Income Tax and Capital Gains Tax during estate administration - Beneficiaries' liability to Capital Gains Tax on inherited assets

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Overview

Understanding how inherited assets are taxed is important for beneficiaries and estate administrators alike. This guide explores Capital Gains Tax (CGT) on inherited assets, its interaction with Inheritance Tax (IHT), and strategies to minimize tax burdens during estate administration. Familiarity with these concepts is vital for success in the SQE1 FLK2 exam and in legal practice, helping future solicitors effectively handle estate planning and administration.

Capital Gains Tax Basics in Estate Context

CGT Liability Overview

CGT is relevant when inherited assets are sold or transferred, not when they are inherited. The tax is charged on the capital gain, which is the difference between the sale price and the asset's value at inheritance (probate value).

Probate Value and Its Role

The probate value, set at the time of death, resets the acquisition cost for beneficiaries. This adjustment can significantly affect tax planning and calculations.

Timing and Trigger Events

CGT liability is triggered by:

  1. Asset sale
  2. Gifting an asset
  3. Exchanging an asset for value
  4. Loss or destruction of an asset (with insurance payouts treated as proceeds)

Advanced Capital Gains Tax Calculations

Step-by-Step Calculation Process

  1. Determine Sale Proceeds: Often the sale price, but can include the market value for gifts.
  2. Establish the Acquisition Cost: For inherited assets, it's the probate value.
  3. Calculate the Base Cost:
    • Add expenses like property improvements
    • Subtract any claimed capital allowances
  4. Compute the Gain: Subtract base cost from sale proceeds.
  5. Apply Reliefs and Exemptions:
    • Annual Exempt Amount (AEA)
    • Principal Private Residence Relief (PPR)
    • Business Asset Disposal Relief
    • Investors’ Relief
  6. Determine the Taxable Gain: Subtract reliefs and exemptions.
  7. Apply the Appropriate Tax Rate: Based on income tax band and asset type.

Complex Scenarios and Considerations

Mixed-Use Properties

For properties with both residential and commercial use, apportionments determine applicable CGT rates and reliefs.

Partial Disposals

For partial sales, the base cost is allocated accordingly.

Valuation Challenges

Unique or illiquid assets may require professional valuation, like unquoted shares or rare collectibles.

Anti-Avoidance Rules

General Anti-Abuse Rule (GAAR)

GAAR allows HMRC to counteract benefits from abusive arrangements, relevant for inherited asset schemes designed to lower CGT liability.

Targeted Anti-Avoidance Rules (TAARs)

Relevant TAARs include:

  1. Bed and Spousing: Selling and repurchasing assets in a spouse’s name to utilize allowances.
  2. Value Shifting: Transferring value to manipulate CGT liabilities is targeted.
  3. Land Transactions: Rules to prevent income profit conversion into capital gains.

Estate Planning Considerations

Anti-avoidance measures require:

  • Genuine commercial intent
  • Proper documentation
  • Professional guidance for complex plans

Interaction Between Capital Gains Tax and Inheritance Tax

Double Taxation Relief

To avoid double taxation:

  1. IHT on an asset can be deducted from its CGT value.
  2. Selling losses within a specific time can offset IHT.

Strategic Considerations

The interplay between CGT and IHT offers planning strategies:

  1. Lifetime Gifting: Gifts before 7 years escape IHT but may invoke CGT.
  2. Hold-Over Relief: Defers CGT on lifetime gifts to reduce tax.
  3. Appropriation: Personal representatives can use multiple CGT allowances.

Strategic Planning and Exemptions

Timing of Disposals

Manage tax efficiency by:

  • Spreading disposals across years
  • Aligning disposals with other income

Use of Reliefs

  1. Principal Private Residence Relief:

    • Full relief for main residence
    • Partial relief for mixed-use

  2. Business Asset Disposal Relief:

    • 10% rate on business assets up to £1 million

  3. Investors’ Relief:

    • 10% rate on shares in unlisted companies, separate £10 million limit

International Aspects

For estates with global elements:

  • Double taxation agreements influence liability
  • Non-UK individuals may use the remittance basis
  • Plan carefully for multi-jurisdictional assets

Examples

Example 1: Inherited Property with PPR

John inherits a property valued at £400,000, which he later sells for £550,000.

  • Gain: £150,000.
  • PPR Eligibility: PPR reduces or eliminates CGT due to main residence status.

Example 2: Inherited Shares with Annual Exempt Amount

Sarah sells inherited shares, gaining £20,000, offset by a £12,300 exemption.

  • Taxable Gain: £7,700 at CGT rate.

Example 3: Mixed-Use Property

A property part-residential, part-commercial, necessitates apportioning gains for CGT calculations.

Conclusion

A strong understanding of CGT in estate administration is key for the SQE1 FLK2 exam and legal practice. Key takeaways include:

  1. CGT applies on asset disposal, not inheritance.
  2. Probate value is critical for CGT computations.
  3. Special cases like mixed-use properties require careful planning.
  4. Anti-avoidance tactics demand genuine intent.
  5. CGT and IHT interactions open strategic opportunities.
  6. Effective use of reliefs and exemptions is important.