The residence nil-rate band, often referred to as the inheritance property tax allowance, was introduced in 2015. While there are certain conditions, this offers the opportunity to significantly reduce, or even eliminate, inheritance tax on your home upon your death. You can use the allowance in conjunction with your traditional inheritance tax (IHT) allowance to shield up to £500,000 of your estate from taxation.
The maximum residence nil-rate band is only available to estates valued at less than £2 million. The allowance will reduce by £1 for every £2 your estate is above the £2 million threshold.
What is the current residence nil-rate band?
In March 2021, the Chancellor, Rishi Sunak, announced that he would freeze a range of tax allowances until 2026. Consequently, the IHT allowance has been frozen at £325,000 and the residence nil-rate band at £175,000.
How does the residence nil-rate band work?
Initially introduced in 2015, the new allowance could mitigate potential inheritance tax on the family home when left to direct descendants. Before the new allowance, as property is a relatively liquid asset, many beneficiaries were forced to sell the family home to cover tax liabilities. While a handy allowance, this is still below the average UK house price of £231,068 shown in the Nationwide House Price Index. However, it is also possible to inherit the residence nil-rate band of your partner upon their death.
A basic example of the residence nil-rate band in operation (assuming you left the family home to a direct descendant):
Value of estate upon death: £500,000
Including family home: £175,000
Value of estate excluding family home: £325,000
IHT allowance: £325,000
Inheritance tax liability: £0
Value of family home: £175,000
Residence nil-rate band: £175,000
Inheritance tax liability: £0
It is important to note that assets valued over and above the tax-free element will attract inheritance tax of 40%. The only exception is a transfer of assets between spouses and civil partners, which are exempt from inheritance tax. However, the assets would be inherited at their original cost, which may have consequences for future capital gains tax.
Transferring family home to direct descendants
As we touched on above, one of the main conditions regarding the residence nil-rate band is that the beneficiaries must be direct descendants. This includes:
- Adopted children
- Fostered children
- Other lineal descendants
It is important to note that assets left to a spouse/civil partner are free of inheritance tax and do not utilise any IHT or residence nil-rate band allowances. There are scenarios where upon the death of a spouse/civil partner, you may be able to inherit secondary IHT and residence nil-rate band allowances. In theory, you could double your estate protection from £500,000 up to £1 million.
Inheriting a spouse/civil partners allowance
Traditionally, the first spouse/civil partner to pass away would leave the bulk of their estate, including the family home, to their surviving partner. As a surviving spouse/civil partner, you can also inherit any IHT/residence nil-rate band allowance not utilised by the deceased. In theory, you could increase your estate tax-free exemption to:
2 x £325,000 = £650,000
Residence nil-rate band
2 x £175,000 = £350,000
Total = £1 million
Therefore, you could leave the following assets to beneficiaries with no inheritance tax liability:
- £650,000 in assets excluding the family home
- Family home to the value of £350,000 if left to a direct descendant
It is crucial to be aware of the allowances available and the fact that you can inherit those not used by your deceased spouse/civil partner. Compared to the allowances available for an individual, the potential cost savings are up to £200,000 (40% of £500,000) when inheriting allowances.
Tax planning is vital
When the Chancellor announced IHT and the residence nil-rate band were to be frozen until 2026, this went relatively unnoticed by many. However, this is a very cunning tax ruse commonly referred to as "fiscal drag". How does this work?
This example will focus on the family home and assume that other assets left in your estate maximise the IHT allowance. As an individual, the maximum residence nil-rate band is £175,000. If we assume annual property price inflation of 4%, and an initial value of the family home of £175,000, the situation would be as follows:
|Tax year||Property value||Residence nil-rate band||Excess||Taxation at 40%|
If the allowance increased by 4% each year, there would be no excess over the residence nil-rate band. As a consequence, no inheritance tax to pay. However, simply freezing the allowance until the tax year 2025/26 has created a potential additional IHT charge of £11,890. Assuming that the value of other assets, coming under the IHT allowance, also increased in line with inflation, the additional IHT burden could be even more significant.
Take professional advice
When undertaking an annual review of your finances, it is critical to consider inheritance tax and the residence nil-rate band. Many people only look at these allowances towards retirement and later life. However, there are numerous ways of mitigating potential taxes on your estate, many years in advance of your death.
The subject isn't the easiest to broach with a partner and family members, but it should be under constant review. Even though the residence nil-rate band's introduction has proved extremely useful, a single allowance is still well under the value of an average family home in the UK.
When you also consider the average London property was worth £501,320 in December 2020 (UK government figures), this puts into perspective the importance of long term tax planning.