New inheritance tax rules: everything you need to know
Much fanfare has been made of the new inheritance tax (IHT) allowance for main homes, which will reduce IHT liability for many people when it is introduced in April.
The so-called residence nil rate band (RNRB) will be in addition to the existing allowance of £325,000 per person or £650,000 for married couples and civil partnerships, and will eventually allow an extra £350,000 worth of IHT-free allowance per couple. However, it is not here yet and will be phased in over three years.
The new allowance will start at £100,000 in the tax year 2017/2018 and rise to £125,000 in 2018/2019, £150,000 in 2019/2020 and £175,000 in 2020/2021. Over the next three years, the rate applicable will be the rate at the date of the person's death.
Partners will continue to be able to transfer assets to each other without being liable for IHT and, like the primary allowance, any unused residence nil rate band allowance from the first partner to die can also be utilised by the survivor.
Ultimately, the RNRB, together with existing IHT-free allowances, will have the effect of lifting main family homes worth up to £1 million out of inheritance tax.
This is because a married couple or civil partnership will be entitled to £650,000 (their £325,000 allowance rolled together) plus £350,000 (two times £175,000 rolled together), which equals £1 million in total.
Naturally, there are stipulations. The property must be left to direct descendants, including stepchildren, adopted children and foster children, and their descendants, but not for instance nieces and nephews.
An estate will only be entitled to the RNRB if a home has been owned, and the property's value for RNRB purposes will be its open market value less any liabilities secured on it, such as a mortgage.
If the value of the home (or share of that value) being inherited by direct descendants is below the maximum available RNRB, the amount of the RNRB will be limited accordingly.
The allowance cannot be used for passing on a buy-to-let property, but it does not have to be a person's current main home or have been owned by them for a minimum period. Personal representatives can nominate which residential property should qualify if there is more than one in an estate.
People whose estates are worth more than £2 million are penalised, however, because the additional allowance is gradually withdrawn, tapered at a rate of £1 for every £2 an estate is worth over this limit.
When an estate exceeds £2.7 million in total, the RNRBs are lost altogether. An estate includes savings and investments, car, land, jewellery and artefacts, so its value can quickly mount up.
So for example, from 6 April 2017 when the RNRB is £100,000, a £2 million estate where the property was originally owned by a couple will benefit from the full £200,000 allowance (as well as the £650,000 NRB), leaving just £1.15 million liable to inheritance tax at 40 per cent, or £460,000.
The measures sound simple but are ferociously complex, however, and a lot of commentary in the press is wrong.
Even the Institute of Chartered Accountants (the ICAEW) has complained about the measures, saying HMRC's decision to demonstrate them with no fewer than 18 case studies 'merely proves the unacceptable complexity of this legislation'.
In particular readers should note there are complications in calculating the taper when the first of a couple to die leaves an estate greater than £2 million, and in working out the downsizing scenario when the RNRB has already been transferred.
What can be done to make the most of the allowance? People with estates over £2 million might consider setting up a trust on the first death to try to keep the remaining estate within the £2 million limit.
Those who wish to benefit from the new allowance should try to use any IHT-exempt assets efficiently, for example by ensuring lump sum death benefits from life assurance policies, pensions and employer schemes do not fall into their estates.
However, this is not all cut and dried. For example, pension pots typically fall out of the scope of IHT; under April 2015's pension freedoms rules, if a person dies before age 75 then any remaining fund is passed on tax-free, and if the person dies aged over 75 then that money can be left to anyone they choose, and the beneficiaries pay tax on it at their marginal rate.
But HMRC may take exception to attempts to take a disproportionate amount of cash out of the IHT net by hiding it in a pension, and may challenge this, particularly if you make large pension contributions and die within two years, or if you transfer and consolidate various pension pots and die soon after.
There are special provisions for certain property that is itself IHT-exempt, such as buildings that qualify for business property relief or agricultural land, and these provisions also count towards the residence allowance.
Much has been said recently about whether the elderly should disinherit their children and instead leave their wealth to their grandchildren, to help the struggling younger generation pay off student debts and to get a toe on the property ladder.
The idea is that the in-between generation skips having to pay any inheritance tax at all on this portion of the family's wealth. In the US, a 'generation-skipping tax' preventing this was introduced back in the 1970s, but it is still possible in the UK without penalty.
This can also be achieved via a 'deed of variation'. It allows an adult beneficiary of a will to divert some of their gifts to other family members. This can be done at any time up to two years after a person's death.
More broadly, it is worth considering whether such an inelegant solution to the problem of rising house prices will stand the test of time.
The measure was introduced to satisfy the Conservative manifesto pledge before the 2010 election to raise the IHT threshold for a married couple to £1 million, as steep house price rises had hit Tory voters in the home counties.
The stated plan is that after 2021 the allowance will rise in line with the consumer prices index, which will make the £2 million taper threshold issue even more pronounced over time, as the residence allowance rises but the threshold remains fixed.
Ironically, probate fees are set to rise steeply from the current flat £215 for all estates worth £5,000 or more. The new lower rate will be £300 for those inheriting £50,000 to £300,000, rising to £12,000 for estates worth £1.6 million-£2 million, and to £20,000 for estates worth £2 million-plus.
HOW IHT AND THE NEW RNRB WILL WORK TOGETHER
- Inheritance tax is imposed at 40 per cent and paid out of an estate before assets are passed on.
- The nil rate band can currently be transferred to any surviving spouse or civil partner, irrespective of when the first of the couple died. The main RNRB will also be transferable where the second spouse or civil partner dies on or after 6 April 2017, irrespective of when the first of the couple died.
- To ensure that the elderly are not dissuaded from moving to smaller properties or entering a care home, anyone who has downsized from 8 July 2015 onwards can claim an inheritance tax credit, but will need to keep evidence that it was their main home.
- If you decide to downsize and use the allowance for the part of your estate equal to the value of the proceeds from the sale of that home, you can't then use any remaining allowance on your new, smaller home as well, as the bands are restricted to one property.
- If a home is held in a trust for a person's benefit before their death, for example an interest in possession trust giving a person the right to live in the family home following the death of their partner, then the home is held in a trust for their lifetime and included in their estate for IHT purposes. The home will no longer be in the beneficiary's estate if the trust comes to an end during the beneficiary's lifetime, for example if it is designed to end should the surviving spouse remarry.
- To qualify for the RNRB, the home must be inherited by direct descendants on the surviving partner's death.
- If a home is held in a discretionary trust, the home wouldn't normally form part of a person's estate or be eligible for the RNRB. However, a property in a discretionary trust may still qualify for the RNRB if the trust meets certain conditions, for example if it was set up for a disabled beneficiary or for children under 25.
CASE STUDY 1
How the RNRB can be transferred
Mr Smith died in 2015 and left his entire estate to his wife, and 100 per cent of his RNRB is therefore available to transfer to his wife's estate.
Mrs Smith dies in July 2019 and leaves her estate, including a home worth £400,000, to her daughter.
On Mrs Smith's death, the maximum available RNRB is £150,000.
Her executor makes a claim to transfer the unused RNRB from her late husband.
So the total available RNRB for Mrs Smith's estate will be £300,000 (£150,000 + (100% x £150,000).
CASE STUDY 2
How the RNRB is tapered
Mr Jones dies in the tax year 2018/19, leaving an estate valued at £2.1 million to his children, including a home worth £450,000. The maximum RNRB that tax year is £125,000.
The RNRB is tapered away by £1 for each £2 that the estate exceeds the taper threshold of £2 million. So the RNRB is reduced by £50,000, to £75,000.
If the value of Mr Jones's estate was £2,250,000 or more, the RNRB of £125,000 would be tapered away completely.