wide; there are some exclusions and exemptions, but it can apply where a parent gives away a home (or part of it) to a child but continues to live there, perhaps being looked after by the child. It can therefore catch ordinary family financial planning arrangements, not carried out with the aim of avoiding IHT.
If the POAT applies, there are provisions setting out how to calculate the taxable benefit.
Since the POAT applies to ‘benefits’, if you are caught by the charge, you may have to pay income tax each year even though you do not actually receive any income.
Election for IHT
POAT is payable where the value of an asset exceeds, roughly, £100,000, whereas IHT does not begin to be payable until a person’s estate exceeds £325,000. It is therefore advantageous for those whose estates are valued at between those figures to elect to be taxed under IHT instead of POAT when possible. In addition, the IHT in this case would be payable on death, while POAT is an annual tax on income while the taxable person is still living.
The POAT rules allow people caught by the rules to elect to pay IHT rather than POAT – the election is for the asset to be treated as subject to a reservation. The normal deadline for such an election is 31 January in the tax year immediately following the tax year in which the person first became subject to POAT. So, if the POAT first arises in 2019/20, the individual must make their election by 31 January 2021.
HMRC have discretion, however, to extend indefinitely the period allowed for making the election for IHT rather than POAT. There is guidance on this in HMRC's Inheritance Tax Manual, which you can find on the GOV.UK website. This means that if you have inadvertently been caught by the POAT rules and have only become aware of POAT after the normal deadline HMRC are likely to accept a late election.
If you want more detailed guidance, you can find this in the Inheritance Tax Manual on GOV.UK.
Where can I find more information?
For basic information on IHT have a look at the section on the GOV.UK website.
More technical information can be found in HMRC’s Inheritance Tax Manual. In particular, their section on gifts with reservation can be found starting at page IHT04071. Their guidance on exempt lifetime gifts starts on page IHT14131.
If you have significant assets, money or property, you may wish to seek professional advice about inheritance tax planning. You can find a tax adviser on the Chartered Institute of Taxation website or the website of the Society of Trusts and Estates Practitioners (STEP).