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The rules around inheritance tax are largely seen as draconian and unfair – so it may surprise you to know there’s one little-used break that lets you cut your IHT liability against your home, even if you no longer own it.
Most families don’t realise that by using “downsizing relief” the value of a previously owned home can be used to offset IHT. The only catch is that the total value of your estate cannot be more than £2.7m.
The inheritance tax threshold – technically known as the nil-rate band – has been frozen at £325,000 for years, allowing the Government to rake in record amounts from a tax that was supposed to only catch the rich.
That makes it all the more important to understand and make the most use of the additional “residence” nil-rate band, sometimes called the “family home allowance”. You might be surprised at how helpful it can be.
Everybody is entitled to the main nil-rate band and since 2008, on the first death of a married couple, the unused proportion of any relief can transfer to the survivor. This applies whenever the death of the first spouse occurs, even if this was before 1975 when IHT was originally introduced as “capital transfer tax”.
For civil partners, the same applies except that the first death must have occurred on or after 5 December 2005, the date the Civil Partnership Act became law in the United Kingdom.
In October 2007, George Osborne promised to raise the IHT threshold to £1m and “take the family home out of inheritance tax”. It didn’t work out like that but his promise is nevertheless the reason we now have the family home allowance.
The basic principle is that, with some limitations, you can now claim an additional £175,000 nil-rate where you pass your home on to your direct descendants at your death. This includes your children and grandchildren, including a stepchild or foster child.
The property will usually transfer through your will but it could also apply if a deed of variation is made following death that has this effect. As with the nil-rate band, any unused family home allowance at the first death can also transfer to the surviving spouse, referred to as the “brought forward” allowance.
However, care is required because a transfer of both the nil-rate band and family home allowance has to be claimed within a two-year time limit. The family home allowance applies to the entire estate on death and is not relief on the home itself.
It therefore reduces the total IHT liability on death. In addition, the family home allowance is applied first in the calculation which means that as long as your property is worth more than £350,000 at death a couple could have combined reliefs up to the £1m promise made by Mr Osborne.
How ‘downsizing relief’ works
Despite this general principle, the property does not necessarily have to remain as your home when you die. As long as it has qualified as your home in the past, the relief can still apply.
In later years, many people outgrow their homes and need to downsize. In addition, about 15pc of those over 85 end their days in care homes. Fortunately the rules recognise this with “downsizing relief”. This can apply if you owned your home after 7 July 2015 and which you then sold in order to downsize or to move into a care home.
At your death, you must have sufficient assets that pass to your direct descendants, but helpfully there is no requirement to demonstrate that these assets arose directly from the sale of your home. The key requirements are that a property must have been your home at some point after 7 July 2015 and was sold before you died. Note that you have to claim downsizing relief, it is not applied automatically.
Estates worth more than £2.7m do not qualify
Unfortunately, there are some detailed rules to consider. Firstly, the family home allowance amount was introduced in stages, starting at £100,000 in tax year 2017-18 and increasing in £25,000 stages over the following three years.
Secondly, the relief is restricted where the whole estate, not just the property, exceeds £2m. Above that amount the relief reduces at £1 for each £2 of the excess. It means that with a brought forward allowance from your spouse, estates above £2.7m will not qualify. This £2m threshold can be relevant at the first death as well because it could restrict the amount of relief carried forward.
The downsizing rules are complicated but they could play an important part in planning your affairs.
If you think you might benefit from downsizing relief and the family home allowance and want to find out more about it, you should search for IHTM46000. This will take you to the HMRC manuals which include some helpful examples.
Finally, spare a thought for your executors. The transferrable reliefs, including downsizing, have to be claimed. For that, the executors will need to provide evidence for HMRC, and the person they would most like to speak to has inconveniently just died.
Please keep your intended executors fully informed well in advance and give them all relevant documents. This applies particularly for downsizing where you may need details of all assets and liabilities at the time the property was sold.
Have a question for Mike? Email taxhacks@telegraph.co.uk
The little-used ‘downsizing loophole’ that cuts inheritance tax
Worth less than £2.7m? This break can reduce liability against your home