The residence nil rate band can provide valuable inheritance tax relief, but it is not always straightforward to preserve. David Downie, Technical Manager at Aberdeen Adviser, explores some of the common pitfalls that can arise when family circumstances and trust planning become more complex.
At the recent Conservative Party conference, Kemi Badenoch pledged that, if the party returns to power, it would scrap inheritance tax (IHT) on the family home as soon as the public finances allow.
It is an emotive subject and, such a change would alter the role of the residence nil rate band (RNRB), but advisers and paraplanners can only plan around the rules in place today.
That means continuing to navigate the residence nil rate band (RNRB), a valuable but sometimes complex relief, particularly when advising clients with blended families.
More complex family dynamics often require more complicated wealth transfer planning to ensure that the needs of different family members can be met.
But when it comes to the family home those plans could be further complicated when trying to make sure that the RNRB remains available
The basics
The inheritance tax residence nil rate band (RNRB) rules are notoriously complex. Broadly, an additional nil rate band of up to £175,000 may be available when a family home passes to direct descendants.
As with the standard nil rate band, any RNRB unused on the earlier death of a spouse or civil partner can be transferred and claimed on the second death.
However, the RNRB is tapered for estates worth more than £2 million. It is fully withdrawn once the estate reaches £2.35 million, or £2.7 million where a full transferred RNRB is also available.
Meaning of ‘closely inherited’
To claim the RNRB, the family home must be ‘closely inherited’. This means it must pass on death to a direct descendant, including a child, stepchild or adopted child.
For cohabiting couples, the RNRB will only be available where the property passes to the deceased’s own direct descendants, rather than to their partner’s children.
Unless the couple are married or in a civil partnership, a child from one partner’s previous relationship is not treated as the other partner’s stepchild.
For example, Paul and Emma are cohabiting, and Emma has a daughter, Olivia, from an earlier relationship. Paul and Emma own their family home as joint tenants, so it will pass automatically to the survivor on the first death. As a result, the executors of the first partner to die will be unable to claim the RNRB.
If Emma dies first and the property subsequently passes to Olivia on Paul’s death, Paul’s executors will not be able to claim the RNRB because Olivia is not treated as his stepdaughter.
This issue would be resolved if Paul and Emma married or entered into a civil partnership, as Olivia would then be treated as Paul’s stepchild.
On Paul’s death, his executors could potentially claim both his RNRB and any unused RNRB transferred from Emma’s estate.
Trusts and the family home
It is not uncommon for the family home to pass into trust on death rather than passing directly to children.
The RNRB can still be claimed where the trust immediately forms part of a direct descendant’s estate. This would be the case where a share of the family home passes into one of the following trusts;
- Absolute (bare) trust
- Disabled trust
- Bereaved minors trust or 18-25 trust
- Immediate post death interest (IPDI)
Using a life interest trust
Where both partners have children from previous relationships, they may choose to own their home in equal shares as tenants in common.
On the first death, the deceased’s share can pass into a trust created by their will. The surviving partner is given the right to live in the property for the rest of their life, after which the deceased’s share passes to their own children.
This arrangement is known as a life interest trust – or a life rent trust in Scotland – and the children who ultimately inherit are known as the ‘remaindermen’.
If the couple are married or in a civil partnership, no IHT will generally be payable on the first death. The survivor’s life interest will qualify as an ‘immediate post-death interest’ (IPDI), meaning the trust property is treated as part of their estate for IHT purposes and the transfer on the first death is covered by the spousal exemption.
On the survivor’s death, their estate will include both the 50% share they own outright and the 50% held in the life interest trust.
The executors may claim the first partner’s unused RNRB against the survivor’s own share if it passes to direct descendants, as well as against the trust share passing to the survivor’s stepchildren.
Unmarried couples do not receive the same IHT treatment. The spouse or civil partner exemption will not apply when a life interest is created for the survivor, and the RNRB available on the first death will be lost.
On the survivor’s death, the RNRB can generally apply only to the share of the property they own outright. The share held in trust will not pass to the survivor’s direct descendants because the deceased partner’s children are not treated as the survivor’s stepchildren.
Discretionary will trusts
Creating a discretionary will trust up to the value of the available nil rate band (NRB) has been a popular planning tool. Prior to the introduction of transferable nil rate bands in 2007 it ensured the NRB was not lost on the first death.
They can still play a part in estate planning today, providing some control over who ultimately benefits from the trust assets and when.
Choosing the right trustees can alleviate concerns that the settlor’s own children may not be taken care of should the surviving spouse have their own children or remarry in the future.
No RNRB will be available on any share in the family home passing into a discretionary trust even if the intention is to ultimately benefit children or grandchildren. Of course, a surviving spouse or civil partner may still be able to claim the unused RNRB against their own share of the property.
This could be an issue if the value of the surviving spouse’s share of the family home is less than the combined residence nil bands.
For example, Carl and Dawn are married and own their property as tenants in common. Carl died in May 2020 and his will left assets to the value of the nil rate band (£325,000) into a discretionary trust with the balance of the estate passing to Dawn absolutely.
At the time of Carl’s death, the family home was valued at £500,000 and his executors transferred his half share of the property (£250,000) into the discretionary trust along with savings of £75,000 to satisfy the £325,000.
Dawn sadly passed away the following year. She leaves her entire estate of £1M to their son Robert. At Dawn’s death the property was valued at £550,000 meaning her half share is £275,000. Dawn’s estate will not benefit from any transferable nil rate band as Carl’s used his NRB.
Her executor’s can still claim Carl’s unused RBRB giving a maximum RNRB of £350,000 in addition to her own standard NRB of £325,000. However, as the value of property passing to direct descendants is only £275,000 it means £75,000 of potential RNRB is lost.
This could have been avoided if on first death Carl’s executors had satisfied the NRB legacy with other assets rather than the property share.
Dawn would then own the entire property rather just half of it – more than enough to satisfy the full £350,000 RNRB saving £30,000 in IHT. If there had been insufficient other assets in Carl’s estate, this may not be possible.
However, some will trusts may allow the trustees of the discretionary trust to accept an IOU or place a charge against the property repayable on Dawn’s death.
Again, this would have given Dawn outright ownership of the property and allow her to fully utilise all the available NRBs.
Summary
The residence nil rate band can deliver an inheritance tax saving of up to £140,000 for a couple, but complex family arrangements and the use of trusts can put the relief at risk.
Careful consideration of property ownership, marital status and how the family home passes on death is essential to ensure this valuable allowance is not unintentionally lost.
Main image: comfortable living, home, cottage, England raphael-wild-yCHF-MGxvG4-unsplash
