How is inheritance tax calculated in the UK?

As talks of a general election heat up, inheritance tax (IHT) will undoubtedly be a topic of focus. Often considered the most unpopular tax, there were rumours that the Conservative government would scrap it in the latest Spring Budget. Labour has pledged to reverse any cuts the Conservatives make, should it get into power.

It has also long been reported that Londoners pay on average the highest IHT bill in the UK. For example, data from HMRC showed that in 2019/20, property accounted for 50 per cent of the wealth in estates in London paying IHT, with an average value of over £820,000. The average estate value in London was over £1.4m, nearly £200,000 higher than the South East, the region with the second-highest average estate values.

Despite the recommendations from the Office of Tax Simplification in 2019, and also the more radical overhaul proposed by the All-Party Parliamentary Group (APPG) for Inheritance and Intergenerational Fairness in 2020, there have been no changes to the IHT regime since the introduction of the residence nil rate band in 2017.

At present, the death rate of IHT is at 40%, with a complicated catalogue of nil rate bands, exemptions and reliefs. According to the Institute for Fiscal Studies (IFS), families are set to pay £15bn in IHT bills by 2032-33, up from £7bn in 2024-25. The main reason for the increase is the fact that the ordinary nil rate band has been frozen at £325,000 since 6 April 2009.

In this article, inheritance tax partner Camilla Bishop considers the factors which explain the differences in IHT across the country and outlines the ways in which it can be calculated.

The residence nil rate band

The residence nil rate band (RNRB) (a further £175,000 at 0% IHT if you qualify or £350,000 at 0% for a married couple) assists estates at the lower end of the scale but does little to help where the estate exceeds £2 million, as it tapers away at a rate of £1 for every £2 the estate is over this threshold. This taper provides a marginal rate of 60% IHT for estates which exceed the £2 million. Furthermore, the RNRB only applies if the deceased had a property they lived in that passed on to his/her children (or other descendants) so those without children lose out altogether.

The introduction of the complicated RNRB legislation did nothing to slow the rise in tax receipts, a big factor being that property prices have increased by over 200% in the last 20 years on average, with the highest percentage increases being in London.

Tax receipts and the home

With the average family home in London exceeding £1 million, it is not surprising that the tax receipts are invariably higher. The family home is often the largest asset in the estate and usually has a direct correlation on the amount of IHT paid. This fact combined with the tapering RNRB means that families with wealth between £2 million and £3 million are hit hard for IHT. For example, the following assumes a married couple with children with joint assets:

• Joint assets of £1 million = no IHT to pay (0%)
• Joint assets of £2 million = £400K of IHT to pay (20%)
• Joint assets of £3 million = £940K of IHT to pay (31.3%)

The future of IHT

It is expected that this will be a contentious topic when it comes to election campaigning, and it is possible that the government will change the IHT regime to simplify the nil rate bands and reliefs or implement a flat rate of gift tax on lifetime gifts and gifts on death. However, right now, one can plan by using potentially exempt transfers (gifts) to ensure that one does not fall into the more penal band of tax as shown above.

There is no seven-year rule in relation to the £2 million test and the qualification for the RNRB, which means that even ‘death bed’ gifts can bring an estate down to £2 million or below to reduce the rate of IHT – although clearly it is not ideal to leave matters this late.

For those with more of an appetite to save IHT, it is possible to look at planning around the family home through a ‘gift with leaseback’ arrangement to potentially save huge sums of IHT through the payment of market rent for a lease for the rest of your life having given away the freehold.

Such an arrangement on a £3 million estate with a £1 million family home could save £140,000 in IHT immediately through reinstating the RNRB, a further £80,000 to £320,000 between years three and seven following the gift (taper applying to the tax due after three years), with a maximum of £540,000 of saved IHT after seven years from the date of the gift.

Such numbers are eye-watering and warrant consideration for those couples whose joint assets breach the £2 million threshold, whether a simple gift is made to bring the estate down to £2 million or a large gift of the family home is made to radically reduce the liability over time, the latter being suitable for couples who can comfortably afford the market rent.

IHT is one tax you can still plan for and with expert advice you can make the most of the available exemptions and reliefs.

If you have questions or concerns about your IHT, please contact Camilla Bishop.