Inheritance Tax (IHT) is a tax levied on the estate of a deceased person, including property, money, and possessions. While it is primarily charged upon death, IHT may also apply to certain lifetime transfers of assets, such as gifts into trusts. Understanding how IHT is calculated is crucial for estate planning and ensuring tax efficiency for beneficiaries.
IHT is due on chargeable transfers that reduce an individual's estate value. These can arise in two ways: during an individual's lifetime, such as transfers into a trust, or upon death when an estate is passed on to beneficiaries. Not all transfers are immediately chargeable. Some are exempt, while others are "Potentially Exempt Transfers" (PETs), which only become subject to IHT if the donor dies within seven years of making the gift.
A person's domicile affects their liability to IHT. Currently, UK-domiciled individuals are subject to IHT on their worldwide assets, whereas non-UK-domiciled individuals are only liable for IHT on UK-based assets. However, from April 2025, new rules may alter the way domicile impacts IHT, making professional advice essential.
Upon death, three types of transfers may be subject to IHT: the deceased's estate (a deemed chargeable transfer), Potentially Exempt Transfers (PETs) made within seven years before death, and Chargeable Lifetime Transfers (CLTs) made within seven years before death. Whether IHT is payable depends on the estate's total value and available exemptions and reliefs.
To determine the IHT payable, follow these six steps:
Step 1: Value the Assets of the Estate
All assets owned or controlled by the deceased must be valued at their open market value at the date of death. These assets include property, cash, stocks and shares, pensions, business interests, vehicles, household items, foreign assets, and debts owed to the deceased.
Special valuation rules apply to certain assets. Jointly owned property is valued based on ownership type (joint tenants or tenants in common). Quoted shares are valued using the mid-price between the highest and lowest market prices on the date of death. Gifts with Reservation of Benefit (GWROB) are also included, where an individual gifted an asset but continued to benefit from it, such as living in a house they had previously gifted.
Additionally, any interest in possession trusts where the deceased was entitled to income must be considered.
Step 2: Deduct Liabilities
The value of the estate can be reduced by deducting outstanding liabilities. These include mortgages, loans, credit card balances, overdrafts, household bills, and unpaid tax liabilities such as Income Tax and Capital Gains Tax.
Reasonable funeral expenses can also be deducted. However, some debts may not be deductible if they were used to acquire IHT-exempt assets, such as those qualifying for Business Property Relief (BPR) or Agricultural Property Relief (APR).
Step 3: Deduct Exemptions and Reliefs
Certain transfers on death are entirely exempt from IHT. These include transfers to a spouse or civil partner (unless the recipient is non-UK domiciled), gifts to UK-registered charities, and transfers to political parties, housing associations, or national institutions such as the British Museum.
Reliefs such as Business Property Relief (BPR), which offers up to 100% relief on qualifying business assets, and Agricultural Property Relief (APR), which provides similar relief for farmland and agricultural buildings, may also be claimed. Additionally, heritage assets of national historic or artistic interest may qualify for special reliefs.
Step 4: Deduct Nil Rate Bands
Each individual benefits from a £325,000 Nil Rate Band (NRB), meaning that no IHT is charged on the first £325,000 of their estate. In addition, if a person's main home is left to direct descendants (children or grandchildren), they may qualify for the Residence Nil Rate Band (RNRB), which provides an additional allowance of up to £175,000. However, estates worth over £2 million will see a tapered reduction in the RNRB.
Unused NRB and RNRB can be transferred between spouses or civil partners, potentially increasing the total tax-free threshold to £1 million. This allows an estate to benefit from any unused allowance from a deceased spouse or partner.
Step 5: Calculate the IHT Payable
Once the final taxable value of the estate is determined, IHT is applied at the standard rate of 40% on amounts exceeding the NRB. However, if at least 10% of the net estate is left to charity, a reduced IHT rate of 36% applies to the taxable portion of the estate. This charitable discount encourages philanthropic giving while reducing the overall IHT liability.
Step 6: Apply Additional IHT Reductions
If the deceased inherited assets within the last five years on which IHT was paid, Quick Succession Relief may reduce the liability. Additionally, if the estate includes assets that are subject to taxation in another country, Double Tax Relief may be available to offset some or all of the IHT payable in the UK.
There are several ways to reduce IHT liability through careful estate planning. One of the most effective methods is gifting assets during one's lifetime. Gifts that fall under the Potentially Exempt Transfer (PET) rules are IHT-free if the donor survives for at least seven years after making the gift. Regular gifts made from surplus income, rather than capital, can also be exempt from IHT if they form part of normal expenditure.
Using trusts can be another way to reduce IHT liability. Trusts allow individuals to transfer assets out of their estate while retaining some control over how they are distributed. Business and Agricultural Property Relief should also be maximised where applicable, as these reliefs can significantly reduce the taxable value of certain assets.
Another way to lower IHT is to leave at least 10% of the net estate to charity, thereby qualifying for the reduced 36% IHT rate. This can be a tax-efficient way to support charitable causes while minimising the overall tax burden on an estate.
Even after death, some planning strategies can help reduce IHT. A Deed of Variation allows beneficiaries to alter how an estate is distributed, potentially redirecting assets to reduce the overall IHT liability. This can be useful when family members agree that an alternative allocation would be more tax-efficient.
Executors can also apply for a Substitution of Value if assets, such as shares or property, decrease in value after the deceased's death. If shares are sold at a loss within 12 months of death or property is sold at a lower value within three years, the estate may be able to reclaim some of the IHT paid, ensuring that tax is calculated on the lower value rather than the higher initial valuation.
Calculating IHT involves multiple steps, including valuing assets, deducting liabilities, applying reliefs, and computing the final liability. While IHT can be complex, proactive estate planning can help minimise tax exposure, ensuring that more of an individual's wealth is passed on to loved ones rather than lost to taxation.
Seeking professional advice is strongly recommended to navigate the complexities of IHT effectively and ensure that all available exemptions and reliefs are utilised to their fullest potential.
Do you need advice or help with Probate and IHT?
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