CAPITAL GAINS TAX (CGT)
The other major tax that affects landlords only arises when they sell a property at a ‘profit’. At this point you may be liable to pay Capital Gains Tax (CGT). The profit is obviously the difference between what a landlord bought a property for and the selling price. The good news is that even if a landlord has made a profit, they are still not automatically liable to pay Capital Gains Tax( CGT ). This is because there are a number of exemptions and allowances from Capital Gains Tax for landlords.
First of all, before deducting allowances a landlord will need to establish the Base Cost of the property. To establish the Base Cost additional costs need to be added to the initial acquisition costs (or where the property was acquired prior to 31st March 1982 the market value on that date which ever is the higher – a process known as rebasing).
The initial capital gain is then calculated by taking the Base Cost from the sales price.
Tom the landlord bought his bungalow in July 1995 for £50,000. He paid stamp duty of £500, legal fees of £350, mortgage broker’s fee of £250 and removal costs of £535.
The place was in a bad state of repair as an elderly couple had lived in it previously. Therefore, it needed complete modernisation.
These works cost as follows:
1. redecoration £2000
2. new kitchen £5000
3. new bathroom £3000
Not content with this upgrading work for his tenants. Tom’s next project was the erection of a shiny new conservatory to house his tenant’s collection of carnivorous houseplants. This cost him an additional £15,000 (comprising of £14,000 construction cost and £1000 design and building regs fees).
However, in his enthusiasm to secure the maximum floor space. Tom the landlord built very close to his neighbours Jerry’s boundary. Jerry was a little jealous of Tom’s magnificent erection and aggrieved that it had crossed onto his boundary. He instructed his solicitor to send a letter threatening legal action to have it removed. Tom the landlord contested this and after Tom had spent £500 on legal fees, Jerry dropped his action.
In 1999 Tom the landlord suffered damage to his weather vein of £500. He secretly suspected that it was malicious damage by Jerry but was unable to proof anything. When Tom the landlord tried to claim for damage to his weather vein, the insurance company refused to pay out, stating it was storm damage and classed as an act of god not covered by his policy.
In 2000 fed up with Jerry’s constant agitation. Tom the landlord sold his bungalow for £125,000. How much was Tom’s Base Cost for Capital Gains Tax ( CGT ) purposes?
|Incidental cost of acquisition||£1000 (legal fees, stamp duty and mortgage broker’s fee). The removal costs were a personal cost and not part of the capital cost of the property.|
|Refurbishment works||£10,000 classed as enhancement works & therefore a capital cost|
|Building of conservatory||£15,000 also classed as enhancement works & therefore a capital cost|
|Legal fees defending title to property||£500 contesting boundary with Jerry|
|TOTAL BASE COST||£76,500|
It all seems fairly straight forward up to now!? However, just to make things a little more interesting, the Revenue have two minor complications called Indexation Allowance and Taper Relief that both potentially effect the Capital Gains Tax ( CGT ) liability.
Indexation, which was effectively replaced by Taper Relief in 1998 was used by Government to account for inflation in the calculation of Capital Gains Tax ( CGT ). Therefore, where a capital gain was made, it allowed a proportion of the increase to be deducted.
This practice reflected the time when inflation alone would have resulted in large increases in capital value. It should also be noted that indexation relief may only reduce or extinguish a capital gain; it cannot convert a capital gain into a loss or increase a loss.
The calculation of the indexation allowance on a capital gain commonly called the ‘indexation factor’ is made according to the formula given below and rounded to three decimal places. The RPI or Retail Price Index is simply a measure of the price of goods and services produced by the Government’s Office for National Statistics (ONS) as a way of measuring prices and inflation.
The formula for the Indexation Factor calculates what the rise in the value of the asset disposed of would have been as a result of inflation given the base date of March 1982 & the end date of April 1998 when Taper Relief was introduced to the Capital Gains Tax (CGT ) calculation. Often these figures have been already calculated and are available in the form of a table, which can be used to speed up the calculation process for Capital Gains Tax.
Formula for calculating the ‘indexation factor’
RD = RPI in month of disposal or April 1998 whichever is the earliest
RI = RPI for March 1982 or month in which expenditure incurred, whichever is the Later
(RD – RI) / RI
Taper relief on Capital Gains
From the 6th April 1998 taper relief took over from Indexation on Capital Gains. Properties purchased by landlords before this date still benefited from indexation. However, capital gains after this date were subject to the new tax regime. Taper relief reduces the chargeable net capital gains according to how long the asset has been held.
Why is it called Taper Relief?
This simply refers to the way that the amount of the gain liable for Capital Gains Tax ( CGT ) ‘tapers’ off the longer the asset is held. Taper relief is given on the net capital gains chargeable after the deduction of indexation allowance and any capital losses realised. It is charged according to the rates stated in table A below.
Assets acquired before March 1998 qualify for an additional year to the period for which they are treated as held after 5th April 98. As you can see the taper for business assets is more generous. Unfortunately for landlords, residential rental property does not count as business asset because property investment is not classified as a qualifying trade. The exception to this is holiday lets. Investing in a holiday let therefore could be a way for landlords to acquire a property and dispose of it quickly without incurring a large Capital Gains Tax ( CGT ) liability. I go on to discuss 2nd homes in more detail in the Landlords Bible.
|No. of complete years after 5/4/98 for which asset held||Capital Gains on business assets
% of gain chargeable
|Capital Gains on non -business assets
% of gain chargeable
|10 or more||25||60|
Main residence exemption
As I’m sure most landlords are aware, where a property is occupied as a person’s main residence they are not liable for Capital Gains Tax ( CGT ) on disposal. This tax exemption is also known as Private Residence Relief or PRR. That’s why you don’t have to pay Capiatl Gains Tax ( CGT ) when you sell your home. There are, as in all cases in tax law, complications. For instance when individuals are required to live away from their property in ‘job related’ accommodation. In these cases it is possible for them to nominate a property they own as their main residence, despite living elsewhere.
Examples of where this might occur are for a:
Frequently the case arises where a landlord buys a home and then has to move because of work, etc. In this situation they decide to rent out their house and therefore on disposal will not have lived in the property for their entire time of ownership. How does this affect a landlords exemption status?
For a start, where a property was rented out prior to 31 March 1982, this period of non-qualifying use is ignored. The tax regulations allows for the proportion of the capital gain to be exempt where the conditions pertaining to primary residence are met. In other words the following equation applies where the period of qualifying use being that period where the property qualifies as the person’s private residence or benefits from one of more of the stated exemptions.
Period of qualifying use/total period of ownership * (multiply) indexed gain
Finally, if you have lived at any stage in the property as your main residence, then the last three years of ownership qualify for exemption from Capital Gains Tax ( CGT ). This even applies when the period of occupation occurred prior to 31 March 1982.
The implications of this are that if a landlord has a property with a large potential capital gain, derived during the last 3 years. Where you have not lived in the property before, the landlord may want to consider moving into it as your main residence to reduce your capital gains tax ( CGT ) liability.
Other exemptions of Private Residence Relief (PRR) that may apply are in circumstances where individuals are required to work away from home. If you think this may apply to you I would obtain a specialist tax text or consult a professional tax adviser as the matter can get very complex.
Alternatively try the practitioner’s zone on the HMRC website. For further details on tax matters have a look at www.propertyhawk.co.uk for advice and the latest developments.
What is the rate of Capital Gains Tax ( CGT )?
This depends on what the landlords income tax rate is. Any net capital gains are worked out after allowing for deductions and allowances. These are then added to your income tax liability. The rate charged corresponds to what would be payable if the sum was derived as income.
Some tax saving tips
I’ve listed below a number of tax savings tips that hopefully you will find useful. For more detailed advice on tax have a look at our tax professionals in the Recommended Links or go to the Landlords Bible.
You don’t have to actually have completed a sale. The deal must have reached a point of no return. In technical terms, you must have an ‘unconditional contract’ for sale. This usually means that contracts have been exchanged and a completion date set.
Think about exploiting, the tax loophole, which allows you to remortgage your home and let it out using the funds to purchase a new home.
This little known loophole was brought about by technical changes in the 04-05 budget. For example, an owner-occupier bought a house for £150,000 using a £120,000 mortgage. The owner now wants to move but also to hold onto this property now worth 250k. Interest on the 120k and up to an additional 130k to enable him to withdraw his equity in the property can be all treated as an allowable expense for tax purposes and be offset against rental income.
Ensure that you claim or your allowances and expenses. Think creatively but realistically.
Capital Gains Tax deferment.
The Chancellor in his efforts to encourage investment in small businesses has created a mechanism to defer paying capital gains tax. Companies can now be set up under the umbrella Enterprise Initiative Scheme as qualifying investments. Investments in these companies allow investors to defer paying Capital Gains Tax ( CGT ) and basic rate income tax.
How does it work? Let’s start with the example where a property is sold realising a capital gain of £100,000 after allowances and deductions. The owner, as a top rate income tax payer would be liable to pay £40,000 Capital Gains Tax ( CGT ). However, they decide to invest the receipts of £100,000 into a EIS company. Following the approval of the investment by the Revenue the individual receives back the £40,000 back in tax. This means that for this £60,000 of funds the investor receives £100,000 worth of shares.
It gets better! It’s also possible where you do not own the company to benefit from income tax relief at the basic rate of 20%. In this situation you would therefore receive £100,000 of shares for a £40,000 net investment. The bad news is that if you sell within 3 years the income tax relief is withdrawn & also you will not benefit from the exemption from capital gains in the share price made during that time.
Should you sell the shares at any stage the original Capital Gains Tax ( CGT ) which was deferred is ‘crystallised’ and the tax will have to repaid. However, as long as you retain the investments or roll them over into another qualify investment the liability remains deferred. A word of warning through. Saving tax by putting money into a good investment can be an efficient way of investing money. However, putting your funds into a poor investment that goes bust will just means that you end up loosing your money as well as the ‘taxman’s’!
Often confusion arises over eligibility of items of expenditure allowable as an expense when calculating income tax liabilities. I have therefore listed below a number of these items under the headings; non allowable and allowable expenses:
1. fees in purchasing the property – included in the base cost when calculating any potential capital gain
2. expenses in connection with the first letting of a property for more than one year
3. repairs covered by insurance. Where a repair is covered then it is only the excess that should be claimed as an expense
4. replacement of a ‘bog standard’ kitchen with a ‘top of the range’ bespoke designer kitchen – classed as capital expenditure. See HMRC website’s property income manual in the Practitioners Zone for detailed guidance and explanation on repair, reconstruction & improvement.
5. architect or building regulation application to alter property – classed as a capital cost
6. capital expenditure of providing the means of travel (normally a car) is not allowable as a deduction.
1. costs of remortgaging a rental property such as surveyors, solicitors and mortgage brokers fees
2. fees received in evicting a tenant where a property is to be re-let
3. accountants fees!
4. cost of any services provided e.g. laundry, gardening and porter.
5. ground rents
6. any interest payable including personal loans and overdrafts which have been used to fund the investment
7. UPVC double glazed windows are now classed as a repair & therefore a revenue item even where they replace single glazing units.
8. costs of evictions e.g. legal costs, court costs, investigations
9. subscription to landlord organisations
10. ‘revenue costs’ of a car (the running costs e.g. fuel, road tax) of trips to rented property, it must be your primary purpose to visit the rental property. However, as the Revenue put it, if you stop off on the way to collect a paper this is ok! Where as if you set off to buy a paper and then visit a property on the way this is not. I think we all now how landlords would perceive this particular journey.
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