Inheritance tax – The residence nil-rate band
This article is an extract from Octopus Investments' publication "A guide to untangling inheritance tax" and it is reproduced with its permission. Read more about Octopus Investments.
The article has been written in accordance with Octopus Investments’ understanding of the law and interpretation of it at the time of publication: remember tax rules can change and benefits depend on circumstances.
A new inheritance tax allowance was introduced in 2015. But the headlines that claimed it will give people a £1 million nil-rate band need closer scrutiny.
Inheritance tax is a problem for homeowners
After years of rising house prices, more people are now facing an inheritance tax liability on their estate, thanks to the increase in the value of their home. What’s more, the current nil-rate band of £325,000 for inheritance tax is expected to remain frozen until 2021.
In 2015, acknowledging the inheritance tax problem faced by large numbers of homeowners, the Government introduced an additional inheritance tax allowance of up to £175,000 to apply to the family home in certain circumstances. However, even with this, forecasts show that HMRC’s inheritance tax receipts are expected to continue to rise.
Despite the intentions of the residence nil-rate band, the number of people who will be able to leave an estate worth £1 million completely free of inheritance tax is likely to be limited.
The residence nil-rate band
- The residence nil-rate band applies to the estates of people who die after 6 April 2017.
- You must plan on leaving a home to your children or grandchildren.
- The allowance was phased in and reached the maximum of £175,000 per person for deaths that occur after 6 April 2020 (£350,000 per couple).
- Adding this to a couple’s nil-rate band equals £1 million per couple.
- From April 2021, it will increase in line with inflation every year.
Who can claim the new allowance?
The intention is that married couples and civil partners can pass on assets worth £1 million, including the family home, without paying any inheritance tax at all.
However, not everyone will benefit, and there are a few rules to be aware of:
- As the name suggests, this allowance will apply where the person who has died owned a property that was at one time their home.
- It will also only apply if the property is being left to the deceased’s direct descendants (children or grandchildren).
- It won’t help you if you don’t own a property. Also, anyone without direct descendants, or who wishes to leave their home to someone other than a direct descendant, cannot benefit.
- Anyone without a property worth at least £175,000 per person, or £350,000 per couple, will only partially benefit.
- The residence nil-rate band will be reduced by a rate of £1 for every £2 by which the estate exceeds £2 million. This means that larger estates may not benefit.
- Anyone who disposed of their property before 8 July 2015 – for example, because they are in residential care or living with their children – will not benefit from the new allowance at all.
What about spousal transfers?
The existing nil-rate band works so that if the first spouse or civil partner to pass away leaves their entire taxable estate to their surviving partner, then the estate of the second spouse can claim a total nil-rate band of £650,000 – double the individual nil-rate band.
In a similar way, the estate of the second spouse or civil partner to pass away will be entitled to claim double the residence nil-rate band applicable in the year of the second death, where their partner’s estate did not make such a claim. The maximum amount of the claim will still be limited to (a) the greater of the allowance at the time of the second death, and (b) the value of the home owned by the deceased.
The residence nil-rate band has been flagged as allowing couples to claim £1 million of inheritance tax exemption. However, to do this, the following criteria have to be met:
- One spouse must pass away after 6 April 2020, when the £1 million maximum was reached.
- The surviving partner must own a home worth more than £350,000 when they die.
- They must leave that home to their children or grandchildren.
- Their total estate must be worth less than £2 million; likewise for their deceased spouse.
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