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You, your family and the Nil-Rate Band

In the second part of a guide to will writing and inheritance tax, Rosie Carr looks at how to keep IHT to a minimum
You, your family and the Nil-Rate Band

Three years ago 17,900 estates paid inheritance tax. This year the number is expected to be 35,000. Before the summer Budget, it was predicted that, five years from now, 63,000 estates would pay inheritance tax (IHT). That figure has been lowered to 37,000 as a result of the introduction of an extra residential allowance in 2017. Still, we are talking about at least one in every 15 people (or, more correctly, their estates) being landed with an IHT bill. If you don't want to be a member of that group, there are steps you can take to prevent it.

Central to all planning for IHT is the nil-rate band (NRB). This is the band of wealth that everyone is entitled to pass on tax free. The addition of a new residential band - in stages over the next four years - has left many people breathing a sigh of relief. But don't assume your IHT problems are over as a result of the extra allowance. As we explain below, it helps but it's not a panacea, and in any case it doesn't apply yet!

Inheritance tax is levied at a rate of 40 per cent, and is applied on the value of assets over and above £325,000 (the NRB) when they are passed to anyone other than a spouse or a civil partner. So your whole estate can pass across to a spouse or civil partner completely tax free, but passing estates or part of an estate downwards, upwards or outside the family, including to an unmarried partner or sibling, will generally result in a tax bill if the value exceeds the available nil-rate band.

The nil-rate bands of married couples can be added together to shelter £650,000.

Spouses usually pass on their estates to the surviving spouse as it's tax free and avoids complications over ownership. But a spouse might choose to leave some of their estate to someone else, say a child from a previous relationship or a sibling. In this case, some or all of their NRB might be used and the gift to the person will be either partly or wholly tax free depending on whether it's worth more or less than the NRB. When the surviving spouse dies, they can utilise what's left of the first spouse's nil-rate band on top of their own. Other deductions may be made to the two nil-rate bands if any lifetime gifts were given within the last seven years of either spouse's life.

In addition to the £325,000 nil-rate band (NRB), from 2017 onwards parents (and grandparents) can use an extra nil-rate band that applies only to residential property. Initially worth £100,000, by 2020-21 this residential nil-rate band (RNRB) will be worth £175,000 per individual. This is useful as for many people the bulk of their wealth consists of the home they live in. The RNRB can only be utilised where the property is being inherited by a direct lineal descendant (including step children, adopted and foster children) - you cannot use it to pass property tax free to siblings or to your unmarried partner. However, like the NRB, it can be transferred to a spouse or civil partner for use on their death. If the value of a share of property is below the RNRB available, the amount of RNRB is limited to the value of that residence - but any unused excess can be transferred to a spouse or civil partner.

 

How much can you shelter?

Both the NRB and the RNRB can be used to shield property from the taxman - but you cannot use the RNRB to shelter non-property assets. Added together, from 6 April 2020 two sets of NRBs and RNRBs can be used by a married couple to pass on tax free a property worth up to £1m to their children. If the family home is worth less than the value of the RNRB, the excess or unused band cannot be used to shelter other assets. So, if a couple have assets other than property worth £700,000 and a house worth £200,000, the maximum they can shelter will be £850,000. However, if the couple in this case had in fact downsized their property after 8 July 2015, or even sold it completely, then RNRBs up to the value of the original property would be available to the estate. The details have yet to be confirmed but the chancellor stated in the July Budget that this would be the case.

Where a spouse dies before the introduction of the RNRB in April 2017, the surviving spouse will still be able to make use of a second RNRB as long as they die after 5 April 2017. No matter what the date of the first death, as long as the second death occurs post 5 April 2017, a RNRB will be assigned to, and transferred from, the first spouse. The transferable RNRB will be 100 per cent of the rate at the time of the second death. And, says Susan Spash, partner at accountants Blick Rothenberg, the first spouse will be deemed to have had an interest in the property even if they did not actually have an interest when looking at the RNRB that is available to the second spouse to die post 5 April 2017.

 

Inheritance tax thresholds 2015-21 
Yearnil-rate band per person/ (married couple)Residential nil-rate band per person/ (married couple)Total estate that can be sheltered per person/ (married couple)*IHT liability assuming house worth £400,000 and other assets worth £350,000**IHT liability assuming house worth £800,000 and no other assets**
2015-16£325,000 (£650,000)Zero£325,000 (£650,000)£170,000 (£40,000)£190,000 (£60,000)
2016-17£325,000 (£650,000)Zero£325,000 (£650,000)£170,000 (£40,000)£190,000 (£60,000)
2017-18£325,000 (£650,000)£100,000 (£200,000)£425,000 (£850,000)£130,000 (nil)£150,000 (nil)
2018-19£325,000 (£650,000)£125,000 (250,000)£450,000 (£900,000)£120,000 (nil)£140,000 (nil)
2019-20£325,000 (£650,000)£150,000 (£300,000)£475,000 (£950,000)£110,000 (nil)£130,000 (nil)
2020-21£325,000 (£650,000)£175,000 (£350,000)£500,000 (£1,000,000)£100,000 (nil)£120,000 (nil)
*Assumes a residential property is part of the estate and worth at least the amount of the RNRB and that the whole estate is not worth in excess of £2m 
**Assuming full NRB/RNRB available. Figures in brackets show liability when two NRBs/RNRBs are applied

 

How IHT is applied

IHT is chargeable on the net value of the estate, so an outstanding mortgage would be deducted from the value of your home. But don't think there's an opportunity here to wriggle out of the IHT net by mortgaging your house and reinvesting in IHT exempt assets or schemes: it won't be tolerated, warns Gary Heynes, head of private client at Baker Tilly. "If borrowing has been taken against a home to reduce the net value and that borrowing was invested in an IHT-exempt investment, the house would still be charged at full gross value," he says. And while debts are deducted, any lifetime transfers that have taken place in the previous seven years will be added back to the estate.

 

How to prevent an IHT bill

First, make sure you use the NRB and RNRB. If you are married you can pass everything to your spouse tax free - without eating into your NRBs. You won't be wasting your tax-free bands. They will still be there and can be used when your spouse dies. At this point, your unused bands - and your spouse's - will be added together, allowing (from April 2020) up to £1m to be passed on to your children free of tax.

While married couples usually preserve the NRB on the first death, it's a different matter for cohabiting couples. Here transfers are not possible, so you should each aim to make use of your NRBs (and RNRBs) on death. To do this you should split your estate so that you each own a share worth up to the IHT threshold*. From 6 April 2020 this will be £500,000 if you own a property or share of property worth at least £175,000.

Everyone at risk of IHT can use lifetime planning to keep their estate below the £325,000 threshold or £650,000 if a second NRB is available to use. You might want to consider reducing your estate during your lifetime to below £2m if it is in excess of this because this is the threshold at which point the RNRB is tapered. This tapering means that an estate worth £2,200,000 in 2017-18 rising to £2,350,000 in 2020-21 will have no RNRB protection. Ms Rosenbloom underlines the threat: it's when your whole estate - not just your residential property - exceeds £2m that you risk losing valuable RNRB.

Another way to bypass IHT is to invest in assets that are exempt from IHT such as Aim or other unquoted shares. Assets such as these qualify under the Business Property Relief rules (outlined in the box below). You don't have to own the business or be involved in it but the business must be a qualifying one and you must hold the shares for a minimum period of two years. Of course, a portfolio of unquoted shares involves risk and you could lose money. Still, you will be saving £40,000 of IHT for every £100,000 of investments. If the Aim share portfolio drops by 20 per cent, your estate is still better off. It's advisable to seek professional help unless you are an experienced investor.

You can also take out life cover (in trust so that it's not included in your estate) with the payout set to match your expected inheritance tax liabilities.

 

How to shrink your estate

As a rough guide, every extra £50,000 of assets inherited above the nil-rate bands means another £20,000 of inheritance tax.

1. Give away assets. You can gift cash, investments and property or any other assets to anyone and if you survive for seven years after you have made the gift (called a potentially exempt transfer), there will be no inheritance tax liability. What you cannot do is give away your home and continue to live in it rent free. It will still be considered part of your estate. However, if you pay your child, or whoever you have given the property to, a market rate of rent, this would be okay. But the payments will need to be backed up with evidence. There is a complication. If you give an asset to someone other than your spouse you could be liable for capital gains tax (CGT) on the increase in value since you acquired it. However, everyone has an annual CGT allowance of £11,100. Every year, therefore a married couple can gift away assets that have made gains up to £22,200 without paying any CGT, and if they survive for seven years after making the gifts, there should be no inheritance tax to pay, either. The NRB can be used to cover lifetime gifts where the donor does not survive for seven years but the RNRB cannot be used for any lifetime transfers.

2. Make gifts of money: you are allowed to give away up to £3,000 to anyone you like each tax year tax free. You can make smaller gifts, too, and also gifts on certain occasions - for example, such as marriage - when you can give a child up to £5,000. All these sums will fall outside your estate when you die.

3. Give away surplus income: most gifts - as shown above - are restricted but you can give away surplus income - there is no limit - as long as it can be shown that it truly was surplus and by giving it away you did not reduce your standard of living

4. Ask grandparents to skip a generation - you could ask your parents to pass assets and property up to the available NRB and RNRB to your children instead of to you. This way your estate isn't increased in size and left facing a bigger IHT burden when you pass your estate to your children.

5. Place assets in trust. After seven years the assets in the trust will not be included in your estate, although if you place more than £325,000 into the trust, there is a tax hit which is 20 per cent on the value of assets above the inheritance tax threshold on trusts set up during your lifetime, and thereafter a 6 per cent charge every 10 years, again on assets above the nil-rate band.

6. You can give your home to your child if they live with you and they contribute to the upkeep and bills and costs - in other words, it's their home, too.

 

Make the most of the nil-rate bands

The assets of unmarried partners should be split so that each partner can utilise their NRB and RNRB as these cannot be transferred. If all or most of the assets are held in one name, you risk wasting all of some of the other partner's nil-rate bands.

In addition, the RNRB of the first cohabiting partner will be completely wasted if the property is passed to the second partner, so if there are children it makes sense to consider passing the first share down, thereby banking an RNRB, says Julia Rosenbloom, director at Smith & Williamson. The rest of the estate can be left to the partner - using the standard nil-rate band of £325,000 to shelter some or all of the assets being inherited. Your ownership of the property may have to be rearranged to a 'tenants in common' basis if it is currently jointly owned, otherwise the jointly-owned share will automatically pass to the other joint owner on the first death.

 

Married couples/civil partnerships

There are scenarios where a married person could be better off using the NRB - say, by passing the asset directly to a child - rather than preserving it. One situation would be where an asset is expected to grow faster in value than the NRB. By passing on the asset while it still falls within the NRB, you are guaranteed to avoid inheritance tax on it, says Ms Spash. This issue will be increasingly relevant in coming years as the NRB has been frozen at £325,000 until April 2021 and thereafter will rise only in line with the consumer prices index (CPI) along with the RNRB. House prices might rise a good deal faster than this, though, so it might be better to bank the NRB/RNRB as soon as possible. This way, if a 50 per cent share is worth less than the NRB on the first death, you can slip 50 per cent of the property through the tax-free band before the value of that share soars and makes it impossible to do so.

But if you pass a share of property to a child before 6 April 2017 aren't you wasting a valuable RNRB? In fact, you're not. Up until 6 April 2017, you will be passing the property down using the NRB because the RNRB is not yet in place. Assuming your spouse dies after 5 April 2017, two residential nil-rate bands would still be available. This means, says Ms Spash, that where the residential property is likely to increase in value faster than the NRB it can still make sense for the property to pass to the children where the first spouse dies before 5 April 2017. "If the first spouse leaves a share of the family home to the children - say, 50 per cent - and uses up 75 per cent of the standard nil-rate band, the children could be better off than if the first spouse had left everything to the second spouse. On the second death, the surviving spouse will own 50 per cent of the property, and will be entitled to two times 100 per cent of the residence banding plus 25 per cent of the spouse's NRB plus their own NRB. If everything had been left to the spouse on first death then the value applied to the RNRB will be greater, so increasing the value of the overall estate that is within the charge to IHT."

Secondly, inheritance tax and the nil-rate band are political footballs and can and do change from time to time. A new government might in future completely alter the rules or remove or reduce the NRB and RNRB, so if change seems likely it could be wise to plan accordingly.

 

If you have remarried or are divorced

Where a couple have divorced but not remarried and both own properties that they choose to leave to their children, they can each make full but separate use of their NRBs and RNRBs (post 2017). If they don't have children they can only use the £325,000 NRB each. Any unused NRB or RNRB cannot be transferred to an ex spouse.

Where a widow or widower inherits an estate from their second spouse, there is a risk that an NRB could be entirely wasted and the children left facing 40 per cent tax on £325,000-worth of assets. That's because while you can use more than two NRBs or RNRBs, you can only ever use up to a maximum of 100 per cent of an NRB. Here's an example: Jane's husband dies and she inherits all his assets. Four years later she remarries and four years later this second spouse also dies. Jane inherits all his estate and when she dies two years later, her estate, excluding property, is worth £800,000. She can use either spouse's unused NRB along with her own to shelter £650,000 of that estate, but she cannot use both spouses' NRBs. One tax-free band is wasted in this scenario.

However, if the first spouse had left £325,000 of assets to their children, Jane could utilise the second spouse's NRB, which would mean that the children inherit £975,000 tax free in total rather than £650,000. In the same way, if both spouses had part used their NRBs on death, Jane could have used what was left of both up to a maximum of £325,000.

 

Making a gift to a sibling

Although legacies to anyone other than a spouse will attract inheritance tax at a rate of 40 per cent above the nil-rate band, it is possible, as a couple, to ultimately leave a gift to a sibling that doesn't use up the nil-rate band on the first death. For example, you would like to gift your sister a cottage in the country worth £180,000. If you leave the cottage as a bequest in your will then your sister inherits the cottage and while there is no tax to pay as it falls safely within the nil-rate band, when your spouse dies, your transferred nil-rate band will be reduced by £180,000. Instead, suggests Ms Spash, you could leave the cottage to your spouse as part of your entire estate and, if they so wished, they could then make a lifetime gift of the cottage to your sister. If your spouse survives for seven years after the gift, the value of the asset will pass outside the scope of IHT and your nil-rate band can be transferred in full.

 

Passing on the family business

Some businesses can be passed down without incurring inheritance tax, thanks to the 100 per cent Business Property Relief. The business will be exempt from IHT if it meets certain conditions relating to the length of ownership, the ownership structure and activities - for example, it's wholly or mainly a trading company and is not involved in investment activity or property letting. The relief can be claimed whether it's your own business or one that you hold unquoted shares in. It covers shares in qualifying Aim-traded companies and managed Aim IHT investment vehicles and portfolios.

Many people choose to leave the business to their children rather than their spouse. They may have a strong interest in keeping a family business going and they may already be working there, says Julia Rosenbloom. "The business would pass to the spouse tax free anyway, so passing it to the spouse is a waste of the BPR - it might be better to take advantage of the relief while it's there. If the business is going to be sold, it may be better to pass it to the children - they would be able to inherit tax free, whereas if the spouse inherits and sells, then when the cash or new assets pass to the children, there will be an IHT liability."

If the spouse inherits and keeps the business going and holds the shares for a further two years he or she would then be able to pass it on tax free. However, Gary Heynes at Baker Tilly, says: "It may be that the assets no longer qualify at the point of the spouse's death, resulting in an unnecessary tax cost when passing the value to the next generation at that point."

Debts secured against business assets have to be deducted from the value of those assets and this may be a consideration for some business owners who wish to maximise the BPR available. However, the alternative - securing the debts against the family home - may not appeal.

Farms have their own Agricultural Property Relief. Anyone running their own business or farm should take expert succession planning advice.

 

*In the first part of this article, which you can read here, we pointed out that jointly-owned property goes automatically to the surviving owner. To be clear, this only happens where the couple own the property as joint tenants and not as tenants in common. Tenants in common own individual shares of the property, whereas joint tenants own the property together. You can read more about this at: www.gov.uk/joint-property-ownership/overview.