Lifetime gifts and inheritance tax

Lifetime gifts and inheritance tax:

The short answer is yes, certain lifetime gifts are brought into account for inheritance tax purposes, but the rules are more nuanced than many people realise.

The seven year rule:

The most important rule is that gifts made within seven years before death are potentially chargeable to inheritance tax. These are known as potentially exempt transfers, or PETs. If the donor survives for seven years after making the gift, it drops out of the inheritance tax calculation entirely. If the donor dies within seven years, the gift becomes chargeable, though taper relief reduces the tax payable on a sliding scale from year three onwards.

The taper relief works as follows:

1. Death within 0 to 3 years of the gift: 100 per cent of the tax is payable.
2. Death within 3 to 4 years: 80 per cent.
3. Death within 4 to 5 years: 60 per cent.
4. Death within 5 to 6 years: 40 per cent.
5. Death within 6 to 7 years: 20 per cent.

It is worth noting that taper relief reduces the tax charged on the gift, not the value of the gift itself. It only matters where the cumulative value of chargeable gifts exceeds the nil rate band.

Exempt gifts:

Not all lifetime gifts are potentially chargeable. The following are exempt from inheritance tax regardless of when they are made:

The annual exemption, which allows gifts of up to 3,000 pounds per tax year. If unused in one year, it can be carried forward to the following year only.

Small gifts of up to 250 pounds per recipient per tax year, provided the recipient has not also benefited from the annual exemption.

Gifts in consideration of marriage or civil partnership, up to 5,000 pounds from a parent, 2,500 from a grandparent or remoter ancestor, and 1,000 from anyone else.

Gifts to a spouse or civil partner, which are fully exempt provided the recipient is UK domiciled. If the recipient is not UK domiciled, there is a limited exemption (currently 325,000 pounds, though the recipient can elect to be treated as UK domiciled for this purpose).

Gifts to charities and qualifying political parties.

Normal expenditure out of income. This is an often overlooked exemption. If the donor can show that the gifts formed part of their normal expenditure, were made out of income rather than capital, and that after making the gifts the donor was left with sufficient income to maintain their usual standard of living, then those gifts are entirely exempt regardless of amount. This can be a very powerful exemption for people with surplus income.

Gifts with reservation of benefit:

A critical trap to be aware of is the gifts with reservation rules. If the donor makes a gift but continues to benefit from the gifted property, the gift is treated as still forming part of the donor's estate at death. The classic example is giving away a house but continuing to live in it rent free. Unless the donor pays a full market rent or genuinely ceases to benefit from the asset, it will be caught by these rules and included in the estate for inheritance tax.

There is also the pre-owned assets income tax charge, which can apply where the reservation of benefit rules do not technically bite but the donor still derives a benefit from the gifted asset.

Chargeable lifetime transfers:

Some gifts are immediately chargeable to inheritance tax at the time they are made, rather than being potentially exempt. The most common example is a gift into a relevant property trust, which is a trust other than a bare trust or a trust for a disabled person. The lifetime rate is 20 per cent on the value exceeding the available nil rate band, with a further liability arising if the donor dies within seven years.

Upcoming changes:

It is worth keeping an eye on any changes announced in Budgets and Finance Acts. The autumn 2024 Budget announced significant changes to agricultural property relief and business property relief from April 2026, which affect the inheritance tax treatment of agricultural and business assets and may influence how people plan lifetime gifts of those assets.

Practical points:

Good record keeping is essential. Executors need to be able to trace gifts going back at least seven years, and the normal expenditure out of income exemption requires clear evidence of the pattern and the donor's income and expenditure. Many families keep no records at all, which creates real difficulties after death.

If you are thinking about lifetime giving as part of inheritance tax planning, the specific circumstances matter a great deal, including the type of asset, whether the donor can genuinely give up all benefit, the donor's age and health, and the interaction between different exemptions and reliefs.

Is there a particular aspect of lifetime gifts you would like me to go into in more detail?