© Sarah Tanat-Jones

There is no tax like inheritance tax (IHT) for arousing strong emotions. Even though it is paid after fewer than one in 25 deaths, it fuels controversy that is out of all proportion to the sums it raises. Surveys suggest it is the only tax that much of the population seriously believes should be abolished.

One reason it is politically toxic is that it affects those who are not rich enough to give away many assets while they are still alive. The tax, which raises £4.8bn a year, was once described as a “voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue”. But that is not true for people whose wealth is tied up in their home.

On average, residential property accounts for a third of IHT bills. As house prices have soared, many more people are exposed to the tax. The threshold for paying IHT has been stuck at £325,000 since April 2009. If it had risen in line with house price inflation, it would now be £434,000, according to the Nationwide house price calculator.

Some of the tensions over IHT were defused in October 2007 when the government made it easier for couples to make full use of their tax-free allowances. But by the 2015 election, rising house prices were once again dragging record numbers of families into the inheritance tax net — with numbers set to double by 2020. 

David Cameron, then prime minister, promised to revive a Tory promise to raise the IHT threshold to £1m. “Inheritance tax should only be paid for by the rich,” he said. The result is the new “family home allowance” which began to be phased in from April 6. For estates that can benefit, it will end up offering a tax saving of up to £140,000.

By then, the new allowance — expected to return the number of estates paying IHT to the levels of 2014-15 — will cost the exchequer £940m a year. After 2021, the allowance is set to increase in line with the consumer price index. That means a surge in property prices would once again drag a lot more estates back into the scope of IHT. Labour, meanwhile, has promised to reverse the cut to inheritance tax. 

How the allowance will work

The new allowance — also called the residence nil-rate band (RNRB) — applies to residential property when it is left to direct descendants. It will result in an additional £100,000 of nil-rate band — the term for the tax-free allowance — in 2017-18, rising to an additional £175,000 in 2020-21. 

As a couple will have two family home allowances along with their existing nil-rate band — the £325,000 allowance — they will eventually be able to pass a £1m property to their children without attracting IHT. 

There are restrictions on who can benefit from the new allowance. Direct descendants include children, grandchildren, step-children, adopted and fostered children and their spouses or civil partners. They do not include nephews, nieces and siblings.

The RNRB only applies in cases where the home, or part of it, was owned by the deceased and included in their estate. It does not need to be in the UK, but it must have been lived in at some stage by the deceased before their death. Any outstanding mortgage should be deducted from the value of the home before working out the impact of the allowance.

The rules have been criticised for their complexity, but the basic principle is straightforward. Simply put, it means that the value of the property used in calculating an IHT bill is reduced by the new allowance. 

So if the value of the home is worth more than the RNRB, the tax should be calculated by subtracting the RNRB from the value of the property. The answer should then be added to the rest of the estate. If the total is more than the £325,000 nil-rate band, the difference should be multiplied by 40 per cent to get the outstanding tax bill. If it is less than £325,000, no IHT is due — and it may be possible to transfer the leftover nil-rate band to a spouse or civil partner.

There are many examples of varying degrees of complexity on the government’s website. But here is a very simple case. Andrew dies in May 2020, leaving his stepchildren a home worth £300,000 plus £190,000 of cash and other assets. The maximum available RNRB in tax year 2020 to 2021 is £175,000. After subtracting the RNRB from the property value, £125,000 is left. That is added to the £190,000 of other assets, making a total of £315,000. That is completely covered by the £325,000 nil-rate band, so there is no IHT to pay. In addition, £10,000 of the nil-rate band is unused and can be transferred to his wife. 

If the value of the home is less than the maximum available RNRB, the unused amount of RNRB cannot be set against the other assets in the estate. But, the unused RNRB would be available to transfer to the deceased’s spouse or civil partner’s estate when they die. In this case, its value is calculated using a percentage rather than an absolute amount, so it will increase in proportion to the growing value of the band. 

It is also worth noting that unused RNRB can be transferred if the first of a couple died before April 6 2017, even though the RNRB was not available at that time. The surviving spouse or civil partner does not have to have previously owned the home with their late spouse or civil partner, or inherited it from them.

Why big estates will not benefit

George Osborne, former chancellor, promised that IHT would be “the tax paid only by the rich” when in 2015 he announced that the allowance would be tapered away for estates worth more than £2m. The rules he introduced stipulate that the RNRB will be reduced by £1 for every £2 that the value of the estate is more than the £2m. 

As a result in 2017-18, an estate over £2.2m will not benefit from the RNRB at all. When the relief reaches £175,000 in 2020-21, the cut-off will apply to estates over £2.35m. That means that in cases where, after the first death, the allowance has been transferred to a surviving spouse estates above £2.7m will not benefit.

Here is an example. Ian dies in June 2018, leaving an estate worth £2.1m to his children including a home worth £450,000. As the RNRB is tapered away by £1 for each £2 that the estate exceeds the taper threshold, the RNRB is reduced by £50,000. The maximum RNRB would be £125,000 in 2018-19, so in this instance it is reduced by £50,000 to £75,000.

Tax planners have spotted an opportunity for some people whose estates might be affected by the taper to avoid it. While couples are commonly advised to leave all their assets to each other, a decision to leave some assets to other beneficiaries would reduce the impact of the taper on the surviving spouse’s estate. 

Up to £500,000 could be given away tax-free on the first death if the nil-rate bands were used in full. That would require a share of the family home to be left to the children or other descendants. The consequences of such a move would need to be carefully considered and in addition, it might require some extra paperwork. 

It would be necessary to hold the property as “tenants in common” to allow each spouse to control how the property passes on death. Many couples will instead hold their family home as “joint tenants” ensuring that on the first death, the house will automatically pass to the surviving spouse. If a couple wants to change the way they own the property, it may be necessary to register the change with the Land Registry. 

The £2m taper is also set to open up the possibility of “death bed” tax planning. Although gifts made within seven years before a person’s death will still fall within the IHT net these gifts are not taken into account when calculating the taper. 

Here is another example. Alice died with an estate worth £2m including a half share of a house worth £1m. She left those assets to her husband who ended up with an estate worth £3m. If he made gifts of £1m of cash to his children shortly before his death, it would reduce the value of his estate to £2m. That would mean that the full £350,000 RNRB would be available and his beneficiaries might save an extra £140,000 of tax. 

What happens after a decision to ‘downsize’?

When the family home allowance was first mooted, critics were quick to point out the risk that it might act as an incentive for older people to remain in large houses, even if they no longer needed the space. 

The government has addressed this potential pitfall by promising that those who downsize or sell their homes on or after July 8 2015 would be able to “bank” their RNRB to be used against a smaller home or against the remaining value of their estate if they were passed on to their descendants.

The downsizing provisions apply if the deceased sold their home — and either downsized to a less valuable home, or ceased to own a home — on or after July 8 2015. To be valid, at least some of the estate must be inherited by the deceased’s direct descendants. 

Only one disposal of a former home can be taken into account for the downsizing addition. If more than one home was sold between July 8 2015 and the date of death, it is possible to choose which disposal is used to calculate the downsizing addition.

The bad news is that the downsizing rules are particularly complicated. The complexity — which requires users to have an understanding of algebra — has been slammed by the Institute of Chartered Accountants in England and Wales. It argues that it is “unacceptable” to pass legislation that applies to a large proportion of the UK population, but which requires professional advice in order to understand and implement it.

But here is a simple example, which illustrates one of its quirks: the value of the relief that can be claimed under the downsizing provision is frozen at the time of the downsizing. 

John owns his own house which is far too big for his needs, so he decides to downsize and rent a property. The house at the time he disposes of it is worth £100,000. When he dies, his estate qualifies for up to the maximum residence nil-rate band of £175,000. The house from which he downsized is worth £150,000 at that time, but the executors can only claim the £100,000 as the relief was frozen at the time he downsized.

Why it might be necessary to rewrite a will

There is more than one reason why it might be necessary to rewrite a will to take advantage of the RNRB. 

People may feel they should take steps to leave the family home to their direct descendants so their estates can benefit from the new allowance. There may also be a case for redrafting wills to get rid of certain types of trusts which are not eligible for the RNRB and so could end up increasing the tax bill of estates. 

The issue is that the RNRB is only available for residential property that is given outright to descendants or to certain types of trusts, including those for bereaved minors and disabled people. As a result there may be problems in cases where property is being placed into a discretionary will trust for the benefit of the children or grandchildren.

There may also be difficulties arising from the trusts that were commonly used for inheritance tax planning more than a decade ago. Until 2007, trusts were often used to capture the value of the nil-rate band of someone who left their assets to their spouse.

Nicola Waldman, a lawyer at Hodge Jones & Allen, advises people with assets over the £325,000 threshold, and who have children, to check their wills to ensure they are taking advantage of the new exemption. She says: “My advice is for people to review their wills every few years. You can’t guarantee that a will you made 10 years ago will be appropriate now.”

In many cases, it will be possible to use “deeds of variation” to ensure estates benefit from the RNRB. These are documents that allow beneficiaries to redirect their inheritance to another person after a death.

How the rules work for unmarried couples

People who leave property to their children or other direct descendants can still benefit from the RNRB whether or not they have tied the knot. But couples who are not married or in a civil partnership will not be able to transfer any unused RNRB to each other. The same is true of the £325,000 nil-rate band.

This underlines a general point about inheritance tax: the rules strongly favour couples whose relationship is legally recognised. People who live together with a lot of assets who cannot — or choose not to — formalise their relationship can face big tax bills if they are bereaved. That is because assets cannot pass tax free between an unmarried couple — or indeed other people such as siblings who might share a home.

For example, if a jointly owned property was valued at £1m, the death of one half of an unmarried couple might leave the other with a tax bill of £70,000 on inheriting the share of the property, before savings and other assets were taken into account. (That is calculated by deducting the £325,000 nil-rate band from the £500,000 value of half the property. The resulting £175,000 is multiplied by the 40 per cent tax rate to give the answer of £70,000.)

The person who died might have had life assurance or leave enough savings — which would also taxed at 40 per cent — to pay the bill. Otherwise, the bereaved partner might be forced to rely on a concession that allows inheritance tax on property to be paid — with interest — in equal annual instalments over 10 years. Ms Waldman says: “It sounds very unromantic but the best IHT advice is to get married or enter into a civil partnership.”

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