29 Jun 2020

PET rescue: saving the IHT Residence Nil Rate Band

The Residence Nil Rate Band has it complexities. But a £350,000 tax free amount is still very welcome. This blog looks at one way to lose that benefit… and a solution to the problem.

April 2020 had “who wants to be a millionaire?” in focus with the televising of Quiz. Inheritance Tax, from 6 April, started to ask the same question as the Residence Nil Rate Band increased to hit the golden £1,000,000. Cue glitter!

Before celebrating just yet, you should be aware that the Residence Nil Rate Band has lots of quirks to it. It is much more than the initial headline grabbing “no more tax on family homes”. And with those quirks come chances to be hovering over the £1m (bet you just said that like Chris Tarrant) prize, for your final answer to take a huge chunk of it away. And unlike the game show, it is possible to lose everything. But there is a way to avoid that painful feeling of clinching defeat from the jaws of victory. A PET might just come to the rescue.

The prize
The maximum £1m tax free amount is made up of a mixture of:-
• a personal Nil Rate Band (£325,000)
• a predeceasing spouse/civil partner’s own Nil Rate Band that was ‘unused’ on their death becoming your Transferable Nil Rate Band (£325,000)
• a personal Residence Nil Rate Band (£175,000)
• a predeceasing spouse/civil partner’s own Residence Nil Rate Band that was ‘unused’ on their death becoming your Transferable Residence Nil Rate Band (£175,000)
So, £325k + £325k + £175k + £175k = £1m

How to not be a (nil rate band) millionaire
But there is a potential sting in this £1m tax relief prize. Helpfully, there is a solution to salve the pain.
For estates over £2m the Residence Nil Rate Band starts to ‘taper’ (i.e. reduce). It reduces by £1 for every £2 over the £2m.
The way in which the Residence Nil Rate Band is calculated matters to how this valuable tax free amount can be lost. And it is the method of calculating that means not only could lose your own Residence Nil Rate Band but you can also lose the benefit of the ‘unused’ Residence Nil Rate Band from a predeceasing spouse/civil partner’s estate. There is a lot (£350,000 of tax free amount) at stake.

How to lose this £350,000?
Well, let’s say you own a residence at date of death which will be inherited by children and you survived a spouse/civil partner who passed their interest in the house to you. A not uncommon situation.
These facts mean you, in principle, qualify for Residence Nil Rate Band (£175,000) and since your spouse/civil partner did not use their Residence Nil Rate Band (as it passed to you tax free), your Residence Nil Rate Band is boosted (by £175,000). £175k + £175k = £350k.
But, if your estate is over £2m the amount of the Residence Nil Rate Band is reduced, bit by bit. If your estate was £2.3m, the total Residence Nil Rate Band is reduced by half to £175,000. If your estate is £2.7m, the entire £350,000 is wiped out… and that includes the Residence Nil Rate Band ‘unused’ by your spouse/civil partner.

PET rescue… recovering the £350,000
All can be saved though. Usually when thinking about the value of an estate in inheritance tax terms, we are thinking about the estate that is subject to tax. Not so for the Residence Nil Rate Band.
The £2m threshold is based on a cruder personal balance sheet looking at purely assets less liabilities. Within that will be assets on which there is no tax (e.g. a trading business or farm). More positively, the £2m does not add back in gifts made within seven years (which can add to an inheritance tax bill).

It is unusual for inheritance tax not to add these Potentially Exempt Transfers (aka PETs) to the estate you actually hold in your name at the time of death. PETs not being included creates a solution to the £2m taper threshold.
If your estate is above £2m, then to save the Residence Nil Rate Band, making a PET should be actively considered. So long as the gift means the estate ends up below £2m, the full £350,000 Residence Nil Rate Band can be secured again.
As the PET is not added back into the estate (for the taper calculation), it does not matter when that gift is made. It could be the day before death or a year or whenever… it does not matter. The only thing that matters is that as at date of death, your personal balance sheet is below £2m. Of course, a steadier route to £2m as part of considered estate and financial planning rather than a single ‘lurching’ gift will be usually preferred.
Making a gift, the PET, can be a very valuable action. A PET could rescue the full £350,000 which means £140,000 less inheritance tax is paid by the estate. That would seem worth it.
Before making a PET (for any reason), there will be points to check. A capital gains tax liability can arise even when a gift is made. The real-life effect of a gift should also be considered… how does it affect the donor, the recipient and others in the real world beyond tax.
Residence Nil Rate Band has other quirks!
This is not the only tricky aspect of the Residence Nil Rate Band. There are many ins and outs with a tax relief which had such a simple policy slogan of no more tax on family homes.

This blog was written by Alan Eccles – alaneccles@bkf.co.uk