Downsizing Relief: Cut Inheritance Tax Bill

Downsizing relief can offer homeowners an effective way to lower inheritance tax (IHT) liability, by moving to a smaller home.

In this guide, we look at what downsizing relief is, how it works and who can claim it.

 

What is downsizing relief?

 

Downsizing relief is a form of tax relief that can enable the estate of a deceased homeowner to still benefit from the residence nil rate band (RNRB) in circumstances where they had downsized to a less valuable home on or after 8 July 2015.

If someone dies and their estate is valued at more than the basic nil rate band (NRB) of £325,000, their estate may qualify for the RNRB before any IHT falls due. The RNRB is an additional £175,000 tax-free allowance for residential property owners that can be offset against any tax payable on their estate after they die. This means that where someone dies, provided qualifying residential property forms part of their estate, the combined thresholds of up to £500,000 can pass on death tax-free, representing an ideal way of legally reducing liability to IHT. Both the basic and residence nil rate bands are fixed until 5 April 2028.

The tax relief rules also provide that any unused amount from the estate of a pre-deceased spouse or civil partner can be transferred. The net effect of the transferable nil rate band (TNRB) and transferable residence nil rate band (TRNRB) rules is to double the amount of money, up to £1 million tax-free, that a surviving spouse or civil partner can leave behind on their own death to any direct descendants, such as any children or grandchildren.

In the case of both a single homeowner or surviving spousal homeowner, where their estate is valued at less than the relevant thresholds, so either £500,000 and £1 million, there will be nothing to pay by way of IHT. It is only once the value of an estate exceeds these thresholds that tax will become payable on anything over, typically at a rate of 40%.

 

What does downsizing relief do?

 

In broad terms, downsizing relief in the context of the RNRB means that the additional residence nil rate band will still apply if the deceased downsized to a less valuable residence in the last few years, or if they sold or gave away a residence. The downsizing addition essentially allows the deceased’s estate to claim back the amount of RNRB that it would have been entitled to had the deceased not made the decision to downsize or sell.

The RNRB itself is designed to make it easier for people to pass on their family home without loved ones facing a huge tax bill or being forced to sell up to pay that bill. The downsizing rules are designed to extend that relief where a former residence has been sold, for example, where the family home has become too big, as is often the case, ensuring that the deceased’s estate still benefits from the tax relief available to other qualifying estates.

In later life, many people choose to move to smaller and more manageable properties. In recognition of this, the UK government made specific provisions to preserve the availability of the RNRB where the deceased has, on or after 8 July 2015, downsized to a less valuable residence and left assets or money of an equivalent value to direct descendants. The relief also applies where the deceased had sold their residence or otherwise ceased to own a residence having moved into a residential home or having gone to live with a relative. In this way, the elderly are not obliged to retain larger homes they would struggle to maintain.

 

How does downsizing relief work?

 

In the UK, IHT is payable on a deceased’s estate on anything over and above the basic nil rate band of £325,000, typically at a rate of 40%. This means that where the net value of the deceased’s estate falls below this amount, the beneficiaries under any Will, or the rules of intestacy where the deceased died without making a Will, will not incur any tax liability.

However, even where the net value of an estate exceeds this threshold, any additional amount can potentially be reduced by applying the residence nil rate band, increasing the overall amount that a person can leave to a loved one on death tax-free to up to £500,000.

The downsizing relief rules simply mean that even where the deceased downsized to a less valuable home, or where they sold or gave away their home, an estate will potentially remain eligible for the proportion of the residence nil rate band that is foregone as a result of downsizing or selling the residence. As such, the RNRB will be preserved where:

the deceased downsized to a less valuable residence and that residence, together with assets of an equivalent value to the lost RNRB, have been left to direct descendants the deceased sold their only residence and the sale proceeds or other assets of an equivalent value to the lost RNRB have been left to direct descendants, or the deceased otherwise ceased to own their only residence, and other assets of an equivalent value to the lost RNRB have been left to direct descendants.

 

When can downsizing relief apply?

 

When someone has downsized to a less valuable home before they die, their estate may still be able to get the RNRB if they qualify for a downsizing addition. This may also be the case where someone has sold or given away the property in question. However, all of the following qualifying conditions must be met for downsizing relief to apply:

• the deceased sold, gave away or downsized to a less valuable residence on or after 8 July 2015
• the former residence would have qualified for the RNRB if the deceased had kept it until they died, and
• the deceased’s direct descendants inherit at least some of the deceased’s estate.

As long as these qualifying conditions are met, there is no limit on the period between the downsizing and date of death. Further, the individual can have downsized any number of times since 8 July 2015 without impacting the availability of the additional RNRB.

 

Qualifying rules for RNRB?

 

To qualify for the RNRB, immediately prior to the person’s death, an estate must include a ‘qualifying residential interest’. The property in question must also be ‘closely inherited’.

 

A qualifying residential interest

 

A ‘qualifying residential interest’ refers to a residential property that the deceased owned and lived in as their home, although it does not need to be the deceased’s main home, or even have been lived in or owned for a minimum period of time. The person also does not need to be living in the property at the time of death, provided it has been used as a residence at some point during their lifetime. A property that the deceased owned, but never lived in, such as a buy-to-let, is not a residence and will not qualify for the RNRB.

Under the RNRB downsizing relief rules, any ‘qualifying residential interest’ is referred to as a ‘qualifying former residential interest’ (QFRI).

 

A property closely inherited

 

In addition to the residence being owned by the deceased, that residence must be ‘closely inherited’ for the estate to benefit from the RNRB. This means that the property, or a share of it, must be passed to a direct descendant, such as the deceased’s children, grandchildren or other lineal descendant. This also includes the spouse or civil partner of a lineal descendant, including any widow(er) or surviving civil partner, provided that they have not remarried or entered into a new civil partnership before the deceased’s date of death.

So long as a residence is left to direct descendants, it does not matter how they inherit that property. The deceased’s home could be left to adult children as a specific legacy in a Will, or it could be included in what is left of the estate after specific legacies have been taken into account, where the home does not have to be expressly referenced. It can also include where a person dies intestate, but direct descendants inherit under the intestacy rules.

 

How is downsizing relief calculated?

 

There is a useful online calculator at GOV.UK when working out and applying the residence nil rate band. This calculator can be used to work out how much RNRB the deceased’s estate may get and the residence nil rate band if a person downsized or sold their home.

To use this calculator, you will need to have:

• an IHT400 account form with the value of what is in the deceased’s estate already worked out
• an IHT435 form if you have already started filling one in
• a completed IHT436 form if you are transferring any unused additional threshold from another estate, where the calculator can also be used to work out any unused RNRB for transfer to the estate in question.

Essentially, the value of the deceased’s estate, including all money, possessions and property, will need to be fully worked out before using the online calculator. This is because RNRB and its downsizing relief is not a form of tax relief on the value of a residence itself, but rather it will be set-off against the entire taxable estate, so that the whole estate shares the benefit of this relief. Applying downsizing relief can be complex, not least where the deceased’s assets are left to a mixture of direct descendants and others, where it strongly advised to seek professional advice when working out either RNRB or downsizing relief.

 

How to claim downsizing relief

 

To claim the downsizing allowance, the deceased must have disposed of a former residence and either downsized to a less valuable property, or ceased to own any property, on or after 8 July 2015. The former residence must also have qualified for the RNRB if it had been kept until death and at least some of the estate must be inherited by the deceased’s direct descendants. Provided these conditions are met, a claim for downsizing relief can be made.

When claiming the RNRB downsizing addition, details of the amount to be used and any supporting information should be set out on the IHT400 account form and form IHT435. If there was more than one residence in the deceased’s estate, only one of these residences can be taken into account, although the executors or personal representatives can nominate which residence that they wish to be taken into account on the relevant form.

Importantly, however, when assessing IHT on property for estates with a net value of more than £2million, there is a tapered withdrawal of the residence nil rate band and its downsizing relief. This means that the amount of available relief is reduced by £1 for every £2 of value by which the estate exceeds the tapered threshold.

 

Downsizing relief example

 

When it comes to the liability of an estate to IHT, downsizing relief is an often under-used form of relief that preserves the value of the residence nil rate band, in this way minimising the amount of tax payable on a deceased’s estate and maximising what can be left tax-free to loved ones after someone dies. The following example illustrates how downsizing relief can work in practice to help avoid inheritance tax or reduce any IHT liability altogether:

A widow sells her house in 2018 for £400,000 and moves into residential care, before dying in 2022. On her death, she leaves behind £650,000 in investments and £350,000 in cash to her adult children and grandchildren. As she has inherited her husband’s £325,000 NRB, she has a total NRB of £650,000, which means that the investments can be passed to the family entirely tax-free. Still, the family wrongly assumes that the RNRB was lost when the widow sold her home, and so pay £140,000 in IHT (40% of £350,000). If they had applied for the RNRB downsizing addition, it is likely that they would not have paid anything.