The Importance of Capital Gains Tax
Although its impact is not as immediate as that of income tax, nevertheless capital gains tax is perhaps the most significant tax from an investor's perspective. Most property investments will eventually lead to a disposal and every property disposal presents the risk of a capital gains tax liability arising and reducing the investor's after-tax return drastically, sometimes by as much as 40%.
Paradoxically, however, capital gains tax is also the tax which presents the greatest number and variety of tax planning opportunities. We will be examining some of these further in Chapter Five. First, however, it is worth recalling how this tax developed and looking at how it affects property and share investors today.
The Development of Capital Gains Tax
Capital Gains Tax was introduced by Harold Wilson's first Labour Government in 1965. The new tax was designed to combat a growing trend for avoiding income tax by realising capital gains, which at that time were mostly tax free, rather than taxable income.
Because the tax was only introduced on 6 th April 1965, gains arising before that date remained exempt from Capital Gains Tax and, for many years, it was thus necessary to make detailed, and often complicated, calculations designed to remove these "pre-1965" gains from the amount to be taxed. In theory, such calculations could still be relevant, although their incidence is now fairly rare.
The high inflation of the late 1970's and early 1980's brought about a significant change after 31st March 1982, with the introduction of Indexation Relief. This new relief was designed to exempt gains which arose purely through the effects of inflation. Ironically, and somewhat frustratingly, however, it was only post-March 1982 inflation which was exempted and, by then, the highest rates of inflation lay in the past.
The next major change came in 1988 with so-called "re-basing". The Government finally recognised the unfairness of not exempting pre-1982 inflationary gains. However, rather than merely combating this oversight with an improved Indexation Relief, instead they decided to exempt all pre-31st March 1982 gains. Hence Capital Gains Tax was "rebased" from 6th April 1965 to 31st March 1982.
Naturally, however, since nothing in the tax world is ever simple, the new 31st March 1982 base did not operate in the same way as the old 6th April 1965 base and phrases like the "kink test" entered the tax adviser's vocabulary, as even more complex calculations became necessary. Only the subsequent passage of time has rendered most of these complexities irrelevant in most cases today.
The Conservative Governments of the late 1980's and early 1990's continued to introduce a number of Capital Gains Tax exemptions and reliefs, including some very generous holdover reliefs for reinvestment of gains, as well as substantial increases in the annual exemption.
By the time of the 1997 General Election, the Conservatives were set well on a path towards the abolition of Capital Gains Tax and a return to the pre-1965 situation.
However, as we all know, the Election on 3rd May 1997 brought an historic victory for "New Labour". Those with potential capital gains awaited the seemingly inevitable crackdown.
But when the changes came, they were very far from the draconian measures which some rather hysterical commentators had predicted. In fact, the new Capital Gains Tax regime ushered in by Chancellor Gordon Brown's second Budget on 17th March 1998 is quite possibly the most generous we have seen since 1965.
Clearly, "New Labour" have recognised that the immense changes in British society over nearly two decades of Conservative Government mean that capital gains are no longer the perquisite of the privileged few, but are now very much a part of life for a significant proportion of the population in the modern economy of investment and enterprise.
The cornerstone of Labour's new Capital Gains Tax regime, Taper Relief, has, from the outset, come in two different tiers, Business Asset Taper Relief and Non-Business Asset Taper Relief.
Since 1998, the rate and availability of Business Asset Taper Relief has been improved significantly, with the maximum relief now reached after just two years, as opposed to the ten year period introduced initially.
Non-Business Asset Taper Relief, which is far more relevant to property investment, has, however, remained unchanged since its introduction.
Who Pays Capital Gains Tax?
Capital Gains Tax is payable in the UK by:
i) Individuals who are UK resident or UK ordinarily resident.
ii) UK resident trusts.
iii) Non-resident persons trading in the UK through a branch or agency.
In this chapter, we will be concentrating purely on category (i) above, i.e. UK resident or UK ordinarily resident individuals investing in property.
Individuals who are UK resident or UK ordinarily resident and also UK domiciled are liable for Capital Gains Tax on their worldwide capital gains.
Individuals who are UK resident or UK ordinarily resident but not UK domiciled are always liable for Capital Gains Tax on capital gains arising from the disposal of UK property but only liable for Capital Gains Tax on "foreign" capital gains if and when they remit their disposal proceeds back to the UK.
The tax concepts of residence and domicile are examined in section 2.17 above. Domicile is also covered further in section 4.2 below. Capital Gains Tax also extends to those who are UK ordinarily resident and this will be examined a little further later in section 5.10.
Capital Gains Tax Advice for Property Investors
I overheard on the radio this morning that property prices in the South East of England have doubled over the last five years.
This really comes as no surprise to me, as I have been advising a great many clients who have seen this kind of capital growth in their property investments. In fact, in many cases, the rate of growth has been even more dramatic, especially when the investor has chosen the location of their investments wisely.
It sounds like great news doesn't it?
Unfortunately, however, there is a "sting in the tail". The Inland Revenue naturally want their share of the action and their share is called Capital Gains Tax, or "CGT" for short.
Capital Gains Tax is charged at rates of up to 40% on the capital growth realised on a property during an investor's ownership. However, the good news is that, over this tax's 40 year history, a great many reliefs and exemptions have been introduced by successive Governments with two major results:
i) Capital Gains Tax is now a highly complex tax,
and (the good news),
ii) The effective rate of Capital Gains Tax actually paid in most cases is considerably less than 40%.
What reliefs are available?
For most property investors, the key reliefs which reduce the actual amount of Capital Gains Tax payable are:
Indexation relief (for properties purchased before April 1998)
Taper relief, and The Annual Exemption (currently £7,900)
These are best illustrated by way of a short example:
Example 1
John bought a house in London as a buy-to-let investment for £100,000 in January 1997. He sells it in January 2004 for £250,000. He is a higher rate taxpayer.
John has made an overall gain of £150,000 (his capital growth). Without the existence of any reliefs, this would leave him with a Capital Gains Tax bill, at 40%, of £60,000.
However, John is entitled to the three reliefs described above.
First, indexation relief. This relief is designed to exempt the purely inflationary element of his capital growth. It only applies to the period up to April 1998, however, as it was then abolished and replaced by taper relief.
Indexation relief is calculated by taking the increase in the retail prices index over the period from the date of purchase of the property up to April 1998 and then applying it to the actual cost of the property. In John's case the index increased from 154.4 to 162.6 over the relevant period, an increase of 5.3%. His relief is thus 5.3% of the property's cost (£100,000), i.e. £5,300.
John's remaining gain after indexation relief is therefore £144,700 (£150,000 less £5,300). This is sometimes referred to as the "indexed gain".
In John's case, his indexation relief does not amount to a great deal, but where properties have been owned for longer periods, it will be more significant.
Next we have taper relief, which was introduced in 1998. This relief operates by exempting a progressively larger portion of the gain as the property is held for a longer period. Relief of 5% is given after three years, 10% after four years, 15% after five, and so on, until the maximum relief of 40% is reached after the property has been held for ten years.
(Note that business property gets a much better rate of taper relief. The rates quoted here apply to investment properties.)
However, as taper relief only came into effect on 6th April 1998, it is only periods after that date which may be taken into account for taper relief purposes.
But this is tax, and in tax there is always an exception to every rule. The exception here is that, where the property was already owned on 17th March 1998 (that was Budget day that year) an extra "bonus year" is counted for taper relief purposes.
So, in John's case, we look at the period of ownership after 6th April 1998 and find it amounts to five years and nine months. Unfortunately, however, for taper relief we can only count whole years, so we count this as five years. In addition to this though, John does get his bonus year, so we end up counting him as having owned the property for six years in all.
John is therefore entitled to taper relief at 20%. This means that 20% of his indexed gain (or £28,940) is exempt. The remaining part of his gain, £115,760, is generally referred to as his "tapered gain".
Finally, John is also able to deduct his annual exemption of £7,900 (assuming he has no other capital gains in the same tax year). This leaves him with a taxable gain of £107,860. As a higher rate taxpayer, his Capital Gains Tax bill would therefore be £43,144 which is due by 31st January 2005.
Even in this very simple example, with no tax planning involved at all, John's effective tax rate is only 29% rather than 40%.
Reducing your Capital Gains Tax bill
There are a great many planning techniques available to reduce, defer, or even eliminate the ultimate Capital Gains Tax bill on the sale of your property. Space does not permit me to present them all here, so I will just provide a brief insight into two basic techniques.
If you would like more detailed information on ALL the capital gains tax planning strategies available, the latest edition of Capital Gains Tax Guides's property tax guide contains over 60 pages of tax planning advice. The guide also covers other taxes that affect the property investor, including income tax, inheritance tax, stamp duty and VAT. We also have a whole new guide on the benefits and drawbacks of investing in property through a company. Click Here For More Information
A Word of Warning
The tax planning techniques which follow are tried and tested. However, all tax planning must be undertaken very carefully. Attention to detail is essential and you should always obtain professional advice on your own particular circumstances.
Using the Main Residence Exemption
The capital gain on your own main private residence (i.e. your home), is exempt from Capital Gains Tax. Where a property has been your main residence for a part of your period of ownership then a partial exemption is available.
Furthermore, whenever this partial exemption applies, it not only covers the period that the property was your main residence, but also will always cover the last three years of your ownership of the property.
And there's more…
Not only that, but having the main residence exemption available also means that you are entitled to a further exemption called "Private Letting Relief". This further relief applies to exempt up to £40,000 of the gain accruing during the period that the property was being let out as private residential accommodation.
With the main residence exemption and private letting relief, the overall Capital Gains Tax bill can be reduced dramatically.
Example 2
As before, John sells a property in January 2004 for £250,000, having originally bought it in January 1997 for £100,000.
However, this time, let us suppose that John himself had moved into the property and adopted it as his main residence just before Xmas 2002. He stayed there until selling the property just over a year later.
John's indexed gain remains the same as before, £144,700.
The last three of his seven years of ownership are, however, exempted under the main residence exemption. In other words, three sevenths of his indexed gain is exempt, leaving only £82,686.
Furthermore, John is also entitled to private letting relief of £40,000, reducing his gain even further, to £42,686.
After taper relief at 20% and his £7,900 annual exemption (as before), John is left with a taxable gain of only £26,249. His Capital Gains Tax bill will be only £10,500, giving him an effective rate of only 7% and a saving of almost £33,000!
Joint Ownership
Holding your property investments jointly with someone else is often a good strategy as each of the joint owners are entitled to their own set of exemptions and reliefs, including the potential to utilise their own annual exemption and up to £40,000 of private letting relief.
For married couples the position is even better as they enjoy the added flexibility of being able to transfer properties between them or in and out of joint ownership free of tax and without affecting their taper relief entitlement.
Let's return to our example to take a look at the effect of this:
Example 3
As well as moving into the property and adopting it as his main residence in December 2002, John also transferred it into joint ownership with his wife Jane.
As in Example 2 above, there is an indexed gain on the property of £144,700. John and Jane each have half of this gain, £72,350.
As before, three sevenths of their gains are exempted by the main residence exemption, leaving each of them with gains of only £41,343.
But now, the key difference is that each of them is entitled to up to £40,000 of private letting relief. They only need £33,443 to reduce their capital gains to the level of the annual exemption (£7,900).
Hence, John and Jane have no Capital Gains Tax to pay at all!
I think most of us would agree that this made the effort of having to move into the property pretty worthwhile!
Carl Bayley is author of the Guides How To Avoid Property Tax and Using A Property Company To Save Tax. Carl also frequently lectures on the subject of property taxation and has spoken on the subject on television.
Copyright Carl Bayley 2005-2008