Capital Gains Tax (CGT) - UK Landlords

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.

Income Tax - UK Landlords

Introduction

It's only a small word but it looms very large in the thoughts and the nightmares of many of us. It was Disraeli who said that there are only two things in life that are certain...., "death and taxes". The good news is that you don't have to be quite so fatalistic. Like anything in life, you can be a victim, or you can make circumstances work for you. It always helps if you have a good accountant to guide you.

I confess it is only belatedly that I've become acquainted with the intricacies of the taxation system. For years I managed without making a return. Not out of any deliberate plan to defraud. But just because I knew I wasn't making any money. My mortgage payments were barely covered by the rental income and having not sold any property, there were no capital gains. So why trouble the poor overworked civil servants I thought!

Then house prices went through the roof! I sold a few properties and realised some capital gains, investing most of it back into property. It was only when talking to a tennis friend, who turned out to be an accountant that I started to think I might need to explore the matter a bit more carefully. A holiday to Australia in which I took along a copy of the Zurich Tax Handbook as a bit of 'light reading' convinced me that there might be a problem. I think it was the bit on 'tax evasion' being a criminal offence punishable by imprisonment that focused my thoughts. I resolved on my return to come clean. To my amazement, the tax system was not as penal or as complicated as I had feared. Now let's look briefly at what the main taxes that affect a property investor are.

My Tax Liabilities

Tax liabilities for rental properties are assessed on the basis of income and capital gains. Firstly, let's examine how liabilities derived from income are calculated.
All income from land and property in the UK is taxed under Schedule A; that includes residential investments whether they are furnished or not. Income and expenses for tax purposes are assessed as a single letting business. So effectively if you have one or one hundred properties, Her Majesty's Revenue & Customs (HMRC) take the total figure rather than looking at individual properties. Income is assessed by tax years ending on the 5th April. Schedule A income is treated as investment income. As such any losses can only be carried forward and offset against Schedule A income and not personal income such as a salary.

Taxable profit is the income that remains after all allowable expenses have been deducted. It's always helpful to have a quick flick through the 'revenues' booklet IR150 in Taxation of Rents for detailed guidance. Like everything these days a copy is available to download from their website http://www.hmrc.co.uk

In essence, your taxable profit is calculated by taking your annual rent and then deducting expenses. For convenience HMRC separate expenses into 5 categories. These are:

Legal & professional- Legal services for a remortgage, valuation fees, mortgage broker fees, landlord safety certificate costs, tenancy agreement costs, letting agent fees, admin cost to close a mortgage, membership fees to a professional body

Repair, maintenance & renewals-redecoration costs, appliance repair charges, plumbing, electrical repairs, etc

Rent, rates, insurance, ground rents, etc -insurance, council tax charges, grounds rent

Cost of services provided, including wages - cleaning, meals

Other expenses -Telecom charges, utility bill costs, computer software, advertising costs, computer purchase (if used exclusively for the business - could be accounted as a capital allowance (see section on capital allowances below)

What are my allowable expenses?

Repair and renewals
Where a property is furnished or part furnished; rather than to claim as each renewal arises it is possible to make a single claim of 10% of rent as a 'wear and tear' allowance. This is accepted by the Revenue as broadly equivalent to the cost of normal renewals of furniture. Beyond the fittings, such as furniture there will be renewals and repair to the building e.g. repair to the roof, bathroom and windows, etc. This raises a real taxation hornet's nest. When does a renewal become an improvement? The latter is not an allowable expense against income (although it can be offset against capital gains - see later under Capital Gains Tax( CGT)).

There is, as with many tax issues, a grey area of when a renewal becomes an improvement. It is largely a question of fact and degree in each case whether expenditure on a property leads to an improvement and therefore become a capital expense. UPVC windows were considered for many years to be an improvement and therefore the expenditure counted as capital. However, in recent years HMRC have relented and accepted that UPVC is for most people the modern equivalent of wood and therefore is considered a renewal.

Another example of the way the HMRC approach the subject is their approach to the refurbishment of a fitted kitchen. For example, they consider that where a kitchen is refurbished, including work such as stripping out and replacement of base units, wall units, sinks, etc, retiling, work top replacements, repair to floor coverings and associated re-plastering and re-wiring. Provided that the kitchen is replaced with a similar standard kitchen then this is a repair and the expenditure can be off set against income. If at the same time additional cabinets are fitted that increase the storage space, or extra equipment is installed; then this element is a capital addition and not allowable and the additional expense should be apportioned as a capital cost. If the standard units are replaced by expensive customised items using high quality materials, the whole expenditure is then judged to be capital.

Loans and Interest

Most people will have borrowed money to finance their investment. When accounting for these costs it is interest payments alone that are an allowable expense. This means where a loan is a repayment mortgage; only the interest element of the loan can be offset against rental income. It is also possible to offset other loans that have been taken out for the business. For instance, when one has been raised to finance a new kitchen or extension of the rental property. It should be quite clear in these cases that the loan is specifically for the business and where possible documentary evidence should be available (just in case the revenue raises an enquiry on the matter). Therefore, if a loan is arranged, try to separate it off from your personal finances. This could be done by using it to set up a separate business account.

Non - standard lettings

So far I have referred to the tax treatment of a 'standard' buy-to-let property rented on an Assured Shorthold Tenancy. There are two categories of residential rentals that are treated slightly differently by the Revenue. These are where somebody rents a room in their house and a furnished holiday let.

Rent a room

Under this system a person is allowed to rent out a room in their own home without having to pay tax providing the rent is no more than £4250 pa. If it is more than this, the taxpayer has the option to have the excess income (i.e. above £4250) taxed as a Schedule A rental profit. Otherwise the entire rent will be taxed in the usual way on the profit from the gross receipts minus allowable expenses.

Furnished holiday lettings

These are treated slightly differently to the Revenue from a standard residential let. This is because of the amount of management time involved and the relatively short rental periods. They are therefore are therefore classified as a business rather than an investment. Consequently a different tax treatment applies.

To qualify as a holiday let the following criteria must be met. The property must be:

* Available for holiday let at least 140 days a year

* Actually let for 70 days a year

* Not occupied by the same person for over 31 days in 7 months

The main advantage to landlords with a holiday let is that the activity is regarded as a trade and is assessed under Schedule D. Therefore, any losses can be offset against an individual's personal income, which includes their salary.

The Changes in Capital Gains Tax and How it Will Impact on UK Landlords

A tax giveaway for landlords?

Landlords are set to be one of the main beneficiaries from the proposed tax changes signaled by the Chancellors Pre-budget Statement last week. This Statement which outlines what changes are to be made for the tax year 08-09 or effectively the tax regime that is to come into force on the 6th April 08. How much is it a give away and are landlords better to sell now under the current capital gains tax regime or should they wait? In this article I set out to investigate what it means to landlords

The current taxation regime

The current system of Capital Gains Tax (CGT) was actually put in place by Gordon Brown in April 1998 when he introduced a system of taper relief to replace the previous system of indexation. The whole idea behind taper relief was that it encouraged businesses and property investors to hold their assets for the long term and discourage short-term investment speculation. The result was a taxation system where the amount of tax paid reduced the longer the landlord held their buy-to-let investment property for up to a maximum relief being given after 10 years of holding their residential property investment.

When does Capital Gains Tax (CGT) apply?

Capital gains tax is a tax that landlord's only pay on disposal of their buy-to-let investment property. It is treated as a top slice of taxable income and therefore the rate that a landlord will pay will depend on what income the landlord has earned in the year of disposal. In calculating a landlord's potential Capital Gains Tax (CGT) tax liability a landlord will have to apply the following concepts to their Capital Gains Tax (CGT) calculation.

1. A landlord should establish the base cost of their buy-to-let investment (effectively cost of acquisition)

2. A landlord should establish the size of the gain by taking base cost from disposal value

3. A landlord should establish if buy-to-let investment held as a non-business or as a business asset (most will be non-business, whilst holiday rentals are classed as a business asset)

4. If the buy-to-let investment property is held as an individual not by a company the landlord can use their annual exemption 2006/2007 £8800 to reduce the amount of the chargeable gain

5. For properties bought before April 6 1998 the gain is subject to indexation

6. Properties bought on or after April 6 1998 the gain is subject to taper relief

Effective rate of Capital Gains Tax (CGT)

For most landlords the effective rate of Capital Gains Tax (CGT) that a landlord will pay depends on their rate of income tax. For a landlord who is a basic rate taxpayer the effective Capital Gains Tax (CGT) rate could reduce to 12% as the percentage of the gain chargeable reduces to 60% after 10 years and this is then charged at 20%. For landlords who are top rate taxpayers the effective rate is double as they pay 40% tax.

The new regime

The new Chancellor Alistair Darling is planning to sweep away the old systems of indexation and taper relief carefully put in place by the previous Chancellor and replace the systems of indexation and taper relief with a single flat rate of 18%.

The verdict for UK landlords

On balance the news for landlords is good. The new flat rate Capital Gains Tax (CGT) will apply to a landlord immediately and means that for a high rate tax payer they will be paying 6% less than they would have done after 10 years under the previous system of taper relief. For basic rate taxpayers things are less clear cut. Under the previous system a basic rate taxpayer would have had to have held their buy-to-let investment property for 4 years before benefiting from a rate as low as 18%. However, this would have eventually reduced to 12% after 10 years or 6% below the rate that will come in on 6th April 2008.
A couple of beneficial points for landlords are that the new system is much simpler to understand and should make property investment disposal decisions and calculations much easier for landlords.

It also makes it far more attractive for landlords to trade their buy-to-let investments buying and potentially renovating a property, holding for a couple of years before then selling their buy-to-let investments on.

However, this may not be so much of a tax gift to landlords as it first appears. For a start, the anticipated slow down in the UK housing market may mean that the opportunities for buying a property and doing it up to rent and then dispose may not be as prevalent as they have been over the last 10 years of the housing boom. Also landlords should be aware that if they are doing this regularly the tax authorities may consider that the landlord is actually engaging in a trade and tax any profit as income anyway.

The reality is for most landlords buying a residential investment property is seen as a long-term investment. ARLA the Association of Residential Letting Agents latest quarterly survey (Sept 07) of landlords showed that 66% of landlords questioned intended to keep their residential investment properties for more than 10 years. These landlords would therefore have benefited from the maximum taper relief available anyway.

The proposed tax changes appear to be a classic case of smoke and mirrors where tax for some landlords i.e. high rate tax payers looks to have come down whilst those for lower rate tax risers potentially goes up.

Should landlords sell?

This potential change in the tax law has thrown up an interesting conundrum for some landlords over what to do over their buy-to-let investments.

Previously the tax system strongly encouraged them to hold their properties for the long-term to maximise their taper relief. Now, for a lower rate taxpayer who has owned their property for 10 years or more a quick disposal before the new regime would save them potentially a considerable sum.

Equally for high rate taxpayers who were thinking of a sale, holding out until the new tax regime is in place could also save them a sizeable amount of money.

Therefore, all this has to be weighed by a landlord against their wider and long-term financial plans and aspirations. If the housing market does weaken considerably by next year selling at a time of low housing demand may not be the best time to exit the market even where a tax saving.