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 you bought the property for and the selling price. The good news is that even if you have made a profit, you are still not automatically liable to pay CGT. This is because there are a number of exemptions and allowances.
Base Costs
First of all, before deducting your allowances you 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).
These are:
* Incidental costs of acquisition (e.g. legal fees, stamp duty, etc).
* Enhancement expenditure (e.g. the cost of building an extension to a property).
* Expenditure incurred in establishing, preserving or defending title to, or rights over, the asset (e.g. legal fees incurred as a result of a boundary dispute).
The initial capital gain is then calculated by taking the Base Cost from the sales price.
EXAMPLE
Tom 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 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 contested this and after Tom had spent £500 on legal fees, Jerry dropped his action.
In 1999 Tom 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 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 sold his bungalow for £125,000. How much was Tom's Base Cost for CGT purposes?
ORIGINAL COST £50,000
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
Annual exemptions
The personal allowance allows each individual to make a certain amount in capital gains each year without having to pay CGT. These exemption changes every year. In the tax year 06-07 it was £8,800. Unfortunately, this exemption only applies in the year of disposal of the asset. Unused balances from previous years cannot be carried forward.
In addition to the annual CGT allowance there are a number of expenses and deductions that can also be taken into account to reduce your potential liability. Some of these are used to generate the Base Cost as previously mentioned. Expenses that are deductible are:
* the costs of acquisition such as solicitors fees, mortgage brokers fees, etc
* money spent on the property, including renovation and improvement costs
* the cost of disposal such as estate agents, solicitors, advertising. Remember not to get caught double counting the costs you may have already included under Schedule A as a repair.
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.
Indexation
Indexation, which was effectively replaced by Taper Relief in 1998 was used by Government to account for inflation in the calculation of 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 gain; it cannot convert a gain into a loss or increase a loss.
The calculation of the indexation allowance 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. 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.
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
From the 6th April 1998 taper relief took over from Indexation. Properties purchased before this date still benefited from indexation. However, gains after this date were subject to the new tax regime. Taper relief reduces the chargeable net 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 CGT 'tapers' off the longer the asset is held. Taper relief is given on the net 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, 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 to acquire a property and dispose of it quickly without incurring a large CGT liability. I go on to discuss 2nd homes in more detail in the Landlords Bible.
TABLE A
No. of complete years after 5/4/98 for which asset held
Gains on business assets
% of gain chargeable Gains on non -business assets
% of gain chargeable
0 25 100
1 25 100
2 25 100
3 25 95
4 25 90
5 25 85
6 25 80
7 25 75
8 25 70
9 25 65
10 or more 25 60
It is possible to use the increased business taper relief where a qualifying business already exists and say acquires a residential unit for use by the staff. Such a unit is considered to be a business asset rather than a personal asset and therefore would benefit from the preferential taper relief. Obviously it would have to be made quite clear that the unit was used or required in connection with the business and was not just let to the public.
Occasionally the disposal of the investment property may not be through the open market but to a connected person e.g. to a relative or a family company. In this case HMRC makes the automatic assumption that the bargain is not at 'arms length'. In this case a "market value" is substituted for the actual sale proceeds if the two amounts differ.
Of course one thing to note is that valuation of property to many is an art not a science and as a result there is an acceptance that valuations by different agents can vary by as much as 10%. If you are planning a transfer, then make sure that you evidence your 'market value'.
Therefore, it would be best to obtain a number of written estate agents valuations. Obviously you then select the valuation that most closely reflects the 'market value' at which the transfer took place.
Generally, there is no CGT payable where there are transfers between husband and wife and also where property is transferred to a charity.
Main residence exemption
As I'm sure you are aware, where a property is occupied as a person's main residence they are not liable for CGT on disposal. This tax exemption is also known as Private Residence Relief or PRR. That's why you don't have to pay 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:
* pub landlord
* care worker
* agricultural worker
* vicar
Frequently the case arises where somebody 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 their 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. This even applies when the period of occupation occurred prior to 31 March 1982.
The implications of this are that if you have a property with a large potential capital gain, derived during the last 3 years. Where you have not lived in the property before, you may want to consider moving into it as your main residence to reduce your tax 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 http://www.propertyhawk.co.uk for advice and the latest developments.
What is the rate of CGT?
This depends on what your income tax rate is. Any net 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 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 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 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'!
Allowable expenses
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:
Non allowable
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.
Allowable
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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