Inheritance tax – making tax-free gifts
There are various exemptions, and potential exemptions, which make it possible to make gifts free of inheritance tax. Making tax-free gifts is a useful way to reduce the value of your estate – and ultimately the inheritance tax that may be payable on gifts.
What counts as a gift? - For inheritance tax purposes, a gift is anything that has value, for example, money, property or possessions. A gift may also arise if the value of your estate is reduced following a transfer, for example, if you sell your house to your children for less than it is worth; the discount element is regarded as a gift.
Gifts to spouses - Gifts to spouses and civil partners are free of inheritance tax.
Gifts out of income - The inheritance tax exemption for ‘normal expenditure out of income’ is very useful and can be used to make tax-free lifetime gifts. For the exemption to apply, the gift must meet three conditions:
An easy way to use this exemption, for example, would be to set up a standing order for a regular amount, say £X per month, to your children or grandchildren, or to meet the cost of school fees or similar.
Gifts made in this way are completely exempt – you do not need to survive seven years to keep the gifts tax-free.
Annual gifts exemption - There is an annual gifts exemption for inheritance tax which allows you to give away £3,000 of gifts in total IHT-free in each tax year. If the exemption is not used in full in one tax year, the unused amount can be carried forward to the following year, after which it is lost if it is not used.
Wedding gifts - Tax-free gifts can also be made, up to certain limits, on the occasion of a marriage or civil partnership. The tax-free limit for wedding gifts is £5,000 where the gift is to a child of yours, £2,500 where it is to a grandchild and £1,000 where the gift is to someone else.
Small gifts - It is also possible to give gifts of up to £250 per year IHT-free to as many people as you like, as long as the recipient has not benefited from another exemption.
Other tax-free gifts - Gifts to help another person with their living costs, such as an elderly relative or a child under the age of 18 can be made free of inheritance tax, as can certain gifts to charities and political parties, housing associations, gifts for national purpose and for the public benefit.
Potentially exempt transfers - You can also give as much as you like away IHT-free – as long you survive seven years. However, there are anti-avoidance rules where you have previously owned an asset or where you continue to retain the benefit of it after you have given it away (for example, if you give your house to your children and continue to live in it rent-free), and care must be taken not to fall foul of these.
If you survive less than three years after making the gift, IHT is payable in full at the usual 40% rate. However, if you survive more than three years but less than seven years from the date of the gift, taper relief reduces the amount of IHT payable. If you survive at least seven years from the date of the gits, it drops out of account and is IHT-free.
Private lettings relief
Lettings relief potentially shelters some of the gain from capital gains tax on the disposal of a property which has been an only or main residence at some point during the period of ownership and which has also been let out.
Where a residence has been occupied as an only or main home, private residence relief exempts from capital gains tax not only the period for which the property was so occupied, but also the last 18 months of ownership. Where the property is let, to the extent that the letting falls outside the last 18 months of ownership, private residence relief is not available for that period. However, lettings relief may be.
Availability of lettings relief
Lettings relief is available where a gain arises on the disposal of a property which:
• at some time has been the individual’s only or main residence;
• during the period of ownership, all or part of the property has been let as residential accommodation; and
• a chargeable gain arises as a result of the letting.
Amount of the relief
The amount of the relief is the lowest of the following three amounts:
1. the amount of private residence relief;
2. £40,000; and
3. the amount of the chargeable gain arising as a result of the letting.
Rose buys a cottage on 1 January 2012 for £200,000 and lives in it as her only or main residence until 30 June 2015. She then moves in with her boyfriend and lets the cottage out. The cottage is sold for £350,000 on 30 June 2018.
The gain on the sale of the property is £150,000.
The property is owned for 6 years and 6 months (78 months).
She lived in it as her main residence for 3 years and 6 months (42 months).
Private residence relief is available for the period in which she occupied the property as her main residence and the final 18 months – a total of 60 months (42 months + 18 months).
The gain eligible for private residence relief is 60/78 x £150,000 = £115,385.
The gain attributable to the let period is the remainder of the gain, i.e. £34,615 (£150,000 - £115,385).
Lettings relief is the lower of:
1. £115,385 (gain eligible for private residence relief);
2. £40,000; and
3. £34,615 (gain attributable to the letting).
As a result of the lettings relief, the full gain is exempt from tax; £115,385 being sheltered by private residence relief and the remaining £34,615 being sheltered by lettings relief.
Living in a let property as a main residence for a period of time can be very beneficial. Not only does it shelter any gain for the period for which it was occupied as such, it also shelters the gain for the last 18 months and brings lettings relief to the table.