The small print on new IHT rules and downsizing

Last year the Government announced measures designed to tackle the growing number of estates drawn into an inheritance tax liability through house price appreciation.

The residence nil-rate band will eventually allow up to £175,000 of property wealth per person to be passed on with no IHT liability. Added to the standard nil-rate band of £325,000, it means a couple can expect to pass on £1m free of IHT.

The allowance only relates to the primary residence of an individual who dies on or after 6 April 2017. However, it is fully or partially transferable on first death of a spouse or civil partner in the same way as the standard NRB, provided it is available.

The RNRB will be phased in, reaching £175,000 in the 2020-21 tax year (see table), and applies to residences sold on or after 8 July 2015. This is referred to as the ‘residential enhancement’. Thereafter, it is expected that the RNRB will increase in line with the Consumer Price Index measure of inflation.

While the new allowance was introduced in principle in last summer’s Budget, the small print was not clarified until the December Finance Bill.

This outlines how the RNRB will operate where a property sale (for example, downsizing in retirement) might deny the opportunity to take advantage of the additional allowance. Broadly speaking, the RNRB will still be available where a sale or downsizing means that equity unlocked in a property might otherwise be ‘lost’ from the allowance. Providing certain conditions are met the estate will still benefit from the maximum RNRB as if the individual had died while owning the original property.

So, where a downsizing occurs, how will the allowance be calculated? The downsizing addition is calculated in percentage terms with the percentage of RNRB lost owing to the sale of the property then added to the person’s residential enhancement and any unused allowance from a deceased spouse or civil partner brought forward.

The process is as follows:

Calculate the percentage of then available RNRB had the individual died with the former residence under their ownership (i.e if the transaction had never happened).

Calculate the percentage of the currently available RNRB the individual can claim based on property owned on death.

The difference between these two percentages is multiplied by the RNRB the individual is otherwise able to claim on death.

Add this amount to the person’s residential enhancement and any unused allowance from a deceased spouse or civil partner.

Example 1:
Individual A sells a property for £250,000 in 2020 and moves into residential accommodation. The RNRB is calculated as follows:

  • £250,000 property value/£175,000 available RNRB at time of sale = 1.42. The sale of the property is 142 per cent of the RNRB. The individual is therefore treated as having entitlement to 100 per cent of the available RNRB on death.
  • On death, the full £175,000 RNRB is added to the £325,000 NRB entitlement, giving the individual a total allowance for IHT of £500,000.

Example 2:

Individual B sells a home for £500,000 in 2020 and buys another for £150,000. They have a deceased spouse and a total RNRB entitlement of £350,000. When B dies the new property is worth £170,000.

By downsizing, B has potentially lost the opportunity to use £180,000 (51.43 per cent) of  the RNRB.

The calculations are as follows:

  • £500,000/£350,000 = 142 per cent. This is to be treated as 100 per cent of the RNRB available on death.
  • £170,000/£350,000 = 49 per cent.
  • £180,000/£350,000 = 51.43 per cent, multiplied by £350,000 = £178,500.
  • B has 100 per cent of the RNRB available, which means the estate can claim up to £350,000 RNRB.
  • The £178,500 ‘lost’ RNRB is added to £170,000, the value of the new property on B’s death (£348,500), which falls within the available RNRB.

If the total amount exceeds the available amount of RNRB, the amount claimable will be capped at the amount of available RNRB.

There are some other factors to be aware of, however:

Where the main residence is downsized to a lower-value property or sold so the full RNRB can no longer be claimed, the new property or an interest in the property or other assets must be left to direct descendants on death for the allowance to apply. If no assets are passed to direct descendants the estate will not qualify for an additional RNRB allowance. It is not necessary for the new residence itself to be inherited by direct descendants. The property can be left to someone else. However, at least some assets must be passed to direct descendants. The additional allowance will then be limited to the lower of the amount of RNRB lost as a result of the downsizing or the value of the property or other assets being inherited by descendants.

For example, on a £1m estate, if assets totalling only £100,000 are passed to direct descendants, only £100,000 of the RNRB can be added to the NRB. This would give a total IHT-free amount of £750,000 (assuming the full £650,000 NRB allowance is available). The sale must also have occurred on or after July 8 2015. Transactions that took place before this date are not eligible for a RNRB allowance. Only properties owned prior to this date can qualify.

Gordon Andrews is life and investments technical manager at Old Mutual Wealth