An increasing number of families are being hit with a 40 per cent inheritance tax (IHT) bill when a relative dies. Rising house prices have pushed many estates over the £325,000 IHT-free entitlement, called the nil-rate band. In 2011-12 the government's inheritance tax (IHT) take was £2.9bn, but the Office for Budget Responsibility forecasts it will rise to £4.7bn in 2016-17 and £6.2bn in 2021-22.
However, the introduction of the residence nil-rate band this week should help some families at risk of incurring IHT. The residence nil-rate band will boost your individual IHT-free entitlement by £100,000, upon death, if you plan to leave a family home to children or grandchildren. And this allowance will rise by £25,000 each year over the next three tax years, so that it will be £125,000 per person in 2018-19, £150,000 per person in 2019-20 and £175,000 per person in 2020-21.
Married couples or those in a registered civil partnership are allowed to pass assets to each other during their lifetime or when they die without having to pay IHT, no matter how much they pass on. Additionally, if one spouse dies without using their nil-rate band or residence nil-rate band allowance, the surviving person can claim up to 100 per cent of their spouse's allowance. This means a married couple have a combined nil-rate band allowance of £650,000. And by 2020, when the full residence nil-rate band has come into force, couples will have an additional £350,000 available to them. This will allow them to pass on a £1m family home to direct descendants - such as children, grandchildren, adopted children, step-children or foster-children - completely IHT-free. Spouses of direct descendants, such as sons and daughters-in-law, are also eligible beneficiaries. However siblings, nieces and nephews, and other relatives are not.
The residence nil-rate band will be gradually withdrawn, or tapered away, for an estate valued at more than £2m, even if a home is left to direct descendants. It will be reduced by £1 for every £2 that the value of the estate is more than the £2m taper threshold.
But if an estate includes multiple properties, the deceased's family can decide which property should qualify for the residence nil-rate band. The only requirement is that the property was owned by and lived in by the deceased at some stage before their death. A property that the deceased owned, but never lived in, such as a buy-to-let property, won't be eligible for the residence nil-rate band. However, the home doesn't have to be a person's main home, or been lived in or owned for a minimum period, and it doesn't have to be in the UK. But it does have to be within the scope of IHT and it must be included in a person's estate.
And the residence nil-rate band will still be applicable if the deceased downsized to a less valuable home, or sold their home on or after 8 July 2015, for example to pay for care home fees. As long as the former home would have qualified for the residence nil-rate band, and the deceased left the downsized property or equivalent assets to direct descendants, then the allowance would still be available. Generally this allowance will be equal to the residence nil-rate band that has been lost because the former home is no longer in the estate.
"From 6 April 2017, a husband and wife will potentially get an extra £200,000 of IHT allowance, saving £80,000 in tax [40 per cent of £200,000]," says Gary Smith, chartered financial planner at Tilney Financial Planning. "But if you haven't reviewed your will for a while, get it reviewed because it may not be worded correctly to benefit from the new residence nil-rate band. You really don't want to lose out on this additional allowance."
Make sure you're in the right trust
The residence nil-rate band does not apply to homes held in discretionary trusts, even when the beneficiaries are direct descendants of the deceased. But many wills written before 2008 are likely to include arrangements for discretionary trusts to be established to the value of the nil-rate band. This was common practice at the time for IHT purposes.
"Since 9 October 2007 a survivor of a marriage or civil partnership has been able to claim up to 100 per cent of their partner's nil-rate band if it wasn't used on the first death, in addition to their own entitlement," explains Patrick Connolly, certified financial planner at Chase de Vere. "Before then the first person's nil-rate band allowance was lost if partners simply left assets to each other. By using discretionary trusts, couples could still combine both of their IHT allowances and so ultimately face a lower IHT bill."
Many people still use discretionary trusts because of the flexibility they provide in terms of controlling what happens to assets after death. This type of trust gives trustees discretion over how, when and who will benefit from the trust proceeds. And they can be useful for planning for the future needs of your children or grandchildren, including those not yet born. As you can describe the beneficiaries simply as 'the grandchildren', as your family grows all the grandchildren can be included and be treated equally.
Assets within discretionary trusts are outside the settlor's estate for IHT purposes. But because these trusts do not benefit from the residence nil-rate band people should think twice as to whether discretionary trusts are still the right approach, so it could be worth getting independent financial advice to help make this decision, says Mr Connolly.
There are a number of trust structures that do benefit from the residence nil-rate band. These include 'immediate post death interest' trusts, bereaved minor trusts, 18-25 trusts and disabled person trusts. Bereaved minors trusts and 18-25 trusts can only be created by parents, so grandparents who want to leave assets to grandchildren should set up a bare or Immediate Post Death Interest trust.
Consider the value of your whole estate
The residence nil-rate band is affected by the value of your whole estate - including assets such as investments and cash. If the estate is worth more than £2m, the residence nil-rate band will be gradually tapered away and lost completely with estates over £2.7m - something to bear in mind when estate planning.
Karen Clark, tax partner at RSM, explains: "If both spouses have estates worth, say, £1.5m, the first spouse to die might want to ensure that sufficient assets pass to beneficiaries other than the surviving spouse. This is so that on the second death the residence nil-rate band is not restricted or lost completely because the second spouse has inherited assets on the first death, and has an estate worth, say, £3m thus losing the entitlement to the residence nil-rate band."
Ben Yearsley, director at Shore Financial Planning, also points out that these rules still apply if you make use of other investments to mitigate IHT, such as business property relief schemes and Alternative Investment Market (Aim) portfolios.
"The best part [of these investments] is that full IHT exemption occurs only two years after making the investment," he says. "But when calculating the residence nil-rate band, they add the value of those assets in, even though they are IHT-free. So if you've got £3m - for example £1m in property, £1m in IHT schemes and £1m in an individual savings account (Isa) - you might think you'll get the residence nil-rate band because you've only got £2m that's taxable. But as they look at the whole estate, which is worth £3m, you won't get it even though a big portion is tax-free."
If the value of the home you are passing on is less than the maximum available residence nil-rate band, meanwhile, it will be restricted to the value of the home. For residence nil-rate band purposes, the value of the home is the open-market value of the property minus any liabilities secured on it, such as a mortgage.
Mr Yearsley says: "If the residence nil-rate band allowance is £175,000 as it will be in 2020, but the value of the property or your share of it is only worth £150,000, then you will only get an allowance of up to £150,000. This probably won't affect many people because if you're reasonably wealthy you will probably have a house or a share of a house that's worth at least £175,000."
How the residence nil-rate band works
Example 1 Mr A dies in the tax year 2020-21 and leaves a home worth £300,000 and other assets worth £190,000 to his children. The maximum available residence nil-rate band in tax year 2020-21 is £175,000. The residence nil-rate band for the estate is £175,000, the lower of £300,000 and £175,000 Nil-rate band: £325,000 Estate value: £490,000 Less residence nil-rate band = £175,000 Remaining value: £315,000 Less nil-rate band = £315,000 No IHT is liable In this case the whole of the residence nil-rate band has been used up, but £10,000 out of the available nil-rate band of £325,000 is unused and can be transferred to Mr A's wife.
Example 2 Mrs B dies in the tax year 2020-21 leaving a flat worth £100,000 and other assets of £400,000 to her son. She leaves the rest of her assets, worth £500,000, to her husband which are IHT exempt. The maximum available residence nil-rate band in the tax year 2020-21 is £175,000. Residence nil-rate band for the estate is £100,000, the lower of £100,000 and £175,000. Nil-rate band is £325,000 Estate value is £500,000 Less residence nil rate band = £100,000 Remaining value = £400,000 Less nil rate band = £325,000 Value that IHT is due on is £75,000 The maximum possible residence nil-rate band for this estate was £175,000, but the value of the flat left to the son is only £100,000. So only £100,000 of residence nil-rate band has been used, meaning that what hasn't been used - £75,000 - is available for transfer to the husband's estate. There's no unused nil-rate band to transfer as this was used in full. Source: HM Revenue & Customs |
