A review of the residence nil rate band and its impact on IHT planning

The RNRB, which is designed to protect the family home from inheritance tax (IHT), was fixed at £100,000 for deaths occurring in tax year 2017/18 and has been phased in gradually over four tax years at a rate of £25,000 per annum until it reached £175,000 in tax year 2020/21. In addition, those who downsize or dispose of their property before their death (for example, to move into residential care) will, in certain circumstances, be compensated for a loss of RNRB with a ‘downsizing addition’. The operation of these downsizing rules is complex and beyond the scope of this article.

Quick Links:

 

• Overview
• Fundamentals
• Transferring the RNRB between spouses/civil partners
• Tapering for estates in excess of £2m
• Protecting the RNRB
• Trusts and the RNRB
• Comments

 

Overview

Like the standard nil rate band of £325,000, the RNRB is transferable between spouses/civil partners to the extent it is not used on the first death. This means that where none of the standard rate band or RNRB is used on the first death, and the second death occurs on or after 6 April 2020, married couples/civil partners with a main residence worth at least £350,000 will be able to leave a total estate of up to £1m to children/grandchildren before any IHT is payable. This has a significant impact on IHT planning strategies for anyone with children and an estate in excess of £325,000 (or £650,000 in the case of a married couple/civil partners) – and they will undoubtedly want to structure their affairs to make the most of this important opportunity. It is thus essential that advisers are able to explain the RNRB to their clients and identify how it can be used to its full effect in any given set of circumstances.

Fundamentals

The RNRB has been phased in gradually between 6 April 2017 and 6 April 2020 on the following basis:

• £100,000 for the tax year 2017/18;

• £125,000 for the tax year 2018/19;

• £150,000 for the tax year 2019/20;

• £175,000 for the tax year 2020/21 and will increase in line with the Consumer Prices Index (CPI) in subsequent tax years.

For deaths occurring on or after 6 April 2017 the RNRB takes precedence over the standard nil rate band. However, unlike the standard nil rate band, which is available to everyone regardless of the composition of their estate or how it is left, the RNRB will generally only be available to the extent that a ‘qualifying residential interest’ is ‘closely inherited’ (an exception is where the downsizing provisions apply). 

A qualifying residential interest (QRI) is broadly an interest in a residential property that has, at some point during the deceased’s period of ownership, been occupied by him/her as a residence. Buy-to let properties cannot therefore qualify as QRI’s although a property that was once occupied by the deceased as a residence, but has been subsequently let to tenants, can be. Holiday homes – whether in the UK or overseas – could also theoretically qualify as QRI’s provided that they are within the charge to IHT and have been used as a residence from time to time by the deceased.

Where the deceased owned more than one QRI and both are given away on his/her death, the deceased’s personal representatives must nominate which one should be treated as the QRI. Clearly, they will need to make sure that the one they nominate is being closely inherited.  It is vital to remember that if no election is made no relief will be available.  There is no default provision.

A QRI will be ‘closely inherited’ if, on the death of the person who owns it (or is deemed to own it for IHT purposes), it passes to any one or more of:

• the deceased’s children or grandchildren;

• the spouses or civil partners of those children/grandchildren; or

• the widows/widowers, surviving civil partners of those children/grandchildren (provided that they have not remarried as at the date of the death of the property owner).

For these purposes, ‘children’ is given a wider meaning than usual and includes adopted, fostered and step-children; any children for whom the deceased acted as guardian while they were under 18; and the children/grandchildren of all such children.

In some cases, property settled in trust on death for persons falling within one of the above categories will also be treated as having been closely inherited (see ‘The trusts and the RNRB’ section below). Notably, however, a property that is left to a spouse/civil partner or to an unmarried partner will not be deemed to have been closely inherited but if it passes to a spouse/civil partner it will, of course, be exempt. 

Where the RNRB is available, it is offset against the value of the estate passing on death and is restricted to the value of the QRI or, if lower, the amount of the QRI that is closely inherited.

 

Example - Ted

Ted has an estate worth £600,000 including a property valued at £250,000. He dies in August 2020 (when the RNRB is £175,000), leaving a 50% share in his house to Irene (his long-term, live-in partner) and the remaining 50% to his children from his first marriage. Ted’s estate will benefit from £125,000 of RNRB. This is because the RNRB is limited to the value of the QRI that is closely inherited. Ted’s estate would, of course, also benefit from the standard nil rate band of £325,000.

Transferring the RNRB between spouses/civil partners

Like the standard nil rate band, if the RNRB is not used on the first death of a married couple/civil partners, it can be carried forward to be used on the second death. Provided the second death occurs on or after 6 April 2017, it does not matter how long ago the first death occurred.

The amount available for carry forward must be calculated in percentage terms and applied as an uplift to the RNRB amount available on the second death. Particular points worthy of note are that:

• The transferable RNRB may accrue to the survivor even if the first to die did not own a QRI; 

• Where the first death occurred before 6 April 2017, the RNRB at the time of first death is deemed to have been £100,000 and the first to die is deemed to have used no part of it – regardless of what actually happened. As a result, in these circumstances, the survivor’s RNRB will always (subject to tapering – see below) benefit from a 100% uplift.

 

Example – Tony

Tony died before 6 April 2017 leaving his entire estate to his wife Shirley. When Shirley dies, in August 2020, her estate can therefore benefit from a 100% uplift to the basic RNRB amount of £175,000 that would otherwise be available. This means that the maximum RNRB available to Shirley is £350,000. Provided, therefore, that Shirley leaves a QRI of at least this amount to her children (or other direct descendants or their spouses/civil partners), her executors will be able to claim the full amount.

If the value of Shirley’s QRI (or the part of it being closely inherited) is less than £350,000, Shirley’s RNRB will be restricted to the lower amount (unless the downsizing provisions apply). Shirley’s estate can also benefit from an enhanced standard nil rate band of £650,000.

In this example, Tony leaves his entire estate to Shirley. However, because Tony died before 6 April 2017 the RNRB result would have been the same (insofar as Shirley benefits from a full transferable RNRB) even if he had left a part of the residence to children on his death (although, of course, part of the standard nil rate band would then have been used on first death).

Where the first death occurs on or after 6 April 2017, the position will be based on the facts of what actually happened on the first death.

Tapering for estates in excess of £2m

The available RNRB is reduced by £1 for every £2 by which the deceased’s net estate exceeds a certain threshold known as the “taper threshold”. The taper threshold is currently set at £2m initially and will increase in line with the CPI from 6 April 2021. “Net estate” for these purposes means everything to which the deceased is beneficially entitled after deducting liabilities, such as loans, but before deducting exemptions and reliefs such as business or agricultural property relief. This means that business and agricultural property is included at its full value - thereby precluding many farmers and business owners from benefiting from the RNRB altogether. Equally, the fact that property may pass to a charity and be exempt from IHT has no impact on the value of the estate for taper purposes.

Tapering will also apply to reduce any transferable (or ‘carried forward’) RNRB where the estate of the first to die exceeds £2m; as well as to any addition given by reason of downsizing or disposal. Consequently, if, in the case of married couples/civil partners, the estate on the second death is sufficiently large, both the RNRB of the survivor and any carried forward transferable amount could be lost altogether. This will be the case even if the estate on the first death was below the £2m taper threshold and/or the RNRB was not used.

Example - Ruth

Ruth, a widow (who has inherited her late husband’s entire estate of £1.25m) dies in July 2021 with an estate of £2.5m that includes a main residence worth £1.6m. Her estate would ordinarily benefit from:

• A standard nil rate band of £325,000 uplifted by 100% under the transferable nil rate band rules to £650,000; and

• A residence nil rate band of £175,000 - similarly uplifted to £350,000.

However, as Ruth’s estate exceeds the £2m threshold by £500,000, the residence nil rate amount available will be reduced by £250,000 to £100,000. This means that even though her late husband’s estate was well within the taper threshold and he used no part of his own RNRB, his RNRB is effectively lost.

Her standard nil rate band is not affected by the value of her estate and the estate therefore benefits from a total nil rate band of £750,000 on her death.

Protecting the RNRB

The practical effect of taper is that for a single person who dies in the 2020/21 tax year, the RNRB will be lost altogether where the estate exceeds £2.35m. For married couples/civil partners who are leaving everything to the spouse/civil partner on first death, the corresponding figure on the second death is £2.7m (tax year 2020/21).

Wealthy clients who would otherwise be able to benefit from the RNRB may therefore want to consider taking steps to preserve entitlement to the RNRB. These could include:

• Giving away surplus income to prevent the estate from growing in value;

• Making lifetime gifts of assets other than QRIs;

• For married couples or civil partners, whose estates are individually worth less than £2m but together above the threshold, ensuring that the benefit of two RNRBs is obtained by leaving a share of the main residence (or other QRI) to children on the first death; or by leaving other assets up to the value of the standard NRB to children or to a discretionary trust on first death to reduce the amount passing to the survivor.

For a married couple/civil partners with a joint estate of £2.8m, making a joint PET of £800,000 could provide a total IHT saving of £460,000 if they both survive the PET period (although capital gains tax considerations could of course apply).

It should be noted that the value of the deceased’s estate for the purposes of the RNRB taper threshold is the value immediately before the deceased’s death. It therefore takes no account of previous lifetime gifts – even if those gifts were made within the last seven years – and even if made a short time before death.

 

Example – Norman

Norman, a divorcee, owns a house worth £1.85m, a business property share portfolio worth £500,000 and investments of £150,000. He plans to leave all his estate to his adult children, Bertie and Angela. Currently, on Norman’s death, due to the impact of the taper rules all of the RNRB will be lost. By making a gift of the business property share portfolio his estate will qualify for a full RNRB. This could result in an IHT saving of as much as £70,000 now the RNRB is fully phased in provided that the gift still qualifies for relief at the time of the transferor’s death.

Of course, death-bed planning should be viewed as a last resort – not least because there is no guarantee that the client would be mentally capable of making the gifts if planning was left to the last minute.

Trusts and the RNRB

In certain circumstances, property settled in trust on death will also be deemed to have been closely inherited. Basically, this will be where the property is to be held either absolutely for the benefit of someone falling within the extended definition of a direct descendant; or on qualifying interest in possession trusts for such a person (in other words a trust where the ‘direct descendant’ has either an immediate post-death interest (IPDI) or a disabled person’s interest). Property will also be deemed to be closely inherited where it is left to a bereaved minor’s trust or an 18-to-25 trust where the beneficiaries will, by definition, be the children of the deceased.

It is important to note that property left to a discretionary trust can never be ‘closely inherited’ - even if all the beneficiaries of the trust are direct descendants. This can have implications for will drafting, and wills made before the changes were announced should therefore be reviewed to make sure that they remain tax-efficient. In particular:

• Wills drafted prior to the introduction of the transferable nil rate band may leave the deceased’s share of the main residence to a discretionary trust on first death. In these cases, the deceased’s RNRB will not be not used (even if the only potential beneficiaries of the trust are the deceased’s children, grandchildren and their spouses/civil partners). Instead the standard nil rate band will be used and the unused RNRB will be available for transfer to the surviving spouse/civil partner (although of course any uplift in the standard nil rate band may be lost).

• If the estate of the second to die also passes to a discretionary trust, the RNRB will not then be available. This may, however, be rectified by the trustees making an absolute appointment to children/grandchildren within two years of the deceased’s death and a claim being made under section 144 IHT Act 1984.

The best advice for clients who have existing wills structured so as to leave a share of property to a discretionary trust on first death will depend very much on the size and the composition of assets in the estate.

• Wealthier clients who want to encourage their children to be financially independent may decide to postpone the age at which they inherit until later in life – 35 or even 40 is not uncommon. However, clients who do this must be made aware that the inclusion of an age contingency means that the gift is not absolute and could render the estate ineligible for the RNRB if the gift comprises or contains the deceased’s only QRI. Consideration should therefore be given to restructuring the gift to give the children either an absolute entitlement at age 25 or earlier (so that the trust falls within the definition of a ‘bereaved minors’ or ’18-to-25’ trust); or a right to income from the date of death (an “IPDI”) even if capital does not vest until much later.

• Where a surviving spouse/civil partner is to be given a life interest in the house on the first death (which is frequently the case in a second marriage/civil partnership situation), the RNRB of the first to die will not be used and will be available to the survivor on the second death under the transferable nil rate band rules. However, if the remainder interest passes to a discretionary trust, the RNRB of the first to die will be lost (unless the survivor has a separate QRI of sufficient value to utilise both RNRBs). In contrast, if the property passes absolutely to the survivor’s children (or step-children) on death of the life tenant, the property will be deemed to have been closely inherited and the RNRB – and the transferable RNRB - will be available to the estate of the survivor.

In the 2018 Budget the Chancellor announced minor technical amendments to the definition of ‘inherited’ to ensure that where a residence forms part of a person’s estate immediately before their death as a gift with reservation (so for, example, where someone has made a gift of the property but has continued to live there rent free), it will only be treated as being inherited by a direct descendant if the property was immediately within the direct descendant’s estate following the original gift.

However, in practice this change may not apply in many cases. This is because, for example, if the property is held in a discretionary trust and the donor is in rent-free occupation then this will be a gift with reservation. However, it will not immediately be in the estate of the direct descendant following the original gift given the trust is discretionary. As such, it will not be treated as inherited by a direct descendant and thus the RNRB will not be available.

Comments

For financial advisers who give clients advice on IHT planning, knowledge of the RNRB provisions is essential. The rules can be complex but provide significant IHT mitigation opportunities in the right circumstances. It will be particularly important to help clients understand how to maximise the use of the RNRB and to ensure that they refrain from action that may inadvertently result in it being lost.

Some concern has been raised in professional circles as to the complexity of the RNRB rules, particularly those on downsizing, compared to the relief they provide.  However, in its report on IHT the Office of Tax Simplification ducked the question of changes to the RNRB on the basis there was not enough experience of its operation.  Nevertheless, it did note that if the current £150,000 RNRB (for 2019/20) were to be replaced with an enlarged NRB at equal cost to the Exchequer, the NRB would increase by only £51,000 (based on HMRC estimates).

Whilst the RNRB will undoubtedly be useful to people with a potential IHT liability who are planning to leave a private residence to children or grandchildren, it is unlikely to mean the IHT liability disappears altogether and other planning will therefore frequently be necessary.