IHT: The Gift That Keeps On Giving (Even If You Downsize)

The downsizing allowance, which can reduce inheritance tax (IHT), is little used but can prove valuable to homeowners who utilise it to its full advantage.

The residential nil rate band (RNRB) allows an individual’s residential property to be exempt from IHT if it’s passed to direct descendants.

The Institute of Fiscal Studies (IFS) points out the potential unfairness of the current rules around the RNRB. First, the IHT advantage is obviously unavailable to individuals who do not own their own home and, on the other end of the scale, it offers a more generous tax advantage to home owners in London and the South East. Second, the RNRB discriminates against home owners who have no children or grandchildren.

However, the availability of the RNRB is not restricted to residential properties that have been owned by the testator for a certain period of time – the rules simply require that they lived in it at the time it was included in their estate. So where might that leave individuals who live in a large or a high value home who are considering downsizing but are concerned they would then forfeit a valuable tax advantage on death?

Clients who are in this position can consider the availability of downsizing relief which allows them, as property owner, to downside without giving up the tax relief that would have been available had they not downsized. The relief is the same as that available under the RNRB (the maximum RNRB for 2020-2026 is ￡175,000).

The downsizing addition is also known as the Qualifying Former Residential Interest and, importantly, is only available for a single property. In practical terms, the downsizing addition is a welcome relief that reflects the reality for aging property owners who find it increasingly difficult to maintain a large home and need to move to a smaller property.

The rules are notoriously complex but essentially, to qualify for downsizing relief, the individual must have transferred the property and moved to a less valuable property on/after 8 July 2015. (The property does not have to be in the UK so long as the owner is domiciled in the UK.)

Further, the RNRB must have been available on that property on death if the individual had kept it; and their direct descendants must inherit some or all of the estate.

‘Direct descendants’ is widely defined and includes step- and foster children, children under a special guardianship order and natural children who have been adopted by a third party (under section 8K, IHTA 1984).

Claiming the downsizing relief

There is no automatic entitlement to a downsizing addition on death - the PRs must claim it (on Form IHT435). Where the deceased ‘downsized’ more than once, the PRs can elect which property to use for the purposes of the downsizing allowance.

Calculating the downsizing allowance available can become complicated where, for instance, transferred RNRB is available in an estate, or where taper relief needs to be taken into account or there is a trust situation (e.g. there is a gift with a reservation of benefit).

For a full explanation of the rules with worked examples, see Professor Lesley King’s webinar on RNRB and downsizing, available as an individual webinar and as part of our Wills and Probate Spring event.