Inheritance Tax is an emotive subject for many people. We work hard to save for the future and want to pass on our hard-earned savings and assets to our children and future generations, without leaving a large tax liability.
When someone dies and their estate is worth more than the basic Inheritance Tax threshold, their estate may qualify for an allowance known as the Residence Nil Rate Band. This is designed to offer an additional tax-free allowance where the person’s residence is left to direct descendants. However, it does come with conditions attached and so may not be available – or available in full – to everyone.
What is the Residence Nil Rate Band allowance?
Under the current rules you can leave up to £325,000 to anyone you choose when you die without Inheritance Tax being payable. This is known as the Nil Rate Band. If you have made gifts in the 7 years before your death or “gifts with reservation” at any time then the Nil Rate Band may be less than this. As of 6 April 2017, if you also leave your residence to your direct descendants, your estate will also qualify for a further Inheritance Tax allowance known as the Residence Nil Rate Band. For deaths during the 2020/2021 tax year, the Residence Nil Rate Band is set at £175,000.
If you leave the whole of your estate to your spouse, your estate will not need to use either of these allowances, because of the Inheritance Tax exemption that applies on assets passing to a spouse. It used to be that your unused Nil Rate Band would be lost in these circumstances, but now the benefit of both unused allowances can be transferred to your surviving spouse. Therefore, if you leave your whole estate to your surviving spouse, his/her estate could benefit from your unused allowances as well as his/her own allowances.
Therefore, where the Nil Rate Band, Transferable Nil Rate Band and Residence Nil Rate Band allowances are available in full, spouses need not usually be concerned about payment of Inheritance Tax if their combined estates fall under a threshold of £1 million. However it is important they make sure that the reliefs do apply in full as they are very complex.
References above to a spouse in this article will also include your civil partner.
What are the criteria for claiming the Residence Nil Rate Band?
The Residence Nil Rate Band allowance is only available if you have a ‘qualifying residence’, which upon death is left to your ‘direct descendants’. The phrases ‘qualifying residence’ and ‘direct descendants’ are specifically defined by the implementing legislation, but in general terms the allowance will be available where your residence is bequeathed to your children or other “lineal descendants”. This includes step-children/grandchildren etc.
So what are the restrictions?
Unfortunately, there are some other restrictions which can often prevent the Residence Nil Rate Band allowance from being claimed. For example, the allowance is reduced for estates exceeding a threshold of £2 million so that for every £2 over this sum, the allowance will be reduced by £1. This is known as the tapering threshold.
Based on 2020-21 tax year rates, for married couples or civil partners who would otherwise have a Residence Nil Rate Band allowance of £350,000, this would be lost entirely if their estate exceeds a value of £2.7 million. The maximum allowance would therefore be reduced from £1 million to £650,000, but this also assumes that their full standard Nil Rate Band and Transferable Nil Rate Band allowances are available.
A further restriction is that the Residence Nil Rate Band allowance is limited to the net value of the property concerned after repayment of any mortgage.
What if I need to downsize or sell my home to fund my care needs?
If you were to downsize to a property valued under the Residence Nil Rate Band, or if you sell your residence when you move into a care home, it is possible that the allowance may be lost in these circumstances, or at least limited.
The good news is that if you downsized or moved to a less valuable residence on or after 8 July 2015, your estate will be able to claim a ‘downsizing addition’ allowance if the following conditions apply:
- Your former home would have qualified for the Residence Nil Rate Band if it had been retained up until the time of death; and
- Your direct descendants inherit at least some of your estate.
The amount of the allowance in these circumstances will generally be equal to the Residence Nil Rate Band which would otherwise have been lost. Unfortunately however, this may still result in a lower allowance for the estate because the available allowance will also depend how much of the remaining estate is being left to direct descendants.
Mr Smith (a divorcee) sold his house worth £250,000 in the 2019-20 tax year and moved to a flat worth considerably less. The rate of the Residence Nil Rate Band at the date of the sale was £150,000.
Mr Smith then died in the 2020-21 tax year, when the rate of the Residence Nil Rate Band had risen to £175,000. Had he retained his house the Residence Nil Rate Band allowance would have been £175,000.
The value of Mr Smith’s flat at the date of his death was £125,000 and the total value of Mr Smith’s estate including the flat had an estate valued at £250,000. In his Will, Mr Smith left the flat to his son, £25,000 to his daughter and £100,000 to his sister.
Given that Mr Smith was a divorcee (rather than being widowed), there is no transferable Residence Nil Rate Band available. Since the value of the flat is under the Residence Nil Rate Band rate at the date of death, it will be necessary to calculate the ‘downsizing addition’ as follows:
Step 1: Divide the value of the house at the date of sale by the available Residence Nil Rate Band at the time. As this figure is over 100% the result should be limited to 100%.
Step 2: Divide the value of the flat at the date of death by the available Residence Nil Rate Band at the time 71%
Step 3: Take away the percentage from Step 2 from the percentage in Step 1 29%
Step 4: Multiply the available Residence Nil Rate Band at the date of death by the percentage in Step 3 £50,750
Step 5: Consider the amount left to descendants (excluding the property). If this is over the amount in Step 4 then the amount in Step 4 is the amount of the ‘downsizing addition’, unless this would take the total RNRB over the maximum available allowance. If the amount left to descendants (excluding the property) is under the amount in Step 4 then the downsizing addition is limited to the actual sum passing to descendants £25,000
Step 6: Add the amount in Step 5 (the downsizing addition) to the value of the flat at the date of death. This is the total amount of Residence Nil Rate Band allowance that can be claimed by the estate. £150,000
Had Mr Smith left the entirety of his estate to his descendants, the total available Residence Nil Rate Band (including the downsizing addition) would have been £175,000 and therefore none of his allowance would have been lost, despite having downsized.
How is the Residence Nil Rate Band allowance claimed?
It is important to note that the Residence Nil Rate Band allowance must be claimed by your personal representatives when submitting the Inheritance Tax return to HMRC. Unlike the normal Nil Rate Band allowance, it cannot automatically be applied when calculating the Inheritance Tax liability.
Personal representatives should take particular care where the downsizing addition is being claimed as the claim must be made, generally within 2 years of the end of the month of death. Claims after the deadlinemay be permitted, but this is at the discretion of HMRC.
The importance of seeking expert legal advice
You should seek specialist advice, particularly if you are considering gifting your residence during your lifetime or setting up a lifetime trust. In some cases, this can be catastrophic to the availability of the Residence Nil Rate Band allowance.
You should also take advice if your estate exceeds the £2 million taper threshold as lifetime planning could mitigate your Inheritance Tax bill.
At Tees we are experts in estate and Inheritance Tax planning. We are also in the unique position of being able to offer a seamless service of both expert legal and independent financial advice. Working hand in glove with our Wealth advisers, we can provide you with a fully joined up view of the options available to you.