Family homes worth up to £1m could be passed on inheritance tax free – as long as you understand the rules
Individuals need to check their wills to avoid missing out on £70,000 of new inheritance tax breaks.
The introduction of the new residence nil rate band, or the family home allowance, means many wills are out of date – and people will not benefit from the new tax break. The residence nil rate band allows couples to pass on a £1m family home free of inheritance tax.
From April 6, each individual can claim an additional allowance of £100,000 to offset the sale of a family home on death, on top of their existing £325,000 inheritance tax exemption. This increases by £25,000 each year until it reaches £175,000 in April 2020.
For a couple this means a £1m family home can be left tax free. However, the rules around how the new tax break will work are so complicated experts warn many individuals could be caught out.
“The conditions to qualify for the residence nil rate band are such that careful will drafting is required to ensure individuals and their spouses qualify,” said Karen Clark, tax partner at RSM, the accountancy firm.
What do I need to change in my will?
Those who use the family home allowance have a £2m limit. This means that if the estate is worth more than £2m individuals start to lose the tax relief, at a rate of £1 for every £2 over the limit.
Assuming the full relief is in place in 2020, once an estate has reached £2.35m it will lose all the home allowance relief. This is increased to £2.7m for a couple – taking into account the second person’s £175,000 family home allowance.
Wills where someone is passing everything to their spouse – the most common set-up – could be caught out by this limit.
For example, a couple each have an estate, including cash, investments and property, worth £1.5m. If everything passed to the spouse on first death, the surviving spouse would end up with a £3m estate, wiping out any of the home allowance benefit. Once the full home allowance takes effect, in April 2020, this represents an additional IHT bill of £70,000.
Instead, assets can be passed on to other beneficiaries on first death, helping to reduce the total estate size, and maximise the family home allowance.
It’s not just wealthy people that can fall foul of the rules, said Ms Clark.
“A typical person living in London and the south-east with a very valuable property, may well have bought it quite cheaply in the 70s and 80s but it has gone up massively in value.
“They might not have lots of other assets to pay an inheritance tax bill of that size.
“Some ordinary people could have a fairly modest three-bed semi in the suburbs. It is not hard for it to be worth £1.5m.”
The family home allowance applies only if you pass the property to direct descendants – typically children or grandchildren.
“It is no good leaving the family home to charity, or stipulating the executor sells the family home and gives the proceeds to charity,” said Ms Clark.
In a scenario where individuals have cash, investments and property in their estate, they should prioritise the investments or other assets going to charity and the property going to children.
Selling your home to go into care
Individuals who downsize or sell their home to fund care do not miss out on the tax break.
In this situation individuals get an “inheritance tax credit”. This means they get the tax break equivalent to the value of their original home.
However, both the lower-value property they moved to, if downsizing, and any remaining proceeds from the sale of the house must go to direct descendants.
For example, if an individual has a property worth £1m and downsizes to another property worth £500,000, the original £1m sum will be eligible for the family home allowance, but only if both the £500,000 property and any remaining assets from the sale of the original home are passed to children or grandchildren.
In the same example if the individual had sold the £1m property and gone into care, any remaining proceeds of that sale would need to be left to direct descendants.
The rule applies only to deaths after April 6 this year, but there is no time limit between the sale of the property and death.
“It is horrendously complicated, I think this is an area we might see some challenges from HMRC,” said Ms Clark.
Owners of more than one property
Individuals who own more than one property can select their main residence for the allowance.
This should be the most valuable property, and should be stated in the will. Buy-to-let properties will not count, but the home doesn’t have to be the one the individual or couple spent most time in.
Rising property values
“Make sure you do use the residential nil rate band on the first death,” said Ms Clark, as you could lose it.
Another pitfall to watch out for is the impact rising property prices may have on the estate.
The £2m limit means that if property prices rise to push the estate beyond that level between first death and second death, some of the allowance could be lost.
If on first death half of the property is passed to children or grandchildren, the family home allowance can be used at that point.