Inheritance tax: the residence nil-rate band
17th July, 2018
In the run up to the 2010 Westminster election, the Conservative party issued a manifesto promise to increase the inheritance tax threshold to £1 million. Seven years on, the Tories made good on their promise when the new residence nil-rate band (RNRB) came into force on 6th April 2017.
The RNRB will be welcomed by many taxpayers as it is estimated that over 22,000 families will benefit from the new allowance by 2020. However, in Shakespeare’s immortal words “all that glitters is not gold”. On closer inspection, the qualifying conditions are both complex and restrictive. The application of the allowance is far from universal, with those who do not own a property or without direct descendants failing to qualify. In addition, estates valued at over £2 million will be penalised.
This article seeks to provide a broad outline of the RNRB and to highlight some of the key areas which should be considered in light of its introduction.
But first, a recap on inheritance tax
Inheritance tax is usually levied at a rate of 40% on the value of the deceased’s estate above the tax free threshold. This falls to 36% if at least 10% of the net estate is left to charity.
The tax free threshold includes:
- The nil-rate band (NRB) of £325,000 per individual, and
- The RNRB, where the qualifying criteria have been met.
There are also a number of reliefs which may potentially be available, such as business and agricultural relief. Reliefs enable qualifying assets to be passed on free from inheritance tax but are beyond the scope of this article.
The nil-rate band (NRB)
Each individual is entitled to pass on an amount of their estate free from inheritance tax. This allowance is known NRB and is currently frozen at £325,000, until at least 6th April 2021.
In the case of married couples and civil partners, all assets can be left to the surviving spouse or civil partner free of tax and without utilising the NRB.
Since 2007 married couples and civil partners can also transfer any unused NRB to the surviving spouse or civil partner.
Therefore, if a husband or wife passes away, leaving their entire estate to the surviving spouse, there will be no inheritance tax to pay on their death and their NRB can also be transferred to the surviving spouse. A widow or widower could thus have a NRB of £650,000, comprised of transferred NRB and their own NRB. This is before taking into account the RNRB.
What is the new residence nil-rate band (RNRB)?
The RNRB is a new inheritance tax allowance which effectively tops up the existing NRB of £325,000, by reducing the amount of the estate that is subject to inheritance tax.
The RNRB has been introduced at a maximum of £100,000 per individual for deaths occurring in the tax year 2017/18.
Table 1: Residence nil-rate band & nil-rate band
The RNRB will increase by £25,000 per annum until it reaches the maximum of £175,000 in the tax year 2020/21. From 6th April 2021 the RNRB will increase in line with the Consumer Prices Index (CPI).
In the case of married couples and civil partners, as with the existing NRB, the RNRB is transferable to the surviving spouse where the allowance has not been used on the first death, either partly or in its entirety. However, the RNRB will be tapered where the net value of the estate exceeds £2 million.
The allowance can be transferred even if one of the couple passed away before the RNRB came into effect on 6th April 2017.
In a nutshell, when the full RNRB comes into force on 6th April 2020, a married couple can potentially pass on up to £1 million worth of assets (including a residential property) to their direct descendants, free from inheritance tax - on the proviso that the qualifying conditions are satisfied.
Will your estate qualify for the RNRB?
The application of the RNRB is complex, however in broad terms the allowance will only be available if:
- The death occurs after 5th April 2017
- A residential property has been included in the estate at death
- The property, or share of it, has been passed on to direct descendants
- The property has been occupied by the deceased as a dwelling house at some point
- The value of the estate is £2 million or less (otherwise tapering applies), and
- The property has been downsized to a less valuable home or sold or given away on or after 8th July 2015.
How much RNRB will apply?
The available RNRB will be the lower of the:
- net value of the residence (taking account of outstanding mortgages or other liabilities), and
- maximum amount of the RNRB band in force at the time of death.
In practical terms, this means that if the property in question has a net value of less than £175,000 per person, or £350,000 in the case of a couple, some of the RNRB will effectively be wasted. So for example, if William dies on 6th April 2020, having been predeceased by his wife Wendy and their family home has a net value of £320,000, £30,000 of the RNRB would not be available to set off against the other assets in William’s estate and is effectively wasted.
Points to consider
Whilst a deep dive of the qualifying criteria is beyond the scope of this article, the points detailed overleaf should be considered by those wishing to maximise what can potentially be a lucrative allowance.
- Ensure that the property, or a share of it, is inherited by direct descendants The RNRB will only apply where the interest in the residence is inherited by direct lineal descendants. Direct descendant is broadly defined to include children, step-children, adopted children, foster children or grandchildren, as well as a spouse or civil partner of a lineal descendant. The RNRB will not be available when a residence is transferred to nieces, nephews, siblings, other non-lineal relatives or certain types of trusts (for example discretionary trusts). If the RNRB is to be maximised, it is important to ensure that where direct descendants exist, the property, or a share of it, is passed on to them.
- Review existing estate planning Wills drafted prior to 2007 commonly leave a share of the family home, up to the prevailing NRB, in trust for the beneficiaries. Whilst there may be situations where these trusts are useful, such trusts may now preclude the RNRB from being applied. Generally, it is advisable to keep your will under review so that it adequately takes account of legislative changes and changes to your circumstances. The advent of the RNRB provides an added incentive to review your will and ensure that your estate is not prevented from utilising the allowance by, for example, passing the family home into a discretionary trust.
- The £2 million taper threshold The government, presumably in a move to placate critics of the new allowance, have included a clawback provision which restricts the RNRB by £1 for every £2 the net value of the estate exceeds £2 million. The £2 million figure is arrived at after deducting liabilities, but before taking account of exemptions or reliefs, such as agricultural or business relief. The fact that the legislation does not enable reliefs to be deducted in working out the value of the net estate is significant. Many business owners in particular will be disappointed to learn that they may be penalised, or in the worst case lose out completely, on the RNRB. This is due to the fact that, whilst shares held in a trading company can generally be passed on free from inheritance tax (assuming business relief applies), their value is included in the estate for the purposes of the RNRB, thus potentially causing the £2 million threshold to be exceeded. Engaging in lifetime planning may assist in minimising the impact of the taper rules by reducing the value of your net estate on death below the £2 million taper threshold. However, there may be tax, legal and financial considerations which should be carefully considered before adopting this course of action. It is strongly recommended that you seek professional advice in this regard. In addition, switching property ownership between each spouse from joint tenants to tenants in common will provide greater flexibility with regard to how property is transferred on death. This may preserve the entitlement to the RNRB if the value of each spouse’s assets can be kept below the £2 million threshold.
- Buy-to-lets and holiday homes The RNRB will only be available with regard to one residential property which has been used as the deceased’s residence at some point and is included within their estate. The property does not have to be the main residence or have been owned or lived in for a minimum period. Therefore, a holiday home (even where it is located outside of the UK) can potentially qualify. Where there is more than one property, the personal representatives will be able to nominate which property should apply. A property which has never been lived in by the deceased, such as a buy-to-let property, will not qualify. However, a property which has been let at the time of death can qualify so long as the deceased resided in it at some point.
- Provision for downsizing, gifting or sale of the property The legislation makes a concession for individuals who downsize, sell or give away their home provided that the disposal occurred on or after 8th July 2015. If all or part of the RNRB has been lost as a result of the downsize, sale or gift, the RNRB may still be available providing the property is replaced with a family home of lesser value, or where it is not replaced, assets of an equivalent value are transferred to direct descendants on death. The downsizing provision ensures that older couples in particular, are not compelled to hold on to a valuable property for the sole purpose of saving inheritance tax. In addition, this concession may be useful where a family home has been sold in order to move into residential care.
The complexity of the new allowance and its restrictive application may necessitate taxpayers having to review their existing arrangements and consider appropriate estate planning to ensure that they are best placed to utilise the RNRB to its full extent. Being pro-active in this regard is to be encouraged. However, before any action is taken we would strongly recommend that you seek professional advice in order to ensure that adequate consideration has been given to all financial, legal and tax implications of any proposed course of action.
Should you wish to review your current arrangements please contact your Davy wealth manager to discuss.
Warning: The information contained herein is based on our understanding of current tax legislation in the UK and the current HMRC interpretation thereof and is subject to change without notice. It is intended as a guide only and not as a substitute for professional advice. You should consult your tax adviser for the rules that apply in your individual circumstances.