Passing on the family home: what really happens

Most people's estate is mostly their house. Which is why the rules about passing on a home matter more than almost anything else in inheritance tax — and why the detail is worth twenty minutes of your time, even if the subject is grim.

The headline is reassuring: a couple can often pass on up to £1 million without inheritance tax. The small print is where it gets interesting, because the extra allowance that gets you to £1 million has conditions attached, and one of them removes it entirely from larger estates.

Here's the whole thing, in order.

Start with the basic allowance

Everyone has a nil-rate band of £325,000. Anything in your estate above that is taxed at 40%.

The nil-rate band applies to everything — house, savings, investments, car, the lot — after debts are deducted.

Two important points before we go further:

Anything you leave to a spouse or civil partner is exempt. No inheritance tax is due on it, whatever the amount. This is why the first death in a couple rarely produces a bill and the second one sometimes does.

Unused nil-rate band transfers to your spouse. If the first partner to die leaves everything to the other, none of their £325,000 was used, so 100% of it passes across. The survivor's estate then has £650,000 of nil-rate band. This is claimed as a percentage, not a cash figure, which means it keeps its value if the allowance rises.

Then the extra allowance for the home

Since 2017 there has been a second, narrower allowance: the residence nil-rate band, worth up to £175,000.

It is not automatic. To get it, the home has to pass to direct descendants — children, stepchildren, adopted or foster children, grandchildren, and their spouses. Nieces, nephews, siblings and friends do not count.

Like the basic band, any unused residence nil-rate band transfers to a surviving spouse. So a married couple leaving their home to their children can have:

• £325,000 + £325,000 = £650,000 of nil-rate band
• £175,000 + £175,000 = £350,000 of residence nil-rate band
• £1,000,000 in total

That's where the famous million comes from. Note what it depends on: being married or in a civil partnership, owning a home worth at least £350,000 between you, and leaving it to your children or grandchildren.

Two clarifications that trip people up:

• The allowance is capped at the value of the home. If the property is worth £200,000, you get £200,000 of residence nil-rate band across the couple, not £350,000. The unused part is not transferable in the way people expect — it's limited by the property's value.
• Only the part passing to descendants counts. Leave half the house to your daughter and half to your brother, and you get the allowance on your daughter's half.

The taper nobody warns you about

This is the bit that surprises people, and it's the reason a "£1 million" estate plan can quietly stop working.

The residence nil-rate band is reduced once the estate is worth more than £2 million. For every £2 above £2 million, you lose £1 of residence nil-rate band.

So:

• Estate of £2,000,000 — full residence nil-rate band available
• Estate of £2,200,000 — £100,000 of it lost
• Estate of £2,350,000 — the whole £175,000 gone

The £2 million test uses the estate value before exemptions and reliefs. That catches business owners and farmers in particular: an estate might attract Business Relief or Agricultural Relief and pay little tax on those assets, but their gross value still counts towards the £2 million test and can wipe out the residence allowance on the house.

The effective marginal rate inside the taper zone is brutal. Each £2 of extra estate value costs 80p of tax on that £2, plus 40% of the £1 of allowance lost — an effective rate of 60% on that band.

What if you've already sold the house?

A common and reasonable worry: if you downsize to a bungalow or move into care, do you lose the allowance?

No. There's a downsizing addition designed for exactly this. If you sold or gave away a more valuable home on or after 8 July 2015, and you leave assets of at least the equivalent value to direct descendants, you can claim the residence nil-rate band you would have had.

It is not automatic. Someone has to claim it, with evidence of the former property's value. That means keeping the completion statement from the sale — put it with your will. Executors have lost this allowance simply because nobody could prove what the old house was worth.

A worked example

Take a widow in her eighties. Her husband died some years ago and left everything to her.

• House: £420,000
• Savings and investments: £310,000
• Everything else, less debts: £30,000
• Total estate: £760,000
• Leaving everything to her two children

Allowances available:

• Her nil-rate band: £325,000
• Her husband's transferred nil-rate band: £325,000
• Her residence nil-rate band: £175,000
• Her husband's transferred residence nil-rate band: £175,000
• Total: £1,000,000

Estate of £760,000 against allowances of £1,000,000 — no inheritance tax due. The estate still has to be reported and the transferred allowances actively claimed, but there's no bill.

Now change one thing. Suppose she leaves the house to her nephew instead of her children. Both residence nil-rate bands fall away, leaving £650,000 of allowance against a £760,000 estate. Taxable: £110,000. Tax at 40%: £44,000.

Same house, same money, one different name in the will.

Gifts, and the seven-year rule

People often try to solve the problem by giving the house away. It's rarely as simple as it sounds.

Gifts generally fall out of your estate after seven years. Between three and seven years, taper relief reduces the tax on the gift on a sliding scale — but note that taper relief reduces the tax on the gift, not the value of the gift, and it only bites once the gift exceeds the nil-rate band. That's a subtlety that catches a lot of people out.

Giving away the home you still live in is particularly awkward:

• If you carry on living there rent-free, the gift with reservation of benefit rules usually pull the house back into your estate for inheritance tax. You get no benefit at all.
• You may instead be caught by a separate income tax charge on the benefit of living there.
• You lose control. If the child you gave it to divorces, is sued, or predeceases you, the house is part of their affairs.
• Capital gains tax may become an issue on a later sale, because the property is no longer their main residence.

None of which means gifting is wrong — but gifting a main home is one of the few areas where doing it yourself, without advice, is genuinely likely to make things worse.

Simpler things that usually help more

Write a will, and check it still says what you think. The residence nil-rate band depends on who inherits the home. Wills written before 2017 sometimes direct the property into trust arrangements that were sensible under the old rules and now cost the allowance.

Own your home in the right way. Joint tenants and tenants in common pass on differently. It matters, particularly in second marriages.

Claim the transferable allowances. They are not applied automatically. The first spouse's paperwork — grant of probate, will, death certificate — needs to be findable years later. Keep it all together.

Use the annual gift exemptions. £3,000 a year, plus small gifts of £250 to different people, plus gifts out of surplus income if properly documented. Unglamorous, immediately effective, no seven-year wait.

Think about life cover written in trust. It doesn't reduce the tax, but it gives the family cash to pay it without having to sell the house in a hurry. For estates that are mostly one illiquid asset, this is often the practical answer.

Consider charity. Leave 10% or more of the net estate to charity and the rate on the rest drops from 40% to 36%.

Where to start

Run your numbers through our Inheritance Tax calculator — it handles the nil-rate bands, the residence allowance, the £2 million taper and gifts within seven years, and shows the workings rather than just a number. It'll tell you within a few minutes whether you have a problem worth paying someone to solve.

Then find your will and read it. Most of the expensive mistakes in this area aren't about tax planning at all. They're about a document that no longer matches the family it was written for.

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This article is general financial education, not personal financial advice. Inheritance tax rules are complex, depend on individual circumstances and can change; the figures quoted are based on current rules. Consider seeking regulated financial or legal advice before acting.