Reducing Your Capital Gains Tax (CGT) Liability

Capital Gains Tax (CGT) applies when chargeable assets are disposed of and is applicable to individuals and trustees but not to limited companies, although Limited Companies do pay Corporation Tax on the gains that they make.

Chargeable assets includes all forms of property unless it is specifically exempt. The main assets it tends to apply to are land and buildings, shares and business assets including goodwill. CGT can be very complex and the rules are far more detailed that can be explained in this brief blog post, so read the Helpsheet after this post.

How a Capital Gain occurs

A capital gain occurs when the value of an asset at the date it is disposed of is higher than when it was first acquired. An asset can be disposed of either by sale or by gift. If you give away an asset in an uncommercial transaction, the market value will replace any actual consideration paid.

For assets acquired before 31 March 1982 the cost usually taken to be the value on that day, although actual cost can be used in some circumstances.

The following also reduce the amount of the chargeable gain...

Incidental costs of acquisition
Expenditure to enhance the value of the asset
Incidental costs of disposal, and
Tax reliefs and allowances (see below)

Rate of Tax

From 23 June 2-1- a new CGT rate of 28% was introduced where the total taxable gains and income are above the income tax basic rate band. Prior to that and below that limit, the rate is 18%. For trustees and personal representatives of deceased persons the rate increased from 18% to 28% on all gains from 23 June 2010.

Tax Reliefs

There are several different tax reliefs which can reduce the chargeable gain, including...

Rollover/holdover relief on replacement of business assets - allowing you to defer the CGT on a gain of a business asset where this is matched with a replacement of a new business asset in the period commencing one year before and ending three years after the disposal.

Business incorporation relief - available when you transfer your business into a Limited Company in exchange for shares

Reducing Tax on Investments: Minimising Capital Gains Tax

Capital gains tax (CGT) is payable on the sale not only of stocks and shares but also of anything other than household goods and personal effects up to the value of £6,000 and private motor vehicles. Subject to certain exceptions, you do not pay CGT on any gain you make when you sell your home. Nor, on the other hand, can you set off any loss against gains made elsewhere.

Capital losses are set off against capital gains in the same tax year and after that there is an annual exemption, currently £7,500. As a result, few people pay CGT.

If the net result of a year's transactions before the annual exemption is a loss, it can be carried forward to succeeding years. The annual exemption cannot be carried forward, but can be applied to the net gains for a year before any loss brought forward which, if not then used, can be carried forward again.

The following investments are exempt from CGT:

gilt edged stock
company debentures and loan stocks
friendly society savings schemes
ISAs and PEPs
company share option schemes
enterprise investment schemes and venture capital trusts
commercial forestry

As with tax on income, investments which are free of capital gains tax need to be good investments in their own right. A taxed gain is better than no gain at all.

Indexation and taper relief

For purchases before April 1998 the cost can be indexed, that is adjusted by the cumulative rate of inflation (RPI) between purchase and April 1998. However, indexation cannot be taken beyond breakeven, i.e. it cannot be used to create a loss.

If you held any shares before 6 April 1998, it is a good idea to calculate the indexed cost now, as it will not change. This can be done by using the CW indexation allowances for April 1998, available in Inland Revenue leaflet CGT1, which can be obtained from your local tax office.

From April 1998, indexation was replaced by taper relief which is based on the length of ownership. It only applies to shares held for at least three complete years, although an extra year is added to the total for shares owned on 17 March 1998.

The percentage of the gain chargeable reduces to 95% after the third complete year and by a further 5% for each successive year, to a minimum of 60% after ten complete years.

For example, if you bought shares in August 1996 and sold them in June 2001, the taxable gain would be calculated as follows:

The original cost would be increased to 5 April 1998 in accordance with the CW indexation allowance for the period, to give the indexed cost.
The excess of the selling value over the indexed cost gives the taxable gain before taper relief.
Although the shares have only been held for two full years since April 1998, as the shares were held on 17 March 1998 an extra year is added, making a total of three years, so taper relief reduces the chargeable gain to 95%

More favourable taper relief applies to business assets, and since 6 April 2000 it also applies to all shares owned in your employing company and to all shares in unquoted and AIM quoted companies.

The percentage of the gain chargeable in this case reduces to 87.5% after the first complete year, to 75% after two years and 50% after three, to a minimum of 25% after four years.

Where shares qualify as business assets only from 6 April 2000, the gain for shares owned on that date has to be apportioned between the two periods.

Calculating the taxable gain

The method of calculating the chargeable capital gain, following the introduction of taper relief.

The complications of indexation and taper relief can be ignored if your gross gains for a year do not exceed the annual exemption, currently £7,500.

Reinvestment relief

Chargeable gains on disposals can be deferred indefinitely if the amounts realised are reinvested in new share issues from qualifying companies under the Enterprise Investment Scheme.

Tax payable

The net chargeable gain for the year is added to your income and is taxed at 10% if any falls within the personal allowance or the 10% band, at 20% for any within the basic rate band (not 22% as for income) and 40% thereafter. CGT liability cannot be set against personal allowances.

Annual planning

This is mainly a matter of ensuring you make use of your annual tax free allowance.

You should keep a running record of your sales during each financial year (starting 6 April), with a note of the gain or loss, after adjusting for indexation and taper relief.

Check on the cumulative position at the beginning of March. If you have a substantial amount of your annual allowance still available, then take a look at the unrealised gains in your portfolio.

Bed and breakfasting

Before 17 March 1998, any unused annual allowance could be applied to unrealised gains before the end of the tax year by selling the shares one day and buying them back the next. This has been stopped by introducing a minimum 30 day interval between selling and buying back, otherwise the two transactions will be ignored for CGT purposes.

It is of course possible to take the risk of being out of the market for 30 days.

Other alternatives are:

If you have not used all your current year's ISA allowance or have uninvested amounts in a PEP, then you can 'bed and ISA' or 'bed and PEP', that is buy back into an ISA or PEP.
If you are married you can sell and your spouse buy back (or vice versa).
You can buy a similar share (e.g. BP for Shell) or your best choice of new investment.

In all these alternatives the sale and buy back can be done simultaneously, so there is no risk of adverse price movement overnight.

The disadvantage is that costs of both selling and buying (including stamp duty) are incurred, although some stockbrokers will forgo some or all of their commission on the second transaction. Also you lose the difference between the buying and selling prices.

Reducing Tax Liability in 2010 and Beyond

Tax planning has always been a very challenging element of the financial planning process. This year it has been especially difficult in light of the uncertainty associated with the pending changes to the tax code. As you may be aware, the tax cuts established by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (both of these acts are commonly referred to as the Bush tax cuts) are set to expire at the end of the year. There has been considerable debate as to whether or not these tax cuts should be extended. With a lame duck congress now in session, time will tell what the eventual outcome will be.

So how do we properly tax plan in the face of such uncertainty? It is crucial to understand your personal situation and how the pending changes could impact you. One of the primary concerns for many taxpayers is the possibility of higher income tax rates as early as next year. If the tax cuts are not extended the current low and high tax rates will increase from 10% and 35% to 15% and 39.6%. Additionally, the maximum capital gains rate will increase from 15% to 20%. Understanding how each case impacts your personal situation can be very helpful in preparing a strategy. Once you understand this you can begin to assess a probability to the potential outcomes and begin making critical tax planning decisions.

Without offering specific tax advice in this newsletter, the following ideas are typically very important considerations to make at the end of each year:

* As always, consider optimizing contributions to your tax-advantaged investment accounts (i.e. 401K, IRA, Roth IRA, etc.). Investment vehicles such as 401Ks and IRAs enable you to lower your current tax bill and achieve tax-deferred growth. Meanwhile, Roth IRAs and Roth 401Ks allow you to pay taxes at today's low rates and enjoy tax-free growth going forward.

* Consider a Roth IRA conversion. Having taxable, tax-deferred, and tax-free accounts could be part of a broader tax diversification and mitigation strategy.

* Be aware of your realized net capital gains and losses for the year and any net capital loss carry over you may have from prior years. This will help you anticipate factors that will impact your 2010 tax bill.

* If you have a net realized capital gain for 2010 and no carry over loss to offset it, consider harvesting some losses from your taxable portfolio to mitigate your tax bill. Remember, long term losses must first be used to offset long term capital gains. Further, short term losses must first offset short term gains. After this netting out process, any remaining long term loss can be used to offset short term gains.

* If in your probability assessment you have determined that the tax cuts are not likely to be extended, consider proactively selling long-term investments with embedded gains and subject yourself to the maximum 15% capital gains rate as opposed to the 20% rate you may be subject to in the future. In fact, if you are in the 10% or 15% marginal income tax bracket in 2010, you can recognize long term capital gains tax free.

* Mutual funds often distribute capital gains at the end of the year, which can catch people unaware. The owner of a mutual fund can contact the mutual fund company and ask what they anticipate the distribution will be. Once you have this information, you can take the appropriate steps to mitigate the tax liability.

Estate Taxes

Another effect of the Economic Growth and Tax Relief Reconciliation Act of 2001 is that the estate tax was completely phased out in 2010. If there are no modifications to this law change, any estate, regardless of size, can be passed to heirs completely tax free. The estate tax is scheduled to return in 2011. However, while there is no estate tax, inherited property no longer receives a step-up in basis, exposing those assets to potentially large capital gains taxes when sold. Watch for adjustments, as these laws are likely to be altered soon.