What the seven-year rule for inheritance tax is – and what it means for you

Families increasingly face inheritance tax despite their attempts to sidestep the divisive 40pc charge.

Over the last three years, families have lost £650m to death duties after falling foul of the so-called “seven-year rule”, Telegraph Money found in a Freedom of Information request to HM Revenue and Customs.

Hundreds more have been forced to pay around £700m over the past five years after falling foul of complex rules on handing their homes down to the children.

Many people choose to give away wealth during their lifetime in order to shrink their estate and slash their tax bill.

Everyone benefits from a £325,000 tax-free allowance, or “nil-rate band”. If your estate is lower than this when you pass away, then no tax will be due. However, if your estate is worth more than this, then everything above the threshold will be taxed at up to 40pc.

But whereas some gifts are immediately taken out of your estate, others are not. For certain gifts, the donor must survive seven years after making them – otherwise their family could be hit by an unexpected tax bill.

With IHT receipts on track to hit £7bn this year, it has never been more important to get your head around the legitimate ways you can avoid it.

Here we explain how the seven-year rule works so you can shelter as much of your wealth for your family as possible.

What is the 7-year rule in inheritance tax?

If the gifter dies within seven years of making the gift, then the nil-rate band is reduced by the value of the gift. In other words, the potentially exempt gifts still count as part of the estate until the seven years are up.

If the value of your taxable estate on death, together with the value of PETs made within the last seven years, exceeds the nil rate band, then IHT will be charged on these gifts.

So a family inheriting a £325,000 estate on death who had received a £100,000 gift from the deceased three years ago would incur a £40,000 tax bill. But if the deceased had given the money eight years ago, there would be no tax to pay.

This strange rule – which clearly incentivises giving away wealth earlier in your life – was introduced to prevent people giving away their wealth on their deathbed. 

Some choose to play it safe and stick within the simplest rules. Andy Butcher of wealth manager Raymond James said he had had clients who were so scared of incurring a tax charge by making PETs that they restricted their gifts to £3,000 a year. He said they do this even though they may have saved more in tax than if they had taken the risk and given away more than the annual exemption. 

Gifts that are exempt from inheritance tax

Transfers of any value between spouses and civil partners are immediately exempt from inheritance tax. In addition, everyone can gift £3,000 a year without incurring a charge. This allowance can be carried forward if it was unused in the previous tax year, meaning it is possible to give £6,000 in one year IHT-free.

There are other exemptions for weddings. Parents can give £5,000 to a child who is getting married while grandparents can give £2,500. To anyone else, the donor can give £1,000.

You can also make smaller gifts of £250 per year, though not to anyone who has benefited from your £3,000 allowance.

On top of this, you can make regular gifts to family members, as long as they come from surplus income and do not leave you with a lower standard of living.

For such regular giving, it is irrelevant whether the donor survived seven years after making them.

Most other gifts, not out of normal expenditure or out of annual allowances, are called “potentially exempt transfers” (PETs). This means they only become IHT-free once seven years have passed.

What is taper relief? 

The one respite, should you fall into the seven-year trap, is taper relief. This reduces the rate of IHT you are charged on the gift depending on when it was made. Gifts given in the first three years are taxed at the full 40pc. Gifts made between three and seven years are then taxed on a sliding scale, as the table below shows.

Remember that taper relief only applies if the total value of the gifts given in the seven years before you die exceed the nil-rate band. 

How to avoid getting caught in the seven-year trap

Daniel Tomassen of accountancy firm HW Fisher said married couples should think carefully about which of them should make the gift, in order to avoid getting caught out by the seven-year rule. 

“Typically you see the spouse who is in better health or younger making the gifts as they are more likely to survive seven years,” he said.

“Alternatively, to spread the risk then they may decide to each make a gift of 50pc. This way the chances of at least one of the spouses surviving seven years is higher and therefore more likely that at least 50pc of the total gifted amount is likely to fall out at least one of their estates for inheritance tax purposes.”

One option is to take out an insurance policy – called a “gift inter vivos” policy – designed to pay out if the gift falls within the seven-year trap. 

“For an annual premium the policy will cover the inheritance tax payable on the gift should they not survive seven years,” Mr Tomassen said. “This provides peace of mind to the executors of the estate who may not have sufficient liquidity to settle the inheritance tax bill on the gifts.”

Your executor will be asked to tell HMRC when you gave gifts within the seven-year period. This is why it is important to keep records of the gifts in order to make life easier for your loved ones.

“The deadline for HMRC enquiries for inheritance tax is significant,” Mr Tomassen said. “Therefore good records can ensure the executors pay the correct amount of inheritance tax and therefore minimise the chances of penalties being levied by HMRC.” 

Does the 7-year rule apply to trusts?

The rules are more complicated if you make a gift into a trust. 

A gift of this nature is called a Chargeable Lifetime Transfer (CLT). This means it is immediately liable for IHT. This is not to say that there will be an immediate IHT charge, but that it will have to be assessed on death to see if there is an IHT liability.  

If the sum of the CLTs made within seven years falls within the nil rate band, no IHT is due. However, if it exceeds the threshold, there will be a charge on the excess at a rate of 20pc.

Kumar Jethwa of wealth manager Coutts said: “The 20pc tax rate requires reassessment on a sliding scale if you were to die within seven years of setting up the trust.”

You may have heard that “a 14-year rule” applies to trusts.

If you had made a CLT more than seven years before your death, and then a PET within seven years, then it would be necessary to look back over 14 years in order to work out how much nil-rate band was still available. This is because even though the CLT was made outside the seven years, it may have reduced your nil-rate band and therefore how much IHT is due on your gifts. 

If possible, you should leave at least seven years after making a CLT before making another CLT or a PET to prevent getting caught by the 14-year rule. Alternatively you could make the PET before the CLT. 

Do I have to pay inheritance tax on my parents’ home?

There is no IHT due if you give your house to a spouse or civil partner.

If you leave your main home to your direct descendants, then you benefit from an additional £175,000 allowance, called the residence nil-rate band. However, the seven-year rule will still apply. 

Mr Tomassen said: “Gifting assets other than cash, then consideration needs to be made with the interaction of other taxes such as capital gains tax and stamp duty land tax. For example, if you gift a buy-to-let property then typically the proceeds are deemed to be the market value and the donor may therefore be subject to capital gains tax on the capital gain arising.” 

Note that if you continue living in the home after you gift it then it may be counted as a “gift with reservation” and may be added to the value of your estate after you pass away.

How do I legally avoid inheritance tax on my parents’ house?

Telegraph Tax Hacks columnist Michael Warburton, a respected Grant Thornton accountant who is now retired, has a comprehensive guide on gifting your home without incurring a tax bill.