The allowance will significantly lift the threshold at which the tax becomes payable for home owners who leave their property to their children.
It follows a Tory election pledge to take most family homes out of inheritance tax. The new relief of £175,000 per person will be phased in from 2017 on top of the existing tax-free allowance for IHT of £325,000, or £650,000 for married couples and civil partners.
It means that from 2020, married couples and civil partners will be able to pass on up to £1 million of housing wealth free of inheritance tax to their children.
IHT is payable at death at the stinging rate of 40 per cent above the tax-free allowance, called the “nil-rate band”.
It is charged on the value of property (minus any mortgage) as well as other wealth including savings, shares and ISAs — though whatever you leave to your spouse or civil partner is automatically exempt from inheritance tax.
Most Britons’ assets are less than the current allowance, but rising property prices have pulled increasing numbers of London home owners into the IHT net. This has been exacerbated by the tax-free limit not having been raised since 2009.
Announcing the additional allowance in the Budget, Chancellor George Osborne said the Government was acting to prevent the number of families paying inheritance tax from doubling over the next five years.
Called the “main residence nil-rate band”, it will apply only to residential property left at death to children or other direct descendants. Buy-to-let properties will not qualify, says HM Revenue & Customs.
And, as with the existing tax-free amount, the new allowance can be transferred to a spouse or civil partner.
This means that in the common situation where couples leave everything to each other, when the first partner dies their assets are automatically exempt from inheritance tax and the unused allowance passes to the survivor.
In effect, this will double the new allowance that applies when the surviving partner dies, from £175,000 to £350,000.
The Chancellor also allayed concerns that older home owners who downsized would lose the new relief. With effect from the Budget, people who sell up or downsize will retain the tax break — a provision welcomed by experts for potentially increasing the supply of family homes for sale.
“It means those living in large houses do not have to continue to do so in order to benefit from the inheritance tax changes,” says Grainne Gilmore, head of UK residential research at estate agents Knight Frank. “This, in time, could help release more large homes back into the market.”
However, Lucy Brennan, partner at accountants Saffery Champness, advised home owners if possible to delay downsizing until details are confirmed of how they will retain the additional allowance. A consultation on this is due in the autumn, with legislation to follow next year.
But while the new tax break will be welcomed by many home owners in the capital, the wealthiest stand to miss out. The additional allowance will taper down for people leaving property and other assets totalling more than £2 million.
None of the extra relief will be available over £2.35 million, or above a maximum of £2.7 million for couples, according to Patricia Mock, tax director at accountants Deloitte.
This could impact owners of larger properties in certain areas of London, she says.
And while the property-rich will still have the existing nil-rate band, it is being frozen until 2021.
How to cut your inheritance tax liability
Even with the new inheritance tax allowance for homes, an individual passing on property and assets worth more than £500,000 — or a married couple leaving more than £1 million — will still be subject to these death duties on some of their wealth.
Meanwhile, the wealthiest home owners continue to face the prospect of huge inheritance tax bills. The liability for people leaving £3 million, for example, remains eye-watering at about £1 million. However, there are a number of possible ways to shrink inheritance tax liabilities.
One is simply to spend more of your money, so you leave less at death. More holidays are one option. By contrast, if you acquire assets such as new cars or art, they remain part of your wealth when calculating inheritance tax.
Parents could also reduce wealth they have in excess of the tax-free limit by giving it away to their children while still alive. The catch is that for most amounts, the donor needs to live at least another seven years for the funds to escape inheritance tax.
The same seven-year rule applies to giving away your home, and if the parents continue to live in the property, they also have to pay the children a full market rent to exempt it from inheritance tax. For the children, this rent is taxed as income.
You could move to a less valuable property, but would then need to give away or spend the extra cash released from the downsizing to reduce your wealth for inheritance tax purposes.
Older people could also extract some of the wealth they have tied up in their homes with a so-called lifetime mortgage or equity release scheme — and then gift or spend the funds raised.
Financial adviser Tilney Bestinvest says such mortgages charge interest of typically about six per cent, which rolls up until death and further reduces the inheritance tax bill on the property.