One of the best ways to avoid inheritance tax is to give away property during your lifetime.
Many people don’t realize that there is a way to unlock unlimited gifts, thanks to a valuable IHT loophole.
Under Section 21 of the Inheritance Tax Act 1984, individuals can reduce their IHT bill by making regular gifts from their income.
Gifts must meet three conditions in order to be considered exempt from IHT. They must count as normal – i.e. “regular” – expenses (so a one-off gift to help your child renovate their kitchen would not qualify). They must be paid from surplus income (not capital), what is left over after paying all your outgoings, and must not adversely affect your standard of living.
As long as they meet all three of these conditions, then no IHT will be due on the payments – potentially saving your loved ones huge IHT bills. Detailed records are vital.
This sounds simple enough. But every person’s situation is different, so it can be difficult to know if your plans fall within the rules.
When Telegraph Money’s Ask a Lawyer columnist Gary Rycroft, of Joseph A Jones & Co Solicitors, wrote about unlimited gifts, we received a number of emails from people wanting to know if their gifts were appropriate.
Here, we answer your questions about how to make regular gifts from surplus income to reduce IHT.
Q: “I am currently arranging a Lasting Power of Attorney (LPA) for my family to use in the event that I am unable to deal with such matters.
“You stated that such an arrangement [regular gifting] it could not be done by those with the power of attorney. However, my question is: if such an arrangement already exists, can those with power of attorney continue to make such payments? Could they also modify the payments made up or down?’
ONE: There are strict rules about donating to LPAs, and rightly so – this is to prevent unscrupulous solicitors from abusing the system and being paid from the donor’s estate.
But what if you want to continue giving gifts even after you’ve lost your ability?
Fortunately, there are exceptions to the rules that will allow you to continue making payments. Under Section 12 of the Mental Capacity Act 2005, an LPA may be allowed to make a gift to himself, a family or friend or “any charity to which the donor has made or is expected to make gifts”, under the condition that it has been given as part of an “ordinary circumstance”.
An obvious example would be someone’s birthday or a wedding. But you could argue that it’s a regular occurrence if you’ve already established a pattern of gifts.
Kate Aitchison of tax firm RSM said drawing up a ‘gift deed’ is one way you can demonstrate your intention to regularly give money to a relative or friend. “The key is to create a common pattern. It is better to donate smaller amounts at specific times than larger variable amounts at random points throughout the year.”
Article 12 also states that the value of the lawyer’s gift must be reasonable “taking into account all the circumstances and, in particular, the size of the donor’s estate”.
Ms Aitchison said that once a person loses capacity, they could also be paying carer fees – potentially reducing the amount they can afford to give. So the LPA could reduce payments and stay within the rules, but increasing them could be dangerous.
If a solicitor wants to make a gift that does not fall within these restrictions, they must apply to the Court of Protection for approval. But this is costly and time consuming.
Q: “My pension income is enough to transfer £1,000 a month into my savings account without affecting our standard of living.
“I have two daughters and I usually transfer money from my savings account to my current account so I can give them £1,000 or more for birthdays and Christmas.
“My question is what documentation is needed? Do I need an accountant to record this or do I have to tell HMRC or is a simple letter included in the gift stating that the money is out of income all that is needed?’
ONE: Your executor will be asked to complete Form IHT403 and provide evidence of your income and expenditure for each of the tax years in which you made gifts from surplus income.
This means you need to keep records of everything from your salary, pensions, investments, income from savings, mortgages, insurance, household bills, travel expenses, holidays and take-home pay care. The executor will then be asked to work out “net income minus total expenses” to prove that your gift fits the rules.
So keep a statement of bank transactions, accounts and so on to make things easier for your executor. To really help them out, you could write your own calculations every year, although you might decide that’s too morbid.
Q: “If one calculates that they can give £5,000 a month from surplus income and after death the calculations show that, say, only £4,000 is actually eligible, what happens? Will the entire £5,000 be disqualified from qualifying or will only the extra £1,000 be disqualified?’
ONE: If HMRC decides that, after making the gifts, your remaining income was not enough to support your standard of living, then they will cancel the extra amount.
Mr Rycroft said: “HMRC will scrutinize the calculations submitted and if they exclude £1,000 from a total gift of £5,000, that £1,000 will become a potentially exempt transfer (PET) and will therefore be subject to the normal rules.”
The PET is an IHT-exempt gift and is no longer considered part of your estate if you survive seven years after it was made. If you die within seven years, tax may be due, but it will be charged on a sliding scale (40% in the first three years, then 32% between years three and four and so on).
So only the surplus of £1,000 a month would be liable to IHT, but whether tax is actually due will depend on when you made the gift.
Q: “Can income received from an ISA that is not spent also be gifted in addition to excess dividend income from investments held in a personal account?”
ONE: Income from an Isa can definitely be included as part of your disposable income for Section 21 gifting.
They are gifts of capital assets that do not qualify, including jewelry or stocks. There are some sources of income that HMRC actually treat as capital – such as withdrawals from life insurance bonds. With these investments one part will be considered income and the rest capital. But rent, interest and dividends all count as income. So, as long as including the income from your Isa in your calculations doesn’t affect your standard of living, your gifts should be clear.
The other thing to think about is whether you have a record of income from the Isa. Because Isas are tax-free – no capital gains tax or dividend tax is required on income – they are not included in tax returns. Ms Aitchison said this could cause problems for executors when they provided evidence that the income was surplus – another reason to keep detailed records of your income and expenses.
Mr Rycroft said you may want to consider giving the entire Isa to maximize your gift.
“If you really don’t need the income from the Isa to fund your spending, why not give all or part of the capital away? It will be a PET, but as a PET any future capital growth and income will still be outside your estate.”
Have a question about reducing your IHT bill? Email us at email@example.com.