Almost 2,000 people who thought they'd reduced the values of their estates by making gifts have seen an inheritance tax break stripped away.

Inheritance tax is charged at 40% on individual estates worth more than £325,000, although this threshold can double for married couples.

Other allowances and exemptions are available to increase this threshold or taper the inheritance tax rate down from 40%.

One such relief is the seven-year rule, which sees people give away assets to reduce the value of their estates and ensure more wealth is passed on.

But a Freedom of Information request from the Telegraph found that since 2016, 1,830 gifts worth £624 million have been deemed taxable at 40%.

If HMRC discovers an individual continues to benefit from an asset they'd given away, it's known as a ‘gift with reservation of benefit'.

The most obvious example is where someone continues to live in, and therefore benefit from, a property they'd gifted to a descendant.

When this happens and HMRC finds out, no tax break applies and the gift's value forms part of the gift-giver's estate for inheritance tax purposes.

The seven-year rule

Gifts of property and other assets can be tax-free if the person making the gift survives for at least seven years after giving an asset away.

Assets can be items such as money in a bank, property or land, jewellery, cars, shares, an insurance policy payout and jointly-owned assets.

Should that person die within those seven years, the gift will be considered part of the estate's value but only if it exceeds £325,000.

If they were to die within three years of making the ‘potential exempt transfer' (PET) of an asset, inheritance tax is charged at the full 40%.

PETs made three to seven years before the gift-giver dies are taxed as follows on a sliding scale due to taper relief being available:

  • 3 to 4 years - 32%
  • 4 to 5 years - 24%
  • 5 to 6 years - 16%
  • 6 to 7 years - 8%.

Gifts gone wrong

Misunderstanding these gifting rules inadvertently risks leaving families worse off in the long run, especially with rising property prices bringing more estates into inheritance tax's net.

Going back to that FOI request, the overwhelming majority of these ‘gifts gone wrong' related to property. A further 13% were cash gifts, while shares and securities accounted for 8%. The rest were classed as "other assets".

Should HMRC discover that an individual continues to live in a property they'd gifted away, without paying rent at market rates or perhaps making a token subsidised payment, the gift will form part of the giver's estate.

For the recipient of the property, the rental payments from the person who made the gift would also be liable to income tax at their marginal rate. Assuming they already own a main residence, a capital gains tax charge would arise when the recipient sells the gifted house.

Others who give away money but want to retain control of it have been caught out. For example, parents who gift money to their children as a loan note, in a bid to retain control if their children-in-law file for divorce and try to run off with the family money, would fail the tax-exemption test.

Should HMRC look into these affairs and find any discrepancy and continued benefit, the gift will be caught and the executor of the estate will be liable to pay the tax bill after the giver's death.

There are often much better options than giving some of your property or money away to reduce the value of your estate.

Talk to us about the implications of planning your estate.