Could you end up paying inheritance tax on your family home?

For most people worrying about inheritance tax (IHT), property is the single biggest issue.

The value of the average home in the UK has risen by 53% since April 2009 according to Nationwide Building Society – and by more than 90% in some parts of the country. That date is significant because it’s the last time that the nil-rate band for inheritance tax was increased.

In short, during a period when the value of the average property has risen from £152,000 to £231,000, the nil-rate band, which governs the value of estates that can be passed on free of tax, has remained stuck at £325,000.

So people who a decade ago would never have come close to hitting the threshold may well now find themselves squarely within it – particularly those who live in regions of the UK where house prices are particularly high.

And this is only likely to affect more people as prices keep rising while the threshold stays right where it is.

The good news – there’s a special allowance for the family home

One problem with property is that not only is it likely to account for a large chunk of your wealth, it can be hard to do anything about. While you may be able to reduce the value of your estate by giving away more liquid assets, your home poses more challenges.

As well as a house being illiquid (in other words, it takes time to sell), many people naturally have a strong emotional connection to their family home. They may be reluctant to sell up while they are still alive, even if this makes sense for inheritance tax planning purposes. Their heirs may not wish to sell up either, but end up with no choice if a large tax bill looms.

However, it’s not all bad news. While the nil-rate band (after which inheritance tax is due at 40% – see my previous article on this) will stay at £325,000 until at least the 2025-26 tax year, the David Cameron government introduced an additional inheritance tax allowance for the family home, which was implemented in stages between 2017 and 2020.

This “main residence nil-rate band” kicks in if you are passing your home to a direct descendent. It gives you an extra £175,000 inheritance tax-free allowance. In practice, this means that the inheritance tax threshold for most people is now £500,000, as long as at least £175,000 of the value of their estate comes from their family home.

Couples get a joint allowance. As a result, they can leave estates worth up to £1m to their heirs with no inheritance tax liability, as long as £350,000 of that value comes from their home.

There are some important caveats to bear in mind. First, you only get the main residence allowance if you are leaving your home to your children or grandchildren (including stepchildren, adopted children and foster children). Nieces and nephews, for example, do not qualify as direct descendants; nor do friends.

Also, special rules apply on estates worth more than £2m. For each £2 that your estate is worth above this threshold, you lose £1 of the main residence nil rate band. So if your estate is worth more than £2.35m, your heirs won’t benefit from any of this extra allowance.

The main residence nil-rate band applies to only one home. It must be included in your estate – not held in a trust - and you need to have lived in it at some stage in your life. But it does not have to be the property you were living in at the time of your death, or to have been owned for a minimum period. And if you own more than one home that qualifies for the allowance, the executor of your estate can nominate which one should be used.

Other minimisation methods to consider

When George Osborne, the chancellor at the time, announced the main residence nil rate band in the summer of 2015, he said it would “take the family home out of inheritance tax for all but the wealthiest”. And the change has certainly had a discernible effect: the number of estates on which inheritance tax is payable and the Treasury’s receipts from the tax both began to fall as the allowance was phased in.

However, the trend is likely to be temporary. With house prices continuing to rise – and no plans for increased inheritance tax thresholds before 2026-2027 at the earliest – more estates will inevitably breach the nil-rate bands even after taking the additional property allowance into account. In more expensive parts of the country for housing, many properties are already caught.

Families worried about this issue may need to take specialist advice on how to mitigate a future inheritance tax bill. There are several options, but the inflexibility of property can pose challenges. You can give your home away, for example, but if you continue living in it and do not pay a commercial rent, you will be deemed to have retained ownership for inheritance tax purposes.

Trusts can be useful ways to manage property more tax efficiently, but these are expensive and come with upfront inheritance tax levies. STEP, the trade body for specialists in estate planning, including lawyers and accountants, can put you in touch with advisers in your area.

Other options include equity release plans, which allow you to borrow against the value of your home without having to make repayments during your lifetime – thus reducing the size of your estate by the outstanding debt. But take professional advice before making such an arrangement.

This is the second part of our series on inheritance tax. For the full report and more, subscribe to MoneyWeek magazine and get your first six issues free – sign up here today.