Protecting the Family Home from Inheritance Tax

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The Residence Nil Rate Band exemption enables individuals to pass on their family home to direct descendants free of Inheritance Tax in certain circumstances. Jarlath Devlin explains what Residence Nil Rate Band is and how it works…

As property prices hit record highs a little over a decade ago, more and more families found themselves facing a significant tax bill following the death of a close relative. For many, the family residence had been their home for the best part of their lives. It may have been a property of modest proportions, but the increase in property values ensured their estate became taxpaying following their death.

Often, an individual’s house was the only significant asset of value in their estate, with minimal savings or other valuables making up the remainder. Executors were left with the choice of either getting a loan to pay the tax or selling the family home.

Following the economic crash in 2007, property values fell back to a more realistic level. However, in recent years they have steadily crept back up. For many families, having to sell the family home to pay IHT is distressing and compounds their grief. However, the news isn’t all bad. In 2017, the Government introduced a Residence Nil Rate Band exemption (RNRB) enabling individuals to leave their home to their family free of Inheritance Tax in certain circumstances.

What exactly is the Residence Nil Rate Band and how does it work?

Currently, the Inheritance Tax Nil Rate Band (the tax-free limit for every estate) is £325,000. Once this is exceeded, inheritance tax is charged at 40%.

RNRB, is an additional Nil Rate Band, currently capped at £175,000 per individual. It applies on estates above the IHT Nil Band Rate where an individual’s home is left to a direct descendant, such as a child or grandchild.

The legislation surrounding Residence Nil Rate Band is complex. Set out below is a simplified explanation of how it works and what people must do to qualify.

Can I benefit from Residence Nil Rate Band if I have gifted my home?

Many parents or grandparents transfer their family home into the name of a child or grandchild during their lifetime, perhaps to prevent it from being sold to pay Nursing Homes fees. However, as they reserve a benefit for themselves by remaining in the property rent-free, this is known as a “Gift with Reservation.” Essentially nothing has really changed other than the legal title of the property being transferred to a family member. The donor is still living in the house as before and the donee does not enjoy the property to the exclusion of the donor.

For Inheritance Tax purposes, if someone continues to benefit from any property they gift away, the transfer is considered to be a gift with strings attached. This legislation came into force in March 1986 to prevent people from gifting away large chunks of their estate while continuing to benefit from them.

As a person’s estate includes any asset to which they were beneficially entitled, the value of the gifted house will be included in their estate at death, but the good news is that the property can qualify for RNRB in such a scenario.

Conversely, where the doner made an outright gift of the house and moved out, say into rented accommodation, it is unlikely that RNRB would be available.

What is classed as a home?

For the purposes of attracting RNRB, a person’s home is any dwelling house they owned or had owned and occupied at some stage as their home while they owned it.

Just to give some examples of how it can work:

• John is an elderly man who buys a new home and moves in. A sudden illness within a few days results in him requiring permanent care in a Nursing Home. In this example, John has established his home in the property and RNRB can be claimed on his death.
• For people who live abroad but are domiciled in the UK, providing the foreign property is included in their estate, RNRB will be available to potentially exempt it from IHT.
• Where someone living in the UK has a foreign domicile, only his/her UK assets are subject to UK Inheritance tax. If their estate includes a UK residence, then RNRB can be claimed.

Who must inherit the house?

To qualify, the house must pass on to a direct descendant of the deceased. Put simply, that generally means a child or grandchild, stepchild, adopted child, a child fostered by the deceased or a child where they are appointed as guardian when the child is under 18. Fortunately, RNRB extends to the husband, wife, or civil partner of a direct descendant (including a widow/widower or surviving civil partner).

Inheriting the family home

There is no set way for a direct descendant to inherit the family home. Where there is a Will, property can pass by Residue or as a direct gift. If the person receiving the residue is a direct descendant, RNRB will apply. If someone dies without making a Will (intestate), RNRB can be claimed by direct descendants.

Where the house passes to a common law partner under a Will drafted many years ago, RNRB will be lost. It may be possible to vary the terms of the Will, redirecting the house to a direct descendant to avail of RNRB. (See section on unmarried couples below).

What about property held in trust?

RNRB is available where a property or share of a property is left to a ‘direct descendant’ as a beneficiary of one of the following trusts:

• Immediate Post Death Interest,
• Bereaved Minor’s Trust and 18-25 Trust (set up for children on death of parents),
• Disabled Trust,
• Absolute Trust/Bare Trust.

Transfers of the house to a Discretionary Trust will not work as the trustees control who receives the benefit of the house, and when.

A spouse can leave up to £1million on the second death

Despite the complexity of Inheritance Tax, it’s reasonably well understood that transfers between spouses are exempt from IHT. That being the case, where the family home passes to a surviving spouse, RNRB will not have been used. As with the basic Nil Rate Band (£325,000), if some, or all, of RNRB is unused after the first death, the survivor can have it carried across and used to mitigate tax on their estate.

As things stand, on the death of a surviving spouse, it is possible to leave assets up to £1million free of Inheritance Tax:

Nil Rate Band £325k x 2 =     £650k

RNRB £175k x 2 =                  £350k

Total =                                     £1million

Sting in the tail

It was all going too well up to now. Nearly everyone appeared to qualify for RNRB on death, but unfortunately that is not strictly true. Once the value of an estate exceeds £2million, the exemption is reduced. For every £2 over the £2million, £1 is lost. Put simply, on the first death, where the estate is valued at £2.35 million, there will be no RNRB available. On the death of a surviving partner, the available RNRB is £350,000, however an estate of £2.7million will ensure that it is wiped out.

Let’s look at a quick example of this scenario in practice:

John’s late spouse Brenda died in 2012, leaving everything to John. John dies in May 2020 with an estate worth £2.2million.

John’s basic allowance is £175,000 and his estate can carry forward Brenda’s unused allowance, also £175,000. The total allowance is therefore £350,000 but as the estate has breached £2million, the allowance must be tapered/restricted. In this instance John’s estate is £200,000 over the £2m threshold. A £100,000 adjustment reduces the available RNRB to £250,000. If the value of the house is less than £250,000, the RNRB will be limited to the lower value.

For more information on how ‘Tapering’ affects RNRB is available online.

Tax Planning

For many people, when drafting their Will, simply leaving everything to the surviving spouse is the lazy option. Unfortunately, this can place your family in a difficult situation when the surviving spouse dies.

Market increases in property values and the accumulation of wealth over the years can see the value of an estate creep over the £2million threshold.

A tax-efficient Will, where relievable assets, such as farmland or a business, are passed to family members, other than the spouse (availing of Agricultural or Business Relief), makes more sense.

Lifetime gifts to your children, when you have a reasonable expectation of surviving for 7 years, is another way to transfer assets out of your estate. People can gift £3,000 per year tax free.

Where the financial situation permits, there is the option to leave a pension pot untouched. Any death benefit paid out, should not form part of the estate, and not impact upon the value of the estate for RNRB.

In the worst-case scenario, where someone has little time left and they have not made adequate provision to ensure their estate is below £2million, there is always the option of ‘death bed gifting’. While the gift will be part of the estate as the 7-year survival test will have failed, the gifted assets will not be aggregated with the other assets in calculating the value of the estate for RNRB purposes. Bear in mind that solicitors cannot authorise such gifts without court approval and the mental capacity of the donor may be pertinent.

How an estate is valued

A person’s estate, put simply, is the sum of everything of value that they own. Certain assets can have their value reduced to nil through Business or Agricultural Relief, but in calculating the value of the estate for RNRB, Business and Agricultural Relief are not deducted.

Lifetime transfers made within 7 years of death, while they may form part of the estate, are not added to other assets in determining the value for RNRB. This is a tax planning opportunity for individuals to transfer wealth to the next generation of the family during their lifetime.

Downsizing the family home

RNRB may be available where a person downsized or sold their home to move into care. The following conditions apply:

• The person sold, gave away or downsized to a less valuable home, on or after 8 July 2015.
• The former home would have qualified for the RNRB if they’d kept it until they died.
• Their direct descendants inherit at least some of the estate.

(For detailed guidance on downsizing calculations, refer to the IHT Manual at IHTM46063).

Tax traps for unmarried couples

Where an unmarried partner inherits a share of the family home, there is no Residence Nil Rate Band available on that death. If on the second death the property passes to their children, RNRB of £175,000 will apply, however nothing can be transferred over from the first partner’s death.

If unmarried partners hold the property as Tenants in Common, each can Will their share to their child or children (direct descendants) to avail of the full exemption.

For the majority of estates, the Residence Nil Rate Band will not pose much of a problem. Most people don’t even need to claim it, providing the house passes to a direct descendant and the estate is under £2million. Where RNRB applies, the following should be kept in mind:

• The estate will be reduced by £175,000 or by the value of the house, if lower. Unused RNRB can be transferred between spouses and civil partners.
• Professional advice should always be taken when an Estate is in danger of exceeding £2million.
• Reliance on Business or Agricultural Relief to reduce the estate value to below £2million is misplaced.
• Finally, always remember, where the value of the home exceeds the £175,000 or £350,000 limits, the difference will be chargeable to IHT at 40%.
• A calculator for working out the RNRB is available online

Here to Help

For more information on Inheritance Tax and/or the Residence Nil Rate Band, please contact myself or one of the Private Client team today.