Sarah Bradford explains why the ‘seven year rule’ for inheritance tax purposes is not always what it seems.
Most people are aware that if they give away property at least seven years before they die, there is no inheritance tax (IHT) to pay on the gift. However, in certain cases where property is transferred into a trust, the seven year rule effectively becomes a 14-year rule.
Potentially exempt transfers and the `seven year rule’
Some gifts are exempt from IHT, regardless of how soon donor dies after making the gifts.
Gifts which are not covered by an exemption and which are made to individuals are exempt from IHT, as long as the person making the gifts lives for at least seven years after making them. However, if the person making a gift does not survive seven years, IHT is payable if the total value of the estate exceeds the nil rate band, which is set at £325,000 for 2013/14. Gifts of this nature are known as potentially exempt transfers (PETs). If a person dies more than three years but less than seven after making the gift, the amount of IHT payable on the gift can be reduced by taper relief.
When seven years becomes 14 years
A lifetime gift into a discretionary trust or an interest in possession trust is a chargeable lifetime transfer (CLT). IHT is payable on the CLT at the lifetime rate (currently 20%) to the extent that the value of the transfer, together with any chargeable transfers made by the same person within the previous seven years, exceeds the current nil rate band. There is no further IHT to pay if the donor survives at least seven years from making the transfer. It is therefore necessary to look back seven years and forward seven years – a total window of 14 years.
The position becomes complicated if a person making the CLT has also made PETs and dies within seven years of making a PET. This has the effect of bringing the PET into charge. Where this occurs, the nil rate band is set against gifts in chronological order.
As a result, a CLT which is made up to 14 years before the donor’s death could affect the IHT payable on a failed PET (a PET made within seven years of death). If a PET becomes chargeable, CLTs made in the seven years before making the PET are taken into account and affect the amount of the nil rate band that is available to set against the PET.
Example – Operation of the 14-year rule
John dies on 1 March 2014.
On 1 July 2000, he settled £200,000 into a discretionary trust.
On 1 May 2007, John gave his daughter Susan £225,000.
No IHT was payable on the gift to Susan as it was a PET. However, the gift was made within seven years of John’s death, so it is taken into account on his death. As the gift into the discretionary trust was made within seven years of the PET, it reduces the nil rate band available to offset against the failed PET.
Nil rate band at death £325,000
Set against CLT (1 July 2000) within 7 years of PET (£200,000)
Available nil rate band to set against failed PET £125,000
Failed PET (within 7 years of death) £225,000
Available nil rate band (£125,000)
Chargeable to inheritance tax £100,000
IHT at death rate of 40% £40,000
Taper relief @ 80% (£32,000)
(PET made between 6 and 7 years before death)
Inheritance tax on failed PET £8,000
The need to take account of CLTs within the seven years preceding another CLT or a PET means that gifts up to 14 years before death can affect the IHT payable on death.
Practical Tip:
If possible 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.
