Unexpected inheritance tax on gifts doubles

The number of families getting unexpected inheritance tax bills on gifts from loved ones has more than doubled over the past decade.

HM Revenue & Customs recovers hundreds of millions of pounds in inheritance tax (IHT) every year on gifts that don’t comply with its seven-year rule — showing how important it is to make gifts early.

Under the rule, certain gifts are tax-free if the donor lives for at least seven years after making them. If the donor dies before then, the gift is included in their estate and may be taxed, depending on the estate’s value.

The number of estates paying IHT on gifts doubled from 590 in 2011-12 to 1,300 in 2020-21, according to data obtained by the wealth manager Evelyn Partners using a freedom of information request.

The IHT collected on gifts also more than doubled, from £101 million in 2011-12 to £256 million in 2020-21.

The seven-year rule is a useful relief for families, allowing large gifts, such as money for house deposits and university fees, to be made tax-free. HMRC will investigate any gifts where it suspects that tax has been underpaid or avoided.

Ian Dyall from Evelyn Partners said: “More families are making gifts in their lifetime in an effort to reduce the size of their estate as more estates become liable to IHT, and it is a growing burden.

“In some cases the donor just doesn’t live long enough for the estate to reap the full tax benefit. But in other cases there is a lack of awareness, or a misunderstanding of the rules around gifting.”

Inheritance tax is widely hated, even though it is only paid by about 4 per cent of estates. The government raked in a record £7.5 billion in IHT in 2023-24, and is forecast to take even more this year. About £2.8 billion IHT was paid between April and July, up £200 million from the same period a year ago.

Inheritance tax is typically charged at 40 per cent on estates valued over the £325,000 threshold. Anyone passing a family home to a direct descendant gets an additional £175,000 tax-free allowance, provided their estate is worth £2 million or less. This allowance decreases by £1 for every £2 that the estate exceeds the £2 million mark.

Anything left to a spouse or civil partner is exempt from tax, and a partner’s allowances can also be inherited, meaning couples can pass on up to £1 million tax-free.

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However, gifts made in the three years before death can be taxed at 40 per cent and those given between three and seven years before death are taxed on a sliding scale, starting at 32 per cent and falling to 8 per cent. Gifts given more than seven years before death are tax-free.

Dyall said: “It can be quite tricky to make lifetime gifts that are completely safe from IHT and suddenly having to settle a surprise 40 per cent tax bill on a large sum will be a challenge for many people.

“Anyone receiving a big gift from an elderly relative might want to assess the tax situation before they either spend it all or plough it into something illiquid like a property.”

It’s important to keep records of any lifetime gifts, because this will help your executor and family to work out what is exempt from IHT and to challenge any disputes made by HMRC.

Nimesh Shah from the accountancy firm Blick Rothenberg said people were often caught out because they left it too late to make gifts.

“No one wants to think about death and taxes, so they put it off. But as you get older it is obviously less likely you will survive the full seven years, so it’s important to plan early. There is also a common misconception that if you give away an asset you are free of IHT,” Shah said.

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You can make small gifts that are exempt from IHT. For example, you can give away £3,000 a year without it becoming taxable later. Regular gifts can also be made, as long they do not affect the donor’s standard of living and are taken from income, rather than savings or capital.

A parent can give up to £5,000 tax-free to a child or stepchild for a wedding or civil partnership. Grandparents can gift £2,500, and anyone else can give £1,000.