The interplay between CGT and IHT when gifting wealth to children

The UK’s system of taxing wealth was already rather messy before the government announced significant changes to inheritance tax (IHT) and capital gains tax (CGT) this time last year.

While the CGT hikes will hurt investor profits, things have become simpler in this area to some degree, with rates now equalised across all assets. However, the proposed IHT reforms to farms, businesses, pensions and AIM shares will add a slew of fresh knots to the estate planning process.

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The relationship between CGT and IHT is both interesting and complicated. Despite operating separately from one another - with their own rates, reliefs and exemptions - the two often cross paths when passing on wealth to your offspring. You might pay one but not the other, can sometimes swerve both, and in certain scenarios the two come into play.

With lifetime gifts racing up the agenda in response to the forthcoming IHT changes, and further reforms speculated at this year’s Budget, it’s useful to learn how the two main “capital” taxes interact, and what you can do to mitigate them.

Let’s answer some of the key questions. Note, given the complexities within intergenerational wealth planning, it’s really important to get expert advice for your specific circumstances.

CGT and IHT: a brief overview

Let’s start by quickly explaining how each works.

IHT is charged on the value of your estate (total possessions, property, investments etc) on death. On anything that exceeds your lifetime tax-free threshold, which can range between £325,000 and £1 million, the rate is 40%.

CGT is a tax you might pay when you sell, transfer or gift assets and make a profit. The first £3,000 of gains every year are tax free, with the excess taxed at either 18% or 24%, depending on whether it lands below or above £50,270 when added to that year’s income.

Is CGT chargeable even when the asset merely changes ownership?

Yes. Even if you’re transferring an asset – such as a second home or share portfolio – rather than selling it, this is classed as a “disposal” under CGT rules. Importantly, if the recipient is a spouse or civil partner, there’s no tax to pay.

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The calculation is the market value at the time of transfer minus the price you paid. You can deduct any costs including stockbrokers’ or estate agents’ fees, stamp duty levied when you bought the asset, and home improvement costs. Offsetting losses against gains is also an option.

Will selling the asset to my children below market value lower my CGT bill?

In a word, no.

If, for example, you sold a second property to a “connected person” – an individual who HMRC considers to be closely linked such as a relative – lowering the price as an act of generosity, it’s still the market value that counts for CGT purposes.

As HMRC confirmed last year in a summary note: “If you sell, give or receive an asset to or from a connected person, you may need to replace the price paid with the market value of the asset when you work out your gain or loss.”

When giving away business assets – including some types of shares – you may be able to claim holdover relief, which means you don’t pay CGT when you relinquish the asset. Instead, the gain is postponed until the recipient triggers a disposal, with CGT calculated on the original purchase price.

Could I end up paying both CGT and IHT?

Whether IHT is payable on the gift depends on when you die.

Each year you can give away £3,000 free from IHT and bring forward last year’s allowance if unused, meaning a couple could gift £12,000 today tax free.

There are some other allowances that you can use, including gifts for weddings which are £5,000 per child, £2,500 per grandchild and £1,000 to anyone else. You can also make tax-free gifts out of income provided it's covered under 'normal expenditure' rules.

For anything that isn't exempt, gifts to someone other than a spouse or civil partner is deemed a potentially exempt transfer, or PET. Simply put, provided you survive seven years from the date the gift was made, it will be removed from your estate’s IHT calculation.

If you die within this period, the impact of IHT is determined by the size of the gift and the year in which death occurred. If the total gift is within your nil rate band – the amount you can leave tax free on death, currently £325,000 - it will absorb a proportion of this figure. But on any excess, the rate of IHT tapers if death occurs from year three onwards, as the table below shows.

In short, if your gift triggers a taxable gain, and you die within seven years of making it, you could pay both CGT and IHT.

A further instance where both taxes may arise is where you give an asset away but continue to derive some use - known as a gift with reservation of benefit (GWROB).

Let’s say you transferred a holiday home outright to your children, causing a CGT charge, but continued to use the property from time to time - it could be treated as having never left your estate and therefore be subject to IHT on death.

Can I gift the family home to avoid CGT and IHT?

In theory, yes. Your main residence is exempt from CGT but it’s not quite that simple. First, unless you pay the new owners a market rent, you must vacate the property, otherwise it will be classed as a GWROB and brought back into your estate.

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Second, the first £175,000 (£350,000 if you’re married) of the family home may already be protected from IHT under the residence nil rate band (RNRB), provided it’s left to direct descendants (children, grandchildren etc) on death. Note, the RNRB is gradually withdrawn once your estate exceeds £2 million. Third, if the new owners don’t use the home as their main residence, they could pay CGT upon sale. And finally, bear in mind the gift will trigger the seven-year rule for IHT.

Are there benefits to transferring the asset to my spouse before selling?

Switching assets between spouses and civil partners is one of the few transactions where both CGT and IHT are exempt. However, if your spouse inherits the asset and then passes it to your children, CGT is calculated on the original purchase price, not the value transferred.

That doesn’t mean joint planning should be ignored – far from it. The annual £3,000 CGT exemption is per person, so by teaming up matched with some strategic planning, you could realise £6,000 in gains every year and not pay CGT. In addition, if your spouse is in a lower tax bracket, some or all the gain might attract the basic rate of CGT.

How will my children be taxed upon receipt and in the future?

Your children won’t pay CGT straightaway but might when they come to sell in the future.

Any future annual income – such as dividends, interest or rent payments – will be taxed at the recipient’s marginal rate, unless the asset is sold and pumped into tax wrappers such as pensions and individual savings accounts (ISA).

When it comes to stamp duty, unless there is a payment in exchange for the transfer of ownership, the value of the gift (or transaction) is zero - so there’s no stamp duty to pay.

What if I don’t want my offspring to receive the asset now?

This is a common dilemma facing parents and grandparents. Gifting assets can make more sense when you’re young as you’ll have better odds of outliving the IHT seven-year rule. However, you might be wary about your offspring inheriting a large windfall in early adulthood in fear they’ll squander the cash.

One workaround here is trusts. These are legal instruments that allow you to move money or assets outside your estate to mitigate IHT, but still retain some control over when the proceeds are distributed and who receives them.

A note of caution here: trusts can be complex, none more so than the tax implications.

Creating certain trusts (discretionary) is considered a chargeable lifetime transfer, meaning anything above your £325,000 nil rate band is hit with an immediate 20% IHT charge. And if you die within seven years, additional IHT is payable, although taper relief is available from year three onwards.

Furthermore, placing shares or property into trust is deemed a disposal under CGT rules – however, hold-over relief might be available, thus postponing the tax bill – and future gains above the annual exemption (which is just £1,500 for trusts) are subject to CGT at 24%.

Despite the complicated tax arrangements, trusts are a wonderful estate planning tool for the right people, in the right circumstances. This is where skilled legal and tax practitioners truly earn their salt.

Should I gift CGT-exempt assets first?

One important thing I’ve yet to mention is that CGT doesn’t typically apply on death, offering a strong argument to cling on to non-CGT exempt assets and gift others first.

CGT-exempt assets include ISAs (you’ll have to sell holdings first as ISAs can’t be transferred into someone else’s name), cash savings, government bonds (gilts) and qualifying corporate bonds.

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Something to consider when selling and gifting ISA money is that you’ll forgo the future tax benefits, possibly leading to higher income tax and CGT bills down the line.

If you own a second property, it might be more tax efficient to gift the rental income rather than the asset itself.

Withdrawing money from your pension and passing to younger generations is something else to ponder, but bear in mind that while no CGT is payable, anything beyond your tax-free entitlement (25% of your total pensions capped at £268,275) is taxed as income.

This approach may have notable appeal as unspent pensions will form part of your estate from April, and if you die after your 75th birthday whoever inherits the pot who isn’t a spouse or civil partner could be hit with both income tax and IHT, leading to a potential effective tax rate of 67% - or perhaps even higher.

Provided the gifts from pension withdrawals are regular in nature and don’t impact your standard of living, they should receive immediate IHT relief under the gifts out of normal expenditure rules. Keeping stringent records is essential to proving you’ve satisfied HMRC’s requirements.