“Gifts out of income” are not a loophole; they’re a long‑standing statutory exemption. The rule sits in section 21 of the Inheritance Tax Act 1984.
A lifetime gift is immediately exempt (so there’s no seven‑year clock) if, and to the extent that, three tests are met:
(1) the gift formed part of the donor’s normal (habitual) expenditure;
(2) it was made out of income (not capital); and
(3) after making the gifts the donor was left with enough income to maintain their usual standard of living.
The statute uses the phrase “taking one year with another” for the income test, which is why HMRC looks at the overall pattern rather than a single month in isolation.
HMRC’s Inheritance Tax Manual expands on each limb:
- “Normal” means normal for the donor, not for some hypothetical average person.
- A single gift can still qualify if there’s evidence it was intended as the first in a pattern; equally, a series might fail if there’s no real regularity or intention behind it.
HMRC considers frequency, amounts, recipients and the reasons for the gifts when deciding if a pattern exists. GOV.UK
The “out of income” test excludes straightforward gifts of capital assets (for example, handing over shares) unless the asset was bought from income specifically to make the gift.
Income isn’t defined in IHT law, so HMRC treats it by ordinary accountancy principles and after income tax. HMRC’s practice is to start with the year in which the gift was made; “old income” doesn’t retain its character for ever – absent evidence to the contrary, HMRC often treats income accumulated for more than about two years as capital. In short: show that, in the year(s) in question, you had enough income to make the gifts without dipping into capital.
Finally, the standard‑of‑living test asks whether, after the normal‑expenditure gifts, the donor still had enough income to maintain their usual lifestyle. You don’t have to demonstrate that the donor paid day‑to‑day bills with that income – only that income was sufficient to cover both the gifts and ordinary living costs. If it wasn’t, HMRC may still allow part of a gift under this exemption and treat the balance as chargeable or exempt under some other provision.
How you actually use (and claim) the exemption
During lifetime, there’s no form to send HMRC when you make an outright gift to an individual. What matters is evidence. Keep a contemporaneous log of gifts (amounts, dates, recipients, and – crucially – the intention that they’re regular), alongside a simple income‑and‑expenditure summary for each tax year the gifts are made. HMRC’s own guidance makes clear that gifts out of income are a distinct, unlimited exemption if affordability from income is proven; your job is to make that proof easy.
A practical way to organise that proof is to mirror the layout HMRC expects from executors. The schedule IHT403 (used at death) contains a ready‑made page‑8 grid: income lines (salary, pensions, interest, rents, etc.), expenditure lines (mortgage, insurance, bills, council tax, travel, entertainment, holidays, care fees, other), and a line for the surplus/deficit. Keep an annual version of this grid in life (one per tax year) and file it with supporting bank statements; it’s exactly what HMRC will look for later.
On death, if a full IHT account is needed, the executors complete IHT400 and add IHT403 (“Gifts and other transfers”). The income/expenditure table on page 8 is completed for each tax year, so this is where your records will be essential for your PRs.
Different forms apply if you’re dealing with trusts or chargeable lifetime transfers (that is, situations where IHT can be due straight away). Since August 2024 HMRC has re‑platformed the trust reporting suite: you use IHT100a (and related forms) for chargeable events on trusts or immediately chargeable lifetime gifts. That’s separate from ordinary out‑of‑income gifts to individuals. If you’re transferring assets into a trust and believe s.21 applies, do take advice.
Common pitfalls
The usual traps are:
(a) confusing capital with income (for example, gifts funded by cashing in investments are generally capital unless you deliberately purchased the asset from income to gift it),
(b) irregular, ad‑hoc payments without evidence of intention to establish a pattern, and
(c) gifts that force the donor to dip into capital to cover everyday expenses – which tends to fail the standard‑of‑living test.
HMRC can and does part‑allow a gift if only part of it is supported by demonstrated surplus income in that year.
Can you combine this with other allowances?
Yes, you can combine gifts out of income with the £3,000 annual exemption – but you cannot combine the £250 small‑gifts exemption with another exemption for the same recipient. GOV.UK’s “gifts” page sets out those interaction rules (and also covers the wedding/civil‑partnership exemptions).
Why the headlines about a “tax raid”? What’s actually official?
Over the past fortnight a run of outlets has reported that the Treasury is looking at ways to raise more from lifetime gifts – specifically a lifetime cap on the total you can give away IHT‑free and potential tweaks to taper relief on gifts made three to seven years before death.
The Guardian, Morningstar and many other papers describe this as options under consideration ahead of the next Budget. None of these pieces amounts to a policy document; they are sourced briefings and industry commentary rather than legislation.
What is official right now is elsewhere in the IHT system. The government has confirmed that, from 6 April 2027, most unused pension funds and death benefits will form part of a person’s estate for IHT purposes; HM Treasury has published the policy paper and its consultation response. Those are hard, on‑record changes that you need to act on, unlike the current press speculation about lifetime gifting caps.
The pensions change is a serious one, and for estates likely to be impacted, lifetime gifting is one possible response. However it is not the only response (and not always the right one). It can have tax consequences and can leave you financially exposed later in life when you may need the money. So the pensions change needs thought and planning now.
Beyond pensions, the government has also been consulting on business and agricultural property relief changes (including their application to trusts). There is a new £1 million per estate Business Property Relief/Agricultural Property Relief allowance but importantly, it does not apply to assets held in pensions. If you own business property (in your pension or otherwise), again, now is the time for a review of your estate planning arrangements.
But in short, there’s no official cap on lifetime gifts or any change to the gifts‑out‑of‑income exemption itself just yet.
What to do now, while the rules are unchanged
Review your estate planning in relation to pensions and business/agricultural property.
If you’re using the s.21 gifts out of income exemption, make it boringly clear that the gifts are (a) regular, (b) from income, and (c) affordable without touching capital for everyday spending. Make sure your records are in order (as above) with evidence for each tax year. Standing orders do help to show regular payments.
Do make sure you don’t trip up on the common pitfalls outlined above.
Ultimately, the gifts‑out‑of‑income exemption remains one of the most powerful and underused parts of Inheritance Tax law. The law has not changed here (yet). Until we see a Budget, a policy paper or draft clauses, carry on using the exemption properly: regular pattern, clear intention, good records, and a clean separation between income and capital.
Jennifer Wiss-Carline is a practising Solicitor regulated by the SRA and a Chartered Legal Executive (FCILEx), bringing over two decades of experience to her practice. Specialising primarily in Private Client law, Jennifer expertly handles matters including Wills, Inheritance Tax and Estate planning, Lasting Powers of Attorney for individuals and businesses, Deputyship Orders and more.
