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How to use 7 year rule in the inheritance tax?

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Inheritance Tax (IHT) is a levy imposed on an estate before it is passed to beneficiaries by inheritance or as a gift.

Even if the tax is paid after the person’s death, it may still apply to some gifts made prior to the death.

If you are making a financial gift, it is important to determine whether it is exempt from taxation or if it will generate a tax bill either now or in the future. That is why it is crucial to be aware of the 7-year gift rule related to Inheritance Tax.

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Introduction to inheritance tax 

Before diving into the 7-year gift rule in inheritance tax, it’s essential to have a basic understanding of what inheritance tax is. Inheritance tax is a one-off levy on the estate (money, possessions, property) of a person who has passed away.

Normally, the tax must be paid within 6 months of the death. It is also known as a cumulative tax because it considers any earlier gifts when assessing the amount of tax due.

Currently, the nil-rate band (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. This is in addition to the main residence nil-rate band (RNRB), which is currently £175,000 (per individual).

Anything at or below this level is tax-free, while any balance over this threshold could be subject to a standard inheritance tax rate charge of 40% or 36% if 10% of the net estate is left to charity. Other tax rate charges may apply.

The term “gift” is also used throughout this article. But what exactly is a gift? Simply put, a gift is something of value (possessions, money, property) or the difference in value when something is transferred (e.g. if you sell a house for less than its worth to your children, the difference in value is a gift).

If you are wondering who pays inheritance tax on a jointly owned property? It is the estate who does.

What is the “7-Year Rule” in inheritance tax?

This rule is often the reason why parents will give their children or grandchildren gifts long before they expect to pass away, in order to avoid paying tax on the gift.

The 7-year rule in inheritance tax applies specifically to gifts. These types of “gifts” do not refer to items that are wrapped in ribbon and paper, but rather to things that have value in a general sense, such as possessions, money, and property.

While some gifts are exempt from inheritance tax, most gifts are subject to inheritance tax rules.

Taxable gifts can be split into two categories. Chargeable lifetime transfers (CLT) relate to gifts that are paid into a discretionary trust and can be subject to an immediate 20% inheritance tax charge.

The second category, potentially exempt transfers (PET), is where the 7-year rule can become effective. A PET gift can be completely tax-free if you live for 7 years after gifting it to an individual.

If you die within 7 years of gifting the asset, it will count towards the value of your estate and the £325,000 allowance.

After 7 years, the gift does not count towards the value of your estate, which is known as “the 7-year rule” for inheritance tax purposes.

If you give a gift and die between three and seven years after handing the asset over, the inheritance tax band is tapered on a sliding scale. This scale is:

Years between gift and death

Tax Paid

Fewer than 3

40%

3 to 4

32%

4 to 5

24%

5 to 6

16%

6 to 7

8%

7 or more

0%

How to use 7 year rule in the inheritance tax
If you die within 7 years of gifting the asset, then the gift will count towards your nil-rate band and may still be subject to IHT.

How does the 7 year rule work?

If someone gives money or a part of their estate to a relative or family member and then passes away within seven years, the person who received the gift may be liable to pay taxes.

What is the gift inheritance tax threshold? 

The inheritance tax threshold, also known as the nil-rate band, is currently set at £325,000 plus the £175,000 RNRB if available. This means that, in total, your estate can be passed to your inheritors without paying any inheritance tax.

However, if the value of your estate is more than the threshold, you’ll need to pay inheritance tax on anything above it. For instance, if your estate is valued at £450,000 and no RNRB is available, you will need to pay inheritance tax on the £125,000 that exceeds the threshold.

Inheritance tax-free gifts 

If you pass away within seven years of giving an asset to someone, the seven-year gift rule in inheritance tax may require the beneficiary to pay IHT. To protect your wealth for your loved ones, you should remember that certain gifts won’t incur any inheritance tax charges if given away while you’re still living. These gifts include:

  1. Gifts to your partner or spouse – gifts made to your UK-domiciled spouse/civil partner are exempt from inheritance tax, and some gifts to non-UK domiciled spouses are also tax-free.
  2. Wedding gifts – when it comes to weddings/civil partnerships, you can give away up to £5,000 to a child, £2,500 to a grandchild/great grandchild, or £1,000 to anyone else without any inheritance tax being due.
  3. Gifts from your income – as long as the gift doesn’t alter your standard of living, you can give away gifts out of your regular income like Christmas/birthday/anniversary presents, regular payments, and life insurance policy premiums.
  4. Gifts to assist with family maintenance – gifts that help your relatives (like your ex-spouse/former civil partner, a child, or a dependent relative) with living costs are tax-free.
  5. Gifts to charities – you can make gifts of any value to charities, universities, museums, and community sports clubs without incurring inheritance tax.
  6. Gifts to political parties – gifts made to political parties are exempt from inheritance tax, if the said political party has at least two members elected to the House of Commons and one of them got 150,000 votes in a general election.

In addition, you can make tax-free gifts worth up to £3,000 each year, as part of the annual exemption. Any unused exemption from the previous year can be carried to the current year, provided that the current year’s allowance is used first.

Anything above £3,000 is subject to inheritance tax. Furthermore, the small gifts exemption lets you make an unlimited number of small, tax-free gifts each year, outside of your annual exemption, as long as each one is worth no more than £250 and you haven’t used another exemption for the same person.

What is the 7 year rule in the inheritance tax?
To protect your wealth for your loved ones, you should remember that certain gifts won't incur any inheritance tax charges if given away while you're still living.

What is the 7 year rule example?

If you gave your child £200,000 and passed away within seven years, only £125,000 of your estate would be exempt from inheritance tax.

For instance, if you gave your grandchild £500,000 and died two years later, they would have to pay £70,000 in inheritance tax, which is 40% of £175,000.

What is taper relief? 

The 7 year rule in inheritance tax has an important aspect known as taper relief. This relief applies if the benefactor passes away before the completion of the 7 years.

In such a case, the inheritance tax payable is calculated on a sliding scale, depending on how long the benefactor survived. Therefore, it is advisable to give gifts earlier rather than later.

Number of Years Before Death

Taper Relief %

Tax Payable on Gifts Above Nil-Band Rate

0-3 years

0%

0%

3-4 years

20%

32%

4-5 years

40%

24%

5-6 years

60%

16%

6-7 years

80%

8%

7+ years

No tax

0%

Remember, taper relief only applies to the amount of tax the recipient must pay on the value of the gift that exceeds the nil-rate band.

For instance, if Person A gifted £600,000 to their son in May 2016 and passed away in March 2021, leaving their £1,200,000 estate to their son as well, there is inheritance tax due on the value of the gift above the nil-rate band (£600,000 – £325,000 = £275,000).

Since Person A died four to five years after making the gift, the amount of IHT their son is required to pay is reduced by 40%. Therefore, the total inheritance tax their son needs to pay is £66,000 (£275,000 x 24% = £66,000).

Because the gift consumed Person A’s entire nil-rate band, their son will need to pay inheritance tax on the estate at the full 40% IHT rate. This results in the estate of Person A having to pay £480,000 (£1,200,000 x 40% = £480,000) before the assets can be distributed.

It is important to note that there are separate rules around property, which provides some with a higher nil-rate band, known as the residence nil-rate band.

This is only applicable to direct decedents, so it is essential to 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 have to pay inheritance tax (IHT) on gifts due to the 7 year gift rule, you may be wondering who needs to pay HMRC. It’s a valid query.

If your estate is more than the nil-rate band, the funds from your estate will be used to pay IHT to HMRC. This is handled by the person responsible for the estate (if there is a will, this is called the executor).

When it comes to gifts, if the benefactor passes away before 7 years have elapsed, the recipient of the gift may have to pay IHT.

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