Inheritance tax: Extra relief for the not-so-poor

London houses
Donald Drysdale By Donald Drysdale for ICAS

13 October 2015

Donald Drysdale discusses the new legislation for a 'residential nil rate band' for Inheritance Tax (IHT), and proposals to extend this to help home-owners who want to downsize.

House prices and the 'IHT trap'

A former council house in central London, bought for £130,000, has been reportedly sold for £1.2 million.  So let's dwell for a moment on tax issues arising from the high property prices in the south east, which fuelled calls for an increase in the threshold for UK inheritance tax (IHT).

Most taxpayers are entitled to an IHT nil rate band of £325,000, allowing them to leave assets to that value on death without incurring IHT – assuming they've not already used part or all of their nil rate band on lifetime transfers.  The limit of £325,000 is to remain unchanged until 5 April 2021.

In 2007 the concept of a transferable nil rate band was introduced.  Any unused part of a deceased taxpayer's nil rate band may be added to the nil rate band of their surviving spouse or civil partner and used by them on their death, so that the effective nil rate band can become £650,000.

The bulk of many an estate consists of an owner-occupied home, and the average house price differs dramatically from place to place.  According to ONS statistics published last month, the average house price in July 2015 was £267,000 throughout the UK as a whole.  The average in London was £499,000, dwarfing the single person's IHT nil rate band and thus creating an 'IHT trap'.  Expensive houses are also found elsewhere, but average prices were only £181,000 in Scotland, £166,000 in north east England and £147,000 in Northern Ireland.

Residential nil rate band

The Budget of 8 July announced a new 'residential nil rate band', to be available when a residence (or an interest in a residence) passes to a direct descendant (that is, the deceased's child, grandchild or other direct lineal descendant) on a death on or after 6 April 2017.

The qualifying residential interest is limited to one residential property, but personal representatives will be able to nominate which residential property should qualify if there is more than one in the estate. A property which was never a residence of the deceased, such as a buy-to-let property, will not qualify.

The expression lineal descendent is defined widely.  A person's children include not only their natural children (whether or not adopted by third parties) but also their step-children, adopted children, children they've fostered at any time, and children of which they've been an officially appointed guardian or special guardian.

The residence nil rate band will be phased in, starting at £100,000 in 2017/18 and then rising to £125,000 in 2018/19, £150,000 in 2019/20, and £175,000 in 2020/21.  From 2021/22 onwards it will increase annually in line with the CPI.  Any unused part will be transferable to a surviving spouse or civil partner.

The new relief seeks to recognise difficulties faced by those living in areas of high property values, but it brings new elements of unfairness.  For example, the new nil rate band is denied to taxpayers with no children, even though they may have equal need of it – for example, on leaving their home to a sibling living with them.  Furthermore, the relief favours individuals choosing to invest in their home as distinct from other assets, and this doesn't seem to meet any compelling public interest.

Where the value of an estate exceeds £2 million, the residential nil rate band will be withdrawn at a rate of £1 for every £2 over this threshold.  Accordingly, estates over £2 million but otherwise entitled to the new relief will suffer an effective IHT rate of 60% in the margin.  For this purpose an estate is valued before deducting business or agricultural reliefs or exempt charitable bequests, and this may penalise some estates rather than others.

Downsizing relief

In another twist, next year's Finance Bill will propose that the residential nil rate band will also be available when a person downsizes or ceases to own a home on or after 8 July 2015 and assets of an equivalent value, up to the value of the additional nil rate band, are passed on death to direct descendants.

This downsizing relief aims to ensure that individuals won't be deprived of the residential nil rate band simply because they choose to downsize to a smaller, less valuable property, or because they sell their home for some other reason – perhaps on going into residential care.  It may create a need to keep records and (in some cases) obtain valuations to support claims for the relief.

The draft legislation on downsizing should be published by December, but we'll have to wait until next summer to see it enacted.  In the meantime, note that estates of taxpayers dying on or after 6 April 2017 may qualify for the residential nil rate band by reference to a home which the deceased owned before downsizing on or after 8 July 2015.

Changes to tax law can create winners and losers, and this is often an unavoidable consequence of tax simplification measures.  By contrast, it seems that these changes are making the IHT regime more complex and more divisive at the same time.

Selective extension of the nil rate band is controversial.  Readers may disagree, but giving the new relief to only certain estates, and by reference (in some cases) to former homes, adds complexities of arguable value.  An across-the-board increase in the £325,000 nil rate band might have been an easier, fairer solution, and one which taxpayers could more readily have understood.

Article supplied by Taxing Words Ltd

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  • Tax

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