It’s one of the best-known inheritance tax rules.
You can hand an unlimited amount of money to your friends and family without paying any tax, as long as you live for at least seven years after making the gift.
But a little-known quirk in the fine print means bereaved families could be forced to part with tens of thousands of pounds more than they expected.
Here’s how the tax trap works – and why all is not necessarily as you may have thought.
What is the seven-year gifting rule?
Everyone has a £325,000 allowance – called the nil-rate band – that can be passed on free of inheritance tax (IHT). Any wealth above this, including the value of your home, is subject to a 40 per cent rate.
There is an additional tax-free allowance of £175,000 specifically for when the family home is left to ‘direct descendants’ such as children or grandchildren.
There is no tax to pay on assets passed to your spouse or civil partner.
Tax trap: A little-known quirk in the seven-year gifting rule means that bereaved families could be forced to hand over more than they expected to the taxman
Any gifts you make are free from inheritance tax if you survive for seven years after making them. But if you die within seven years, it becomes known as a ‘failed gift’ in the eyes of HM Revenue & Customs.
It is widely understood that if you die within seven years, a lower rate of inheritance tax will be applied than the full 40 per cent, thanks to ‘taper relief’.
The official guidance says the closer to the full seven years you survive, the lower the tax rate – in other words, it tapers off until it reaches zero.
For any payment made in the last three years before death, the full 40 per cent is levied.
Any gifts made between three and four years before death face a 32 per cent charge; between four and five it is 24 per cent; between five and six it is 16 per cent; and between six and seven years before death the IHT rate is 8 per cent.
But these rules are more complicated than they appear – with a costly loophole. In fact, taper relief only applies to gifts that exceed the nil-rate band – gifts valued above £325,000.
In practice, this means that on your death any failed gifts will be the first thing to use up your nil-rate band.
If you have made a failed gift, your estate will have less tax-free allowance to use on other assets, such as property, savings and investments, which will be charged at the flat rate of 40 per cent.
Marianna Hunt, of investment firm Fidelity, says: ‘Most people fundamentally misunderstand how taper relief is applied, thinking it will cut their tax bill when, in many cases, it won’t.
‘There’s even the chance you could have used up your nil-rate band entirely if the failed gifts are worth £325,000 or more.’
Rachael Griffin, of wealth manager Quilter, says: ‘The number of conversations I’ve had where people don’t understand taper relief are numerous.’
This loophole can fundamentally change an inheritance tax bill for the worse. Here’s how it works:
£78,000 tax trap
Take John, for example, whose total wealth adds up to £1.1million. John gifts £600,000 in cash to a niece but dies just over five years after making the gift.
Under taper relief rules you might conclude John’s niece would have to pay IHT at a rate of 16 per cent of £600,000, which is £96,000.
This would leave John’s nil-rate band untouched, so £325,000 of the remaining £500,000 could be passed on free of tax, and just £175,000 would be clobbered with the full 40 per cent tax.
Everyone has a £325,000 allowance – called the nil-rate band – that can be passed on free of inheritance tax
That would generate a tax bill of £70,000 which, added to the £96,000 from the tapered gift, gives a total of £166,000 paid on the inheritance.
But that would be wrong. In fact the quirk in the taper relief means the total tax bill is thousands more.
This is because the £600,000 gift is first counted towards the nil-rate band and uses it up entirely.
That means the remainder of the gift to John’s niece – £275,000 – then benefits from the 16 per cent taper relief rate of tax.
That leaves John’s niece paying back just £44,000 of the failed gift, so it is good news for her.
But it is bad news for the rest of John’s estate and any other beneficiaries of the remaining £500,000.
There is now no tax-free allowance left, so the whole of that chunk will be hit with the full 40 per cent rate – or £200,000.
This takes the total tax due on John’s estate to £244,000 – £78,000 more than the family might have expected, according to the calculations by Fidelity.
These figures assume John is not married and no other gifting allowances have been used.
Is it still worth it?
If the taper relief rule isn’t as generous as it first appears, you may wonder if there is any point in making a gift. Why not simply leave it to someone in your will?
Elsa Littlewood, partner at accountancy firm BDO, argues that there is still value in making a gift when you are alive, as long as you know you won’t need the money for anything else, such as care.
She says: ‘You may survive seven years, then it falls outside of your estate and that tax-free nil-rate band can be used again for another gift.
‘Also, once you’ve used up the £325,000 allowance, your next gift benefits from full taper relief.’
What if I leave my house to my children?
Those who leave their main property to a direct descendant, such as a child or grandchild, get an extra £175,000 allowance completely free of inheritance tax.
This amount, known as the residence nil-rate band, usually means £500,000 can be passed on free of death duties (and £1million for a married couple).
It’s a large enough allowance that most people will be able to pass on their family home without their children paying a penny in IHT.
The good news, says Ms Griffin, is that this extra tax-free amount is specifically ringfenced for property. Any failed gifts will not eat into the extra £175,000 allowance.
However, it does mean that most of the potential £500,000 tax-free allowance will not automatically apply to a family home as it may be eaten away by failed gifts.
Let’s look at Sarah this time. She gifts £600,000 to her daughter but dies a little more than five years later. She also bequeaths her the £500,000 family home and leaves £500,000 in other assets.
If the taper relief rate of 16 per cent were levied on the whole £600,000 cash gift, then £96,000 would be due on that.
The £500,000 home would be completely tax free and 40 per cent would be paid on the other £500,000, so £200,000 on the rest of the estate.
Again, that would be wrong. In reality just £44,000 is due on the gift and £330,000 is payable on the rest of the estate, according to calculations by Quilter.
This is because the £600,000 failed gift uses up Sarah’s £325,000 nil-rate band, exceeding it by £275,000.
The family home then only benefits from the £175,000 extra allowance, which means £325,000 is subject to tax at 40 per cent. Sarah’s remaining £500,000 wealth is also taxed at the full rate.
Those who leave their main property to a direct descendant, such as a child or grandchild, get an extra £175,000 allowance completely free of inheritance tax
How to avoid the quirk
The best way to avoid this taper relief trap is to make gifts that will definitely fall outside of your estate.
There are several generous gifting allowances you can use while you are still alive – and even if you die within seven years of donating the money, the gifts will not trigger a tax bill.
For example, everyone gets a £3,000 gift allowance every tax year that is exempt from their estate.
Plus, if you didn’t use one year’s allowance you can carry it forward to the next tax year, but it cannot be carried forward any further. It means a couple could give away up to £12,000 in one tax year.
You can also donate an unlimited number of small gifts up to £250 if you haven’t used a different allowance on the same recipient.
Another nifty trick is to make a tax-free gift to someone getting married or entering a civil partnership. You can give £5,000 to a child, £2,500 to a grandchild or great-grandchild and £1,000 to anyone else.
But these gifts need to be made ‘in consideration of’ a marriage or civil partnership – payments must be made just before it takes place and not after.
Arguably the most generous allowance is known as ‘gifts out of normal expenditure’, as it allows you to give away an unlimited amount free of inheritance tax.
However, there are strict criteria. The payment must be regular, out of your income and must not affect your standard of living – and you must keep good records.
- Have you been caught out by inheritance tax rules? Tell us what happened, email: l.evans@dailymail.co.uk
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