For individuals with an estate over £325,000 on death, they are liable to pay inheritance tax (IHT) at 40 per cent, taking a massive chunk out of wealth that can be passed onto the next generation. The situation changes in the new tax year, where there will be an additional residence nil rate band (RNRB), which will apply to anyone passing a qualifying residence to direct descendants. It will be applied first to the estate before the standard nil rate band.
The first tranche of the RNRB will be introduced in the new tax year to individuals who die on or after this date and will phase in as follows:
After the 2020/21 tax year, it will increase each tax year in line with the Consumer Prices Index. Reliefs such as Business Property Relief and Agricultural Property Relief are ignored when calculating the value of the estate.
Large estates will not benefit to the same extent with the RNRB tapered for estates over £2m with the available RNRB being reduced by £1 for every £2 by which it exceeds this value. The entire RNRB will be lost altogether where the estate exceeds £2.2 million (tax year 2017/18). Before the assets are passed on, inheritance tax will be paid out of the estate.
The amount of RNRB that can be used against the estate may not be the entire property, as it only applies to the share of the residential property that is closely inherited by direct descendants. These includes children, step-children, adopted and foster children, grandchildren and the spouse or civil partner of a linear descendant. The allowance can only be used for one residential property per individual, which the original owner must have at some point occupied. If the property is smaller than the available RNRB allowance, the amount that can be used won’t be above the value of the property that is closely inherited.
If the RNRB is not used on the first death of a married couple or civil partners, it can be carried forward to be used on the second death, as is the case with the standard nil rate band. Regardless of when the first death happened, this applies provided the second death occurs on or after 6 April 2017. If the first death occurs before this date, even though the RNRB wasn’t available at the time, they are deemed to have used none of RNRB. This means a 100% uplift is applied to their RNRB when the second death occurs and home is left to direct descendants. This in effect doubles their RNRB allowance. Bear in mind, it’s the estate on second death that counts. The relief will be tapered if the estate on second death exceeds £2m even if the estate on the first death was not used and the RNRB transferred.
It may be assumed that if you downsize to a lower value property, you will lose some benefit of the RNRB. A compensatory ‘additional’ nil rate band (ANRB), applying to main residences sold on or after 8 July 2015, will be available, in addition to the RNRB on the new residence. The ANRB generally will be equal to the RNRB that has been lost as a result of the disposal and so the maximum RNRB may still apply, provided certain conditions are met.
There are quite complicated transactions involved with specific formulas used and so it’s worth seeking financial advice on this matter. The ANRB will only apply on death if both the new lower value property and other assets are closely inherited by direct descendants and is restricted to the value of the assets being closely inherited.
The RNRB applies where the residential property is passed over directly. In other words, it won’t apply where it is inherited via some trusts, such as through a discretionary trust, but this depends on who the beneficiaries are and their rights to the assets and income of the trust.
Some trusts for the benefit for children and grandchildren will not result in a loss of the allowance. This is where the property is held absolutely for the benefit of the descendant or through an interest in possession trust, the RNRB can still be claimed. The latter is where the beneficiary of a trust has an immediate and automatic right to the income from the trust as it arises. Other trusts such as Bereaved Minor Trusts, 18 – 25 Trusts and Disabled Persons’ Trusts will also retain the additional nil rate band.
The importance of Estate Planning
As with the above, it’s important to be aware of the wider implications of financial planning efforts. There may be additional options or unintentional impacts that have not yet been considered. Estate planning can involve gifting, but here the seven-year rule applies. This means if death occurs within this timeframe of making the gift, its value is still counted towards the estate for inheritance tax purposes. Where a primary residence is gifted prior to death, say if someone was going into care, and they died within 7 years, there may be an inheritance tax liability, whereas if the residence was closely inherited on death the RNRB would apply and there may be no liability at all.
Often estate planning is left too late and therefore the action to effectively plan to reduce inheritance tax liability and ensure as much wealth is passed onto the next generation is possible is hindered. Despite the changes made by the government to “take the family home out of inheritance tax”, the Office of Budget Responsibility forecast last week in its analysis of the economy alongside the Budget, the Treasury will take in £1.8billion more over the next five years than was predicted last November. This starkly emphasises that it is up to us to maximise the rules available and ensure we don’t pay more tax than is necessary.