Throughout our lives, we engage in various financial transactions including the making of gifts and loans. These actions can have significant implications, especially when it comes to estate planning, inheritance tax and the distribution of assets following a death. Understanding how gifts and loans are treated on death is crucial for effective estate planning and ensuring that your wishes are honoured.
Gifts made in life (Lifetime gifts)
A gift is a voluntary transfer of property or money without expecting anything in return. Gifts can be given for a variety of reasons for example birthdays, weddings, or simply as acts of kindness.
A gift can be:-
- anything that has value e.g. cash, land, buildings or possessions.
- a loss in value when an asset is transferred e.g. if you sell your property to a family member for less than the market value, the difference between the market value and the price paid counts as a gift.
Legally, gifts are considered as complete when the giver (the donor) has an intention to give, the donor delivers the gift and the recipient (the donee) then accepts it.
When you provide for gifts during your lifetime, the value of your personal estate is reduced. This can lower the overall inheritance your beneficiaries will ultimately receive on your death, but it can also reduce your estate's liability to inheritance tax (IHT) if you survive 7 years from the date of the gift.
Loans made in life (Lifetime loans)
Loans, on the other hand, involve the transfer of money or property with the expectation of repayment. Loans can be formal, with agreement in written form and with specified interest terms, on the one hand or informal and accordingly based only on verbal agreement. Typically, in a loan arrangement, the lender expects the borrower to repay the loan either within a specified period or at some defined point in the future.
For inheritance tax purposes, a loan is defined as a sum of money which you give in order to receive the same back in return - either with or without interest. It is essential when making a loan that you agree in writing the terms upon which the loan is made.
It can be difficult to establish after the event whether a payment is a loan or a gift unless there is some form of written agreement in place between the parties. Even if a loan is to your friends or family, it is still advisable to have some form of written agreement in place, so that your intentions are clear.
Treatment of gifts on death
Gifting to individuals can be a popular tool in mitigating your inheritance tax liability. However, when a person dies the treatment of gifts they have made during their lifetime can vary and therefore it is important to understand the implications of gifting from an IHT perspective. The following is a summary of the main allowances / reliefs available:
- Annual allowance: An individual can give away up to £3,000 capital cash per tax year without it being added to the value of their estate for IHT purposes. If the previous year's allowance has not been used it can be carried forward to the current tax year allowing a maximum of £6,000 to be gifted in one tax year.
- Potentially Exempt Transfers (PETs): Gifts of capital that exceed the annual allowance will reduce a person's Nil Rate Band allowance (NRB) which is currently £325,000 (i.e. the threshold at which IHT is charged at 0%) for a period of 7 years from the date the gift is made. Such gifts are known as PETs. If the donor survives for 7 years from the date of the gift, the gift becomes exempt from IHT and the donor's NRB is restored. However, if the donor dies within 7 years, the donor's NRB is reduced by the value of the gift thereby reducing the NRB that is available to the deceased's personal estate potentially resulting in IHT being due on the donor's death estate.
- Taper relief: If you die within 7 years of making a gift and there is IHT to pay on it, the amount of IHT due after your death depends on when you made the gift. Gifts made in the 3 years before death are taxed to IHT at the full 40%. Gift made within 3 to 7 years before death are taxed on a sliding scale known as taper relief. It must be stressed that taper relief is however only available if the value of the gifts made within 7 years of death exceed your NRB of £325,000.
- Exempt gifts: Certain gifts are exempt from IHT, including gifts between spouses and civil partners, gifts made in consideration of a marriage / civil partnership (there are set specified limits depending on the relationship between the donor and donee) and the valuable normal expenditure out of income exemption. The latter exemption allows the donor to make a series of IHT effective gifts from surplus income. There is no monetary limit to this exemption so the size of the exempt gift is only limited by the amount of the donor's surplus income. To qualify for the exemption, the gifts must:-
- form part of normal expenditure (a regular pattern of gifting);
- be made out of income; and
- leave the donor with sufficient income to maintain their usual standard of living.
This exemption is claimed following death of the donor by the executors completing HMRC form IHT403. It is helpful to the executors if the donor can keep records of gifts made, with details of their income and expenditure, using the form during their lifetime.
Treatment of loans on death
Loans can complicate estate administration. If a loan is still outstanding as at the date of your death, then it will be classed as an asset of your estate. Your executors are under a duty to collect in the loan as part of the estate administration process. An outstanding loan increases the estate's value and therefore potentially the IHT liability.
To give clarity to your executors as to your intentions, you can state in your will that certain loans you have made do not require to be repaid – this will convert any such loans to legacies on death under your will and so just as with an outstanding loan, the value of the unpaid loan remains in your estate for IHT purposes.
If you decide in your lifetime to write off a loan that you have made you should document this in the form of a written agreement between you and the donee - this will convert the loan to a gift (PET) as at that date. If you survive 7 years from the date the loan was written off, then the value of the gift will fall out of your estate for IHT purposes.
HMRC advise that they only accept the release of a loan by way of a gift if the release is effected by deed.
Estate planning considerations
Tensions can arise following a death where there is no documentation in place to clarify the nature of a lifetime payment, made by the deceased in life. Proper estate planning / the taking of advice can help manage gifts and loans effectively:
- Documentation: keep detailed records of all gifts and loans, including dates, amounts, terms and the intended effect on death. This helps the executors manage the estate accurately and ensures compliance with IHT legislation.
- Legal advice: seek legal advice on estate planning to understand the implications of any existing gifts and loans and give instructions for the preparation of an appropriate will that reflects your wishes.
- Communication: inform your beneficiaries of the details and intended consequences of any gifts and loans to avoid confusion and disputes after your death.
Conclusion
Gifts and loans made in life and their treatment on death requires careful consideration. By understanding the legal consequences and IHT implications individuals can plan accordingly to help prevent disputes, ensure their estate is managed smoothy and importantly that their wishes are honoured.
On death, executors, potential beneficiaries and indeed HMRC will want to determine the status of any financial assistance received from the deceased during life. Having a clear agreement in place between the parties to any such financial arrangement can save both time and possible conflicts after death.
If you need help establishing how your estate should be passed on during your life and after your death, please get in touch with one of our wills and estate planning experts.
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