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Giving away assets while you’re still alive, is a popular way to avoid paying inheritance tax (IHT).
By making these gifts during your lifetime, it’s possible to remove wealth from your estate legally and potentially spare your loved ones a 40% tax charge on your death.
But gifting isn’t always straightforward, especially when it comes to non-cash gifts. There’s also a common misunderstanding that lands some families with a surprise tax bill. Here’s what you need to know about ‘gifts with reservation of benefit’ to ensure you don’t breach the tax rules.
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According to data obtained by TWM Solicitors, in the last year, the tax authority HMRC has conducted 461 investigations into estates, resulting in gifts worth £156 million potentially becoming subject to IHT. That’s more than double the 220 investigations recorded the previous year.
The reason? HMRC concluded that the gifts had not been wholly given away. They were what it calls ‘gifts with reservation of benefit’ – which means that the original owners continued to enjoy them in some way.
Madeleine Beresford, partner in the private client team at TWM, says: “Gifting assets can be an effective way of reducing a future IHT liability, but it’s important that families understand the rules.
“One of the most common mistakes is where someone gives away an asset but continues to benefit from it in some way. In those circumstances, HMRC may still treat the asset as forming part of the estate for IHT purposes.”
Alan Barral, financial planner at Quilter Cheviot, describes gift with reservation of benefit rules as one of the biggest traps in IHT planning.
“The rules are deceptively simple on the surface but complex in practice. HMRC takes a strict view of what counts as a “gift”, and continuing to get any benefit from it will generally mean the gift hasn’t been effective for IHT purposes.
“Many people don’t realise that even seemingly minor benefits, such as using a holiday home for a few weeks a year, or keeping the right to rental income, can keep the asset in their taxable estate.”
He adds: “Take the example of a parent who gifts their home to their adult child but continues to live there without paying a full market rent. To the parent, this may feel like a completed gift, but because they still live in the property, HMRC will treat it as though they never gave it away at all.
“The same principle could apply to other assets, such as gifting a classic car but continuing to drive it. The tax consequences can be both surprising and costly.”
“Ian Dyall, head of estate planning at wealth management firm Evelyn Partners, says he’s encountered confusion amongst clients too, who are convinced the plans they’ve made are watertight. “I was presenting at a client event recently and a client was convinced he had mitigated his liability simply by putting his home in his child’s name.
““His child lived elsewhere and he was paying no rent. It was only when I showed him a similar example in the HMRC tax manual that he believed he had an issue. Resolving it is not easy, as transferring back to the father would result in a capital gains tax bill for the son.”
Dyall says that if you give away an asset, but continue to benefit from it in some way, you’ll breach HMRC rules.
“If you gift an asset, it is usually treated as a ‘potentially exempt transfer’, or PET. Provided you live for seven years after making the gift, it will no longer form part of your estate for inheritance tax.
“However, if you continue to use the asset, or the gift can be taken back if you choose to do so, then HMRC will deem there to be a reservation of benefit and the gift will continue to form part of your estate indefinitely.”
The only way that you can give away an asset tax-effectively but continue to benefit from it, is to pay for its use. If you do that, it must be the full market rate, not a nominal payment.
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The most obvious example where problems arise is when people give the family home to their children and then continue to live there rent-free.
But there’s still scope for confusion if the arrangement is formalised and a market rent is paid, says TWM’s Madeleine Beresford.
“It is commonly reported that those who give away their home and continue to live there must pay the recipient a market rent for their occupation. That income is then taxable in the hands of the beneficiary.
“What is often misunderstood is that this continues beyond the seven-year period after the gift, and the gift can fall back into the taxable estate even decades later if people don’t keep up with rent payments and rent reviews.”
Even if you move out, you could still encounter problems if you regularly take any other benefits from it. For example, if you store some of your possessions there because you’ve downsized and don’t have space in your new home.
Beyond property gifts, TWM Solicitors says these rules can also catch out families in certain scenarios, including:
Gifts of jewellery may also be problematic if you reserve the right to wear the item for special occasions or continue to pay for its insurance.
Ian Dyall points out that the rules can apply to trusts, too. “We recently saw a trust created in 2000 which held assets worth £1 million. The client thought that as the money was held in trust it would not be subject to inheritance tax.
“Unfortunately, he was named in the trust as a potential beneficiary of the money he settled in the trust. Therefore, there was a reservation of benefit and all of the trust’s assets were part of his estate.”
To get a clearer picture of what HMRC might consider to be a reservation of benefit, it’s worth checking its inheritance tax manual.
You would be forgiven for thinking HMRC would never know if you broke the rules. But the tax authority is clamping down on tax evasion and uses a supercomputer, called Connect, to identify people that may not have paid the correct amount of tax.
If it decides to investigate, HMRC has wide-ranging powers to scour everything from your bank statements and bills to photos on social media.
With IHT currently charged at a rate of 40% on any assets in your estate that are above your tax-free threshold (£325,000 per individual, plus an extra £175,000 for direct descendants if you are passing on a family home), it’s not surprising that families are prepared to explore any avenue that might reduce the amount of IHT they pay.
But putting plans in place yourself could backfire, as Dyall points out. “Some people have tried to avoid the rule by selling their home, and giving the money to the children to buy a new home which the parents then live in.
“This potentially may avoid the reservation of benefit rules, as the parents never owned the new home, but if it does it is likely to be caught by another piece of anti-avoidance legislation called pre-owned asset tax.”
If you’re concerned about IHT, it’s best to seek legal advice or consult a financial planner that specialises in estate planning. They will be able to advise you on a raft of strategies that can be used to reduce an IHT bill.
That way you can be confident that, when the time comes, the plans you have put in place will stand up to scrutiny from HMRC and your loved ones won’t be hit with a surprise tax bill.
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