Inheritance tax warning as gifting trap could leave families with tax bills worth thousands

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Families are being urged to understand the seven-year rule before giving away money or property

Thousands of families across the country could be hit with hefty tax bills they never saw coming, all because of a little-understood rule around financial gifts.

The trap catches people off guard at the worst possible time, often leaving them scrambling to find money they simply do not have.

Major changes to inheritance tax are coming next year, prompting more families to consider giving away money during their lifetime to reduce their tax bill.

However, gifting money can have unexpected consequences and could leave the very people you are trying to help facing a tax bill of their own.

The problem can arise if the person making the gift dies within seven years.

From April 2027, unused pension funds will be brought into the inheritance tax net, encouraging more people to consider lifetime gifting as a way to reduce the value of their estate.

People can give away lump sums of any size through what are known as potentially exempt transfers. If they survive for seven years after making the gift, it will normally fall outside their estate for inheritance tax purposes.

But if they die within those seven years, the gift can be brought back into the inheritance tax calculation, potentially leaving families with an unexpected bill.

Sarah Coles, head of personal finance at AJ Bell, warns that gifts made in the seven years before someone's death can be pulled back into the inheritance tax calculation.

She said: "When someone dies, it’s their estate that’s liable for inheritance tax. However, there are exceptions to this. If they have given gifts worth up to the value of their nil rate band during the previous seven years, they are brought back into the estate on death.

"If they have given away more than their nil rate band, the gifts are brought back in chronological order. Once the nil rate band is used up, there’s tax to pay on any subsequent gifts."

The critical sting, Ms Coles explains, is that the bill does not necessarily fall on the estate. Instead, it lands on the person who received the gift.

"Taper relief may apply, and bring the rate of tax down, but it’s payable by the person who received the gift.

"If you were given one of these gifts, but the person giving it insisted you spent it on buying something – like a property – you may be left unable to pay the bill without borrowing the cash."

That means a recipient who believed they had been given money free and clear could find themselves personally liable for a substantial and entirely unexpected tax demand.

Ms Coles illustrates the danger with a stark example. If someone hands over a sum of money on the condition that the recipient uses it to purchase a property, that cash is effectively locked away in bricks and mortar.

Should the person who made the gift then die within seven years, the recipient could face an inheritance tax bill with no readily available funds to cover it. They may have no choice but to borrow money to settle the debt.

Taper relief can reduce the inheritance tax due on certain gifts if the person who made them dies between three and seven years later. However, the tax may still need to be paid by the person who received the gift, rather than the estate.

The standard inheritance tax rate is 40 per cent, but this can fall to 32 per cent if the person dies three to four years after making the gift.

It drops to 24 per cent after four to five years, 16 per cent after five to six years and eight per cent after six to seven years.

Once seven years have passed, no inheritance tax is due on the gift.

There is another pitfall that catches people out when they try to give away property but continue to exert influence over it.

Giving a property to family does not necessarily mean it will fall outside your estate for inheritance tax purposes after seven years.

Under the "gift with reservation of benefit" rules, the property could still be counted as part of your estate if you continue to benefit from it after giving it away.

Ms Coles explained: "If you continue to get any benefit from the property, such as living in it without paying market rent, it's not counted as being given away at all for IHT purposes."

There is also a risk if you give the property away but continue to have too much control over it.

For example, refusing to allow the new owner to redecorate or insisting your furniture remains in the property could raise questions over whether you have genuinely given it away.

Ms Coles described this as a "relatively grey area", warning that HMRC could decide the donor has "not been entirely excluded from benefiting from the property", meaning it may still be counted as part of their estate.

For those looking to make smaller, safer gifts, an annual allowance of £3,000 is available, which leaves the estate immediately for IHT purposes and can be carried forward for one year.