How does Inheritance tax work?
When someone dies, their estate may be subject to Inheritance tax (“IHT”). The value of their estate is calculated by adding up all the value of all their assets, and then deducting any debts that they owe.
Assets left to a spouse are free of IHT.
Where assets are left to anyone other than the spouse, the next step is to work out what allowances are available.
Each person is given a nil rate band (currently £325,000) on which they do not pay IHT. If they had a spouse who died before them and had not used all of their nil rate band, this can be transferred to the surviving spouse so that they are entitled to a £650,000 allowance in total.
There is also a residence nil-rate-band (“RNRB”), which is set against the value of someone’s residence. This is currently £175,000. Again, if the first spouse to die does not use their RNRB then this can be used by the surviving spouse giving a total allowance of £350,000. The RNRB is clawed back on estates worth more than £2 million so that £1 of relief is lost for every £2 above that limit.
The RNRB is only given against the value of the property, and only where the property is left to a ‘direct descendant” which usually means a child of the deceased or the spouse / widow of such a child.
For example, a husband and wife own a property worth £500,000 and have assets worth £250,000, the husband dies first leaving everything to his wife, and she dies three years later leaving everything to their two children equally.
On the first death, there is no IHT as everything has passed between spouses.
On the second death, both the RNRB and the NRB are available to the wife’s estate.
The estate is worth £750,000. The RNRB of £300,000 is set against the property, leaving £200,000 potentially subject to IHT. However, the NRB of husband and wife taken together is £650,000 and this is more than enough to shelter that £200,000 and the additional £250,000 from tax.
Gift with Reservation of Benefit (GWROB)
If someone gives an asset away to another individual, it will be a Potentially Exempt Transfer (PET), and as long as the donor survives seven years, it will fall out of the donor’s death estate for IHT purposes. The beneficiaries of the donor’s estate therefore save IHT at a maximum of 40% as a result of the gift.
The reservation of benefit anti-avoidance rules were introduced in FA 1986. They ensure that a donor must genuinely give away all the rewards and benefits of an asset if it is to be excluded from their estate. If the asset is given away but the donor continues to derive benefit from the asset, the asset will still form a part of the deceased estate at the date of death.
Taper relief takes the form of a percentage reduction in the tax which would otherwise be payable on the transfer. It follows that if no tax is payable on the transfer because it doesn’t exceed the nil rate band (after cumulation), there can be no relief.
|Years between transfer and death
|Percentage of full tax rate applied
|3 to 4
|4 to 5
|5 to 6
|6 to 7
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