We’ve discussed the functioning of inheritance tax, and even some of the discussion around its fairness, here and here. One common question is how it relates to capital gains tax and even income tax. In other words, on an inherited property, when is inheritance tax (IHT) applied, and when is capital gains tax (CGT) applied?
An overview of Capital Gains Tax (CGT)
1. Capital Gains Tax (CGT) is paid on gains you make when you dispose of an asset. Usually that means you sold it, but it could also mean that you gave it away or exchanged it for instance.
2. It is paid on assets like property, businesses, or financial assets. It is not paid on investments in ISAs, UK gilts, gifts to spouses, or your own home.
3. Capital Gains Tax rates depend on whether your total income and capital gains exceed the £43,000 limit of the basic income-tax rate and whether the gains are from property or other sources:
– 10% – below basic rate – not property
– 18% – below basic rate – property
– 20% – above basic rate – not property
– 28% – above basic rate – property
An overview of Inheritance Tax (IHT)
1. Inheritance tax of 40% is paid on the portion of estates that exceed £325,000
2. It is not due on business interests, in addition to some other exclusions
The relation between Capital Gains Tax, Income Tax and Inheritance Tax
1. Inheritance tax is the only tax that has to be paid upon inheritance. It is normally paid by the estate rather than by the heir. The heir does not have to pay Income Tax, Capital Gains Tax or Stamp Duty on inheritances or gifts that are subject to IHT.
2. Once the assets are yours, however, you must pay income tax on the income they generate (e.g. dividends, rents, interest) and must pay capital gains tax if you dispose of them and make a gain vs. the value they were assessed at when inherited.
3. The capital gains relief on your home continues to apply. So if you inherited your home and then choose to sell it, you do not have to pay. If you already owned a home and inherited another, you must inform HMRC which one you designate as your primary home within 2 years. If you do not, and then sell one of the properties, they are free to judge whether the one you sold was your primary home or not (in which case you’d have to pay capital gains tax).
4. Interestingly, because assets are valued at market value in probate, but estates only pay inheritance tax, and because heirs receive the assets at the probate value and are only liable for capital gains tax above that value, the capital gains of the deceased are ‘wiped clean’. This can be significant for estate planning.
Robert, aged 70, owns a £500,000 London rental property, which he acquired several decades ago for only £150,000. He is discussing estate planning with his son William. Robert pays income tax above the basic rate. So if he sells the property, he will have to pay 28% capital gains tax on his £350,000 gain, which equals £98,000. If he then passes away and leaves an estate of £402,000 (the property minus the tax), his estate will have to pay 40% inheritance tax on the portion that exceeds the £325,000 threshold. So 40% * £77,000 = £30,800. Net of taxes, William would have an inheritance of £371,200.
If, instead, Robert keeps his property, when he passes away, it will be valued in probate at its market value of £500,000 and the estate will have to pay 40% tax on the £175,000 portion that exceeds the IHT threshold, which equals £70,000. So net of taxes, William would have an inheritance of £430,000.
On the other hand, if the London property were Robert’s home, he wouldn’t pay capital gains tax on his sale, so if he did sell it before he passed away, the case would be the same as above – whether the estate consists of a property or of cash, the rules are the same – and net of taxes William would have an inheritance of £430,000.
Now assume that William has in fact received the £500,000 property (and paid the IHT out of other funds) and the London market has got much hotter and the value of the property increased to £600,000. If, and when, he disposes of it, he will have to pay Capital Gains Tax on the £100,000 gain normally if it is a rental property, and be exempt if it is his home.
Although at first glance the combination of Capital Gains Tax and Inheritance Tax can be confusing, once you understand the rules it is really very simple. The key points to remember for your estate planning are that:
No capital gains are paid when you receive an inheritance,
Inheritances are passed on at market value, ‘wiping out’ previous capital gains,
Before and after inheritance, the capital gains rules apply normally.