London estates routinely pay inheritance tax their owners never expected to owe

What inheritance tax is and who pays it

Inheritance tax (IHT) is a tax on the estate of someone who has died. In England and Wales, it is charged at 40% on the value of the estate above the available threshold. The tax is paid by the estate before beneficiaries receive anything -- which means executors must find the cash to pay HMRC before probate is granted, even if the estate's wealth is tied up in property.

Most estates do not pay IHT. HMRC data suggests around 4-5% of UK estates are liable each year. But in London, that proportion is significantly higher -- because the nil-rate band has remained at £325,000 while property values have grown substantially over the past two decades.

IHT is paid by the estate, not the beneficiaries directly. However, the practical effect is the same: a £200,000 IHT bill on a £700,000 London flat means the beneficiaries receive £500,000, not £700,000.

The nil-rate band and residence nil-rate band

Every individual has a nil-rate band (NRB) -- the amount of their estate that is free from IHT. The NRB has been £325,000 since April 2009. Under the Finance Act 2023, it is frozen at this level until at least April 2030. There is no indexation. Every year the freeze continues, more London estates fall into the taxable band simply because of inflation.

Married couples and civil partners can transfer unused NRB to the surviving spouse on the first death. This means a couple can have a combined NRB of up to £650,000. This transfer is not automatic -- it must be claimed during the administration of the survivor's estate, but there is no time limit for the claim.

In addition to the NRB, there is a residence nil-rate band (RNRB) of £175,000 per person, available when a residential property is left to direct descendants (children, grandchildren, or their spouses). This brings the potential combined threshold for a married couple passing a family home to children to £1,000,000. However, the RNRB is tapered away for estates above £2,000,000 at £1 for every £2 of excess.

Calculating your potential inheritance tax liability

Understanding your estate's IHT position requires totalling all assets -- property, savings, investments, business interests, life policies held in your own name -- and deducting liabilities including mortgage balances and other debts. Pensions are generally outside the estate and excluded from this calculation.

Once you have a gross estate figure, subtract the available NRB and RNRB to find the taxable estate. Apply 40% to the taxable estate to find the estimated IHT liability. The calculator below walks through this calculation with your own figures.

Gifts and the seven-year rule

Gifts made during your lifetime can reduce your estate for IHT purposes, but most gifts only fall outside the estate if you survive seven years from the date of the gift. These are called potentially exempt transfers (PETs). If you die within seven years, the gift is brought back into the estate calculation -- though taper relief reduces the effective rate between years three and seven.

There are several exemptions where gifts are immediately outside the estate regardless of when you die. The annual exemption allows gifts of up to £3,000 per year (and you can carry forward one unused year). Small gifts of up to £250 per person per year to any number of people are exempt. Gifts out of normal expenditure from income -- regular payments from surplus income that do not reduce your standard of living -- can be exempt without limit, though detailed records are required.

Wedding gifts are exempt up to £5,000 from a parent, £2,500 from a grandparent, and £1,000 from anyone else. Charitable gifts are fully exempt from IHT, and leaving 10% or more of your net estate to charity reduces the IHT rate on the remainder from 40% to 36%.

Trust strategies for reducing IHT

Trusts can form part of an IHT planning strategy, though the rules are complex and the benefits depend heavily on the type of trust, the assets involved, and the timing. A protective property trust in a will ring-fences one partner's share of the family home, ensuring that share is not included in the survivor's estate for care cost or IHT assessment purposes.

Discretionary trusts during lifetime allow assets to be moved outside the estate after seven years, subject to the ten-year anniversary charge and exit charges under the relevant property regime. Nil-rate band trusts, once common, are less used since the introduction of the transferable NRB, but may still have a role in some estates.

IHT planning through trusts requires specialist advice. The interaction between IHT, capital gains tax, and income tax within trusts is complex. Our trust planning guide covers the main structures in detail, and our matching service connects you with specialists.

The London-specific IHT problem

A family that bought a three-bedroom house in Islington, Dulwich, or Richmond in the 1990s for £200,000-£300,000 may now hold a property worth £1,000,000-£2,000,000. Combined with savings and pensions, these estates can generate IHT bills of £200,000-£400,000 or more -- on assets that are entirely illiquid until the property is sold.

The executors must pay IHT before probate is granted, creating a timing problem for property-heavy estates. HMRC offers an instalment option for property -- IHT on real property can be paid in ten annual instalments, with interest charged on the outstanding balance. But this requires careful planning and is not automatic.

For London homeowners, the conversation about IHT planning is not optional. If you own property in London and have not reviewed your estate plan, the probability that your estate owes IHT is significant. An estate planning review with one of our matched specialists typically takes 90 minutes and produces a clear picture of your current position.

Inheritance Tax -- The London Homeowner's Guide -- common questions