When someone dies, a person's property and possessions, otherwise known as their estate, may become subject to inheritance tax (IHT). This is the tax payable on a deceased's estate where the value of that estate exceeds a certain threshold (currently referred to as the ‘nil rate band’) set by the government annually. The current nil rate band is £325,000 and it is the value over this amount that is taxed at a flat rate of 40% unless there are any other reliefs that can be taken into account.
By making lifetime gifts to loved ones, it may be possible to reduce the amount of inheritance tax payable on death, in this way maximising how much you can pass on to your friends and family after you die. However, to be effective, where there are no inheritance tax consequences arising from making a gift, it must meet certain strict criteria.
In broad terms, gifts fall into three categories: exempt transfers, potentially exempt transfers (or PETs), and chargeable lifetime transfers (or CLTs).
An exempt transfer is a gift that can be made at any time during your lifetime, whose value will be entirely ignored for the purposes of inheritance tax, even if you die shortly after making it. For example, this could include the £3,000 annual exemption that can be gifted to loved ones without this being added to the value of your estate. There are also various other low value exempt gifts that you can make without attracting any IHT.
In contrast, potentially exempt transfers are gifts that will only become fully exempt from inheritance tax if you survive the date you made the gift by a period of 7 years. This is known as the 7-year rule.
If you die within the 7 year period, the value of the gift is effectively added back into the value of your estate. If the gift itself is taxable because it exceeds your nil rate band, then taper relief can apply depending on how many years you have survived it. If it is less than 3 years, however, the full value of the gift will be subject to inheritance tax at the flat rate of 40%.
For those gifts falling within the chargeable lifetime transfer category, these may attract an immediate tax charge, with an additional charge should you then die within 7 years of the gift being made. A gift made into a discretionary trust would be treated as a chargeable transfer and can have a knock-on effect to past or future lifetime gifts if the value exceeds your nil rate band. However, these trusts can still prove to be useful tools as part of your overall tax planning, especially where there are minor beneficiaries.
The rules relating to gifts and the inheritance tax consequences that can flow from this can be complex.If, for example, you sold your house to an adult child for less than it is worth, the difference in value will count as a gift and would be subject to the capital gains tax regime in your lifetime with a potential for inheritance tax to apply to the gift element of the transaction if you failed to survive 7 years.
There are also a number of other potential tax traps, or financial catches, that can arise when making a gift during your lifetime, including the following:
reservation of benefit: where you gift an asset but continue to derive a benefit from it, like giving away your house but continuing to live there, you may be treated as still owning it for inheritance tax purposes, even if the gift was made more than 7 years before your death;
deprivation of assets: where you gift an asset but subsequently require nursing care, you may be treated as still owning that asset for the purpose of the financial assessment undertaken by the local authority to determine your contribution to the cost of your care;
capital gains tax liability: where you gift certain assets, such as shares or a second home, this may be treated as a disposal for capital gains tax purposes, where you may be liable to an immediate charge to tax if the asset's value has increased since it was acquired.
It is important to always seek specialist legal advice when gifting money or giving away assets during your lifetime for the purposes of avoiding inheritance tax after you die. This can require careful estate planning and expert knowledge of the law.
Legal disclaimer
The matters contained herein are intended to be for general information purposes only. This blog does not constitute legal advice, nor is it a complete or authoritative statement of the law in England and Wales and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its’ accuracy, and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should always be sought.
