The £1million Inheritance Tax allowance misconception

It is a common misconception that there is a blanket Inheritance Tax (IHT) allowance of £1 million.

Whilst a cumulative IHT allowance of £1million may apply to married couples and civil partners, there are a number of requirements to reach this figure, which, if not considered, may lead to a sizeable and unforeseen IHT charge on death, leaving loved ones receiving less than intended.

Subject to applicable IHT exemptions (such as the spouse and charity exemptions), if the net value of an estate exceeds the available IHT allowances, then a 40% IHT charge will apply. It is therefore important to be aware of what allowances are likely to be available to your estate, so that you can determine how much IHT might be due and consider lifetime tax planning measures accordingly.

The Nil Rate Band and Transferable Nil Rate Band

Broadly speaking, each individual benefits from an IHT allowance of £325,000, known as the Nil Rate Band (NRB).

The full NRB may not be available on death, as the value of lifetime gifting is brought back into the deceased’s estate for IHT purposes. To see how lifetime gifting interacts with and can erode the NRB, please see this article.

If the estate of the first person in a marriage or civil partnership to die does not use all of their NRB, for example, if the value of their estate is within the available amount, or some or all of their estate was covered by an IHT exemption, the portion of unused NRB can be transferred and used on the survivor’s death in conjunction with their own available NRB. This is known as the Transferable Nil Rate Band (TNRB), and this is only available to couples who are married or in a civil partnership.

For example, if on the first death of a married couple, the whole estate passes to the surviving spouse, then the spouse exemption would apply to the entire estate, regardless of its value, and none of the NRB would have been used. On the surviving spouse’s death, their own NRB and their spouse’s TNRB would be available (subject to lifetime gifting), potentially totalling a maximum IHT allowance of £650,000.

The Residence Nil Rate Band and Transferable Residence Nil Rate Band

In addition to the NRB and TNRB, a further IHT allowance of up to £175,000, known as the Residence Nil Rate Band (RNRB), may be available if certain criteria are met.

1. The estate includes a qualifying residential interest

In order to claim the RNRB, the deceased’s estate must include a qualifying interest in a residential property that has, at some point, been occupied by the deceased as their home.

The property does not need to be the deceased’s main residence at the date of death, nor does the deceased need to own only one property. However, buy‑to‑let or investment properties that have never been occupied by the deceased will not qualify.

Downsizing relief may apply to preserve the availability of the RNRB where the deceased had downsized or even sold their property and subsequently ceased to own an interest in a residential property. Such rules should be carefully considered, and advice should be sought if you wish to rely on this relief.

2. The qualifying residential interest was closely inherited

The qualifying interest in a residential property must be inherited by a direct descendant, either outright or via certain types of trusts, with the following most commonly qualifying as direct descendants for these purposes:

• children (including adopted, fostered and stepchildren)
• grandchildren or remoter issue, such as great-grandchildren
• the spouses of such children, grandchildren and remoter issue.

If the qualifying interest in a residential property is inherited by siblings, nieces/nephews, parents, or unrelated individuals, the RNRB will not apply.

If the RNRB is available to an estate, it is possible to transfer any unused RNRB from a predeceased spouse or civil partner’s estate as well. Once again, this further Transferable Residence Nil Rate Band (TRNRB) is only available to couples who are married or in a civil partnership.

The TRNRB provides a further inheritance tax allowance of £175,000, but it is important to note that the value of the combined RNRB and TRNRB is limited to the value of the deceased’s property interest. Therefore, whilst the combined allowances ostensibly provide a further tax-free amount of £350,000, if the deceased’s home was worth, say, £200,000, the allowances would be limited to this amount.

Even where the criteria for the RNRB have been met, the deceased’s available RNRB may be subject to a taper and eroded away due to the value of the estate.

Where the net value of the estate exceeds £2million, the RNRB is reduced by £1 for every £2 over that threshold. Once the net value of the estate reaches £2.35 million (or £2.7 million where a predeceased spouse or civil partner’s TRNRB is also available to the estate), the RNRB is lost entirely.

Therefore, where an individual’s estate has a net value of over £2million, there is often scope for lifetime planning to be implemented to ensure that the RNRB is preserved. Giving away assets can reduce the IHT payable on your death, both by reducing the size of the estate that is subject to tax and also by bringing the value of the estate within the RNRB threshold in order to benefit from the maximum allowances.

Conclusion

If, on the death of a surviving spouse or civil partner, the NRB, TNRB, RNRB and TRNRB allowances are all available in full, then the total IHT allowance available will reach the much-coveted figure of £1million, but as detailed above, the estate will need to meet numerous requirements for all of these allowances to be available.

With recent budget measures introduced to further freeze the NRB at £325,000 and RNRB at £175,000 until 2031, more estates are suffering from the effects of fiscal drag and becoming taxable estates for IHT purposes.

The Birketts view

Birketts’ private client advisory team can advise individuals and families on their current exposure to IHT, the available allowances in the circumstances and how lifetime planning, wills and post-death variations can be used to mitigate against IHT and ensure IHT allowances are preserved.