When thinking about estate planning, many people wish to give a lifetime gift to family or friends. It can be a rewarding experience to see the beneficiary enjoy the gift during your lifetime. You might be motivated to make the gift because the beneficiary is in need of money (e.g. to help them purchase a property, or to alleviate financial hardship), or for inheritance tax planning reasons. No matter your reason for making a lifetime gift, it is important to be aware of the tax rules that govern how that gift is treated. In this article, we look at lifetime gifts, Potentially Exempt Transfers (PET), and reservation of benefit.
The majority of lifetime gifts to non-exempt beneficiaries will be classed as Potentially Exempt Transfers (PETs). In order to become exempt from inheritance tax, the person making the gift must survive for seven years after the transfer is made.
However, the situation becomes slightly more complicated where the person making the gift continues to enjoy a benefit from it. Special rules were introduced to prevent people from avoiding inheritance tax by giving away their property, without at the same time relinquishing the use or benefit they previously enjoyed from it.
What is a gift with reservation of benefit?
A gift with reservation is where an individual transfers ownership of an asset to a beneficiary, but where the transferor continues to benefit from it following the transfer. For example, a person may gift their home to their children but continue to live in the property.
What are the rules concerning gifts with reservation?
When, on the date of the transferor’s death, a gift is subject to reservation, the value of that gift will be treated as part of their estate for inheritance tax purposes. It will be treated as if the gift was never made, notwithstanding legal ownership may have passed from the deceased to the beneficiary during their lifetime. However, the deceased may only have continued to enjoy a benefit in the asset gifted for a limited period, and if the reservation ceased more than seven years before the transferor's death, the gift will qualify as an exempt transfer.
Paying rent while living in a gifted property
It is possible to demonstrate that you no longer reserved a benefit in a gifted asset, even though you may continue to use it after the date the gift is made. For example, you might enter into an agreement with the beneficiary to pay them rent for the ongoing use of the asset. However, the rent amount must be full market rent and reviewed regularly. Such rentals are often looked at carefully by HMRC in the event of death.
It may be surprising to know that the gifts with reservation rules also apply to properties owned abroad. For example, if a UK domiciled person gifts a foreign property to their child, but continues to use it as a holiday home free of charge, the whole value of the property will be chargeable to IHT.
Pre-owned asset income tax charge
Other anti-avoidance rules exist to prevent gifts being made to fund the purchase of new assets from which the donor derives a benefit. When a parent makes a gift of cash towards the purchase of a property, if they benefit from the property, they may be subject to a charge even where they have never been the owner of the property.
‘Pre-owned assets tax’ (POAT) applies where a person removes an asset from their estate but continues to enjoy a benefit from it, and the gift with reservation rules do not apply. The person will be liable to pay income tax on the benefit the person receives from using the asset.
For example, where a parent provides cash for their child to buy a home, and this home includes a ‘granny flat’. If the donor lives in this part of the property, this will result in a POAT charge. If an individual fails to pay POAT in their lifetime, the family may find tax, interest, and even penalties are owed upon death.
Specialist Estate Planning Lawyers, Edinburgh
Fraser Scott is an Associate within our Asset Protection Group and specialises in estate planning and tax. If this article has raised any questions or you would like to discuss your affairs then please complete our contact form or call 0131 225 1200.
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