What is the 7 year rule in inheritance tax?

Inheritance tax (IHT) is a tax levied on an estate before the assets are passed to the beneficiary via inheritance or as a gift. Although IHT is paid on death, it can also apply to some gifts that are made before the person dies. If you’re making a financial gift, you need to understand whether the gift is tax-free, or whether it will create a tax bill, either immediately or further down the line. That’s why it’s critical to understand the 7 year gift rule in inheritance tax. 

Alongside these complexities, the government will announce the Autumn Budget on 30th October. The Labour government faces the certainty of addressing a £22 billion funding deficit, which will result in changes to taxes and spending. Inheritance tax is one area where key adjustments are expected to boost tax revenues. This article will examine the current rules and explore the potential changes that could be introduced. 

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Introduction to inheritance tax 

Before we explain the 7 year gift rule in inheritance tax, it’s important to provide a basic overview of what we mean by the term “inheritance tax.” 

Simply put, inheritance tax is a tax on the estate (i.e. money, possessions, property) of a person who has died. It's a one-off tax that must normally be paid within 6 months of the deceased's death (exceptions may apply). IHT is also referred to as a cumulative tax because it takes into account earlier gifts when assessing the amount of tax that is due. 

Currently, the nil-rate band (i.e. tax threshold) for inheritance tax is £325,000 for individuals, or a combined nil-rate band of £650,00 for married couples or civil partnerships in addition to the main residence nil-rate band (RNRB) currently £175,000 (per individual), whereby no tax is paid on amounts at or below this level. However, any balance over this threshold could be subject to a tax charge which at present, is a standard inheritance tax rate charge rate of a hefty 40%, or 36% where 10% of the net estate is left to charity. Other tax rate charges may apply and are discussed later in this article.

You’re also going to be hearing the term “gift” throughout this article. But what is a gift? Forget about ribbons and wrapping paper. HM Revenue and Customs (HMRC) defines a gift as something which has a value (i.e. possessions, money, property), or a loss of value that occurs when something is transferred (i.e. if you sell a house for less than it’s worth to your children, the difference in value is defined as a gift). 

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Understanding the 7 year gift rule in inheritance tax 

So, what is the 7 year rule in inheritance tax? Essentially, there are a range of gifts that are exempt from inheritance tax. Everything else is defined as either a chargeable lifetime transfer (CLT), which is for gifts into a discretionary trust that may be subject to an immediate 20% IHT charge (if paid by the trust, or 25% if paid by the settlor), or a potentially exempt transfer (PET) where the gift will only be completely tax-free if you live for 7 years after gifting it (assuming that the gift has been given to an individual, rather than a business or trust). If you die within 7 years of gifting the asset, then the gift will count towards your nil-rate band, as we mentioned above, meaning that it may still be subject to IHT. After 7 years, the gift doesn’t count towards the overall value of your estate. This is known as the 7 year gift rule in inheritance tax. However, the 14 year rule may mean that a failed CLT brings a previous PET back into the estate for assessment.

What is the gift inheritance tax threshold? 

As we stated earlier in the article, the inheritance tax threshold (also referred to as the nil-rate band) is £325,000 plus the £175,000 RNRB (if available). This is the total amount of your estate that you can pass onto your inheritors without paying IHT. However, if the value of your estate exceeds the gift inheritance tax threshold, you’ll have to pay inheritance tax on anything above the threshold. For example, if your estate is valued at £450,000, you will only need to pay inheritance tax on £125,000 (assuming no RNRB is available). 

Inheritance tax-free gifts 

If you die within 7 years of gifting an asset to an individual, the 7 year gift rule in inheritance tax means that the beneficiary may be required to pay IHT. If you want to protect your wealth for your loved ones, it’s important to remember that some gifts don’t incur any inheritance tax charges if you give them away while you’re still living. 

Inheritance tax-free gifts include: 

• Gifts to your partner or spouse – any gifts you make to your UK-domiciled spouse/civil partner are free from inheritance tax, and some gifts to non-UK domiciled spouse are also exempt.
• Wedding gifts – in a wedding/civil partnership, you can gift (free from inheritance tax) up to £5,000 to a child, £2,500 to a grandchild/great grandchild, or £1,000 to anyone else. 
• Gifts from your income – as long as the gift doesn’t affect your normal standard of living, you can make gifts out of your normal income, i.e., Christmas/birthday/anniversary presents, regular payments, life insurance policy premiums, etc. 
• Gifts to assist with family maintenance – gifts helping your relatives (i.e., ex-spouse/former civil partner, a child, or a dependent relative) with living expenses are free from inheritance tax. 
• Gifts to charities – you can make gifts of any value to charities, universities, museums, and community sports clubs without paying inheritance tax. 
• Gifts to political parties – finally, gifts you make to political parties are exempt from inheritance tax, assuming that the political party in question has at least 2 members elected to the House of Commons and 1 member has been elected with 150,000 votes in a general election. 

There’s also an annual exemption for inheritance tax-free gifts worth up to £3,000. In other words, every year you can gift up to £3,000 free from inheritance tax. Furthermore, you can carry over an unused annual exemption from the previous year, provided that the current year's allowance is used first. Remember that gifts valued above the gift inheritance tax threshold of £3,000 are subject to IHT. In addition, there’s the small gifts exemption, which enables you to make an unlimited number of small inheritance tax-free gifts each year, outside of your annual exemption. These gifts are for up to £250 each, provided that you have not already used another exemption for the same person. 

What is taper relief? 

Another key aspect of the 7 year rule in inheritance tax, is taper relief. Essentially, taper relief comes into play if the benefactor doesn’t live for the full 7 years. It means that if the benefactor survived for 3 years or longer, the inheritance tax payable is applied on a sliding scale. As you can see, it’s better to give gifts earlier, rather than later. 

Remember, taper relief only applies to the amount of tax the recipient has to pay on the value of the gift that’s above the nil-rate band. 

For example, suppose Person A gifted £600,000 to their son in May 2016. Person A died in March 2021, having left their £1,200,000 estate to their son as well. Because Person A died within 7 years of making the gift, it contributes towards their nil-rate band. IHT is due on the value of the gift above the nil-rate band (£600,000 - £325,000 = £275,000), but because Person A died 4-5 years after making the gift, the amount of IHT their son is required to pay was reduced by 40%. So, the overall amount of inheritance tax that Person A’s son needed to pay was £66,000 (£275,000 x 24% = £66,000). 

Because the gift used up Person A’s entire nil-rate band, their son will need to pay inheritance tax on the estate at the full 40% IHT rate as well. This means that the estate of Person A had to pay £480,000 (£1,200,000 x 40% = £480,000) before the assets could be distributed. 

There are separate rules around property, which means a higher nil-rate band is available for some, known as the residence nil-rate band. The residence nil-rate band is only applicable to direct decedents, so it’s important you understand the rules depending on who is receiving the gift, how the tax is applied to the gift and how these different rules apply to you.  

Who pays inheritance tax on gifts? 

If you end up incurring IHT on gifts because of the 7 year gift rule in inheritance tax, you’re probably wondering who’ll actually need to make the payment to HMRC. It’s a legitimate question. 

If your estate is above the nil-rate band, funds from your estate will be used to pay inheritance tax to HMRC. This will be dealt with by the person who is dealing with the estate (if there’s a will, this person is referred to as the executor). When it comes to gifts, if the benefactor dies before 7 years have elapsed, the recipient of the gift may have to pay IHT. 

Potential Budget Changes:

There is speculation that the Labour government may overhaul the 7 year rule as part of efforts to raise additional revenue. One possible change could be extending the seven-year period to ten years, which would increase the likelihood of gifts being subject to IHT. Additionally, past proposals from a 2020 All Party Parliamentary Group suggested introducing a 10% tax on lifetime gifts above a £30,000 annual allowance, regardless of when they are made.  

If implemented, such reforms would fundamentally change the way potential exempt transfers work and potentially impact individuals looking to pass on wealth during their lifetime. Families may need to reassess their estate planning strategies, particularly if they plan to make significant gifts to reduce the value of their taxable estate. 

How can we help? 

The gift inheritance tax threshold along with the broader 7-year gift rule, is a fairly complex topic. With potential changes coming in October, these rules may be amended or significantly altered, leaving many unsure of the best course of action. If you would like to discuss your specific situation and explore inheritance tax planning options, please contact The Private Office for a free initial consultation with one of our financial advisor for a free initial consultation.

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The Financial Conduct Authority (FCA) does not regulate estate planning, tax or trust advice.