Gifting things to your loved ones while you’re alive can help reduce the value of your estate. A smaller estate could lower the Inheritance Tax burden you leave behind. But your gifts might be taxable long after you gave them. Here is all you need to know about the seven-year tax rule.
We’ve previously written a post on cash gifts and their impact on inheritance tax. The post outlines things you could gift to your family without having to pay inheritance tax. Whether you are gifting assets or cash, your gift might be subject to inheritance tax depending on when you gave the gift. The rule is known as the seven-year tax rule.
The seven-year rule in a nutshell
The premise of the rule is this: You can make a gift to your friends and family, and your estate won’t need to pay inheritance tax on it if you live for the next seven years. If you happen to die within the seven years, then your gift could be subject to inheritance tax.
For example, if you gift £100,000 to your child in 2020, the gift isn’t included in your estate if you live past 2027. If you die within the next seven years, then your estate may have to pay inheritance tax on it.
It’s important to note that any income from the gift the beneficiary receives might always be subject to other tax, such as Capital Gains Tax.
The seven-year rule in action
When you first gift an asset or cash, the gift will become something called Potentially Exempt Transfer. The assumption is that you’ll continue to stay alive for the next seven years and no inheritance tax is charged at the time.
Potentially Exempt Transfers must be a gift made by an individual to another individual or a trust. Gifts made from a corporation or a company are excluded. If you still have an interest in the gift, then it also won’t qualify.
For example, if you gift away your home but still live in the house rent-free. Your house would be considered part of your estate and subject to inheritance tax, even if seven years had passed from the moment you gifted it.
If you die within seven years, the gift becomes a Chargeable Transfer. The gift is added to your total value of the estate. You’ll need to pay inheritance tax if the combined value of your estate is above the inheritance tax threshold. The current threshold is £325,000.
The tax rate changes depending on when you gave the gift
The amount of inheritance tax your estate needs to pay depends on when you gave the gift. Here are the rules regarding the rates:
- If you gave the gift in the three years before you die, you pay 40%.
- If 3 to 4 years before, tax is 32%.
- If 4 to 5 years before, tax is 24%.
- If 5 to 6 years before, tax is 16%.
- If 6 to 7 years before, tax is 8%.
The rates are called ‘taper relief,’ and the reduction doesn’t reduce the value of the gift, only the tax payable. Taper relief is only applicable to gifts and not the rest of your estate. Any other asset above the threshold is subject to the usual 40% inheritance tax rate.
You should also note the oldest gifts are attributed first against the inheritance tax threshold. For instance, gifts you gave five years before you died are counted towards the allowance limit first.
If you have given gifts below the £325,000 threshold and your total estate is not worth more, then your estate won’t need to pay inheritance tax.
The exemptions to the seven-year rule
It’s a good idea to remember that married couples or civil partners can pass their estate to their spouse tax-free. If you are married or in a civil partnership and you leave everything to your surviving spouse, they won’t pay inheritance tax on the estate.
Gifts to a charity are also exempt from inheritance tax. If the value gifted to charity is at least 10% of the net estate at the date of death, you will also reduce the payable inheritance tax. Gifting can reduce the rate from 40% to 36%. The definition of a net estate in this context is the value left over after deducting exemptions and other available reliefs.
You should remember that you have an annual gift allowance of £3,000 a year. Any assets or cash you give away below the total allowance in a year isn’t added to the value of your estate. It is possible to forward your annual allocation by one year. If you don’t gift anything in 2020, then you could gift £6,000 in 2021. But please note the annual allowance can only be forwarded by one year!
It’s also worth noting that gifting into certain types of trusts can increase the seven-year rule into a 14-year rule. Gifts into trusts can create immediate inheritance tax bills, and a series of gifts into trusts can lengthen their taxable status. For most trusts, inheritance tax is only due on anything above the £325,000 threshold and gifts made in the previous seven years. You can find more information on trusts and inheritance tax from this Government guideline.
How to reduce inheritance tax
Keep the above in mind if you want to reduce the inheritance tax bill. Tax planning helps if you’re about to inherit your parents. It’s also helpful in terms of ensuring your family doesn’t have to deal with a significant inheritance tax bill when you die.
Trusts are a popular way of lowering the inheritance tax bill. Different types of trusts have different ways of calculating tax liability, however. Many trusts are not subject to inheritance tax after you die. But you may need to pay tax while you are still alive. Due to the complexity, it’s always advisable to talk to a financial advisor before you set up a trust.
Since gifts can fall under the scope of inheritance tax, it’s a great idea to keep track of them. You want to have a record of:
- Gifts you give and to whom you gave them.
- When you gave the gift and how much it was worth.
Tracking your gifts gives you a better idea of the size of your estate and the possible tax it might incur after your death.
