Capital Gains Tax (CGT) is a tax on the gain you make when you sell or otherwise dispose of an asset. You usually dispose of an asset when you no longer own it – for example you:
- Sell it
- Give it away
- Transfer it to someone else
- Exchange if or something else
Capital Gains Tax is one of the two significant capital taxes for any property investor, the other being Inheritance Tax. In both cases, the tax payable is being driven by the capital value of the property. A capital gain arises on the disposal or part-disposal of an asset or part of an asset. While a lot of focus is placed on property, the disposal of shares or antiquities or other assets would represent a capital gain. Simply put – Net sales proceeds less base cost equals capital gain.
Note: A property investor who intends to flip a property, the sale will lead to a CGT liability.
Capital Gain Basics
Before getting into specifics, it’s important to cover some of the basics that underpin everything. Capital Gains Tax is payable in the UK by:
- Individuals who are UK resident
- UK resident trusts
- Non-resident persons trading in the UK through a branch or agency.
Rates and Allowances
Each year nearly everyone who is potentially liable to Capital Gains Tax gets an annual tax-free allowance – also known as the ‘Annual Exempt Amount’. You only pay Capital Gains Tax if your overall gains for the tax year (post deducting any losses and applying any relief) are above this amount. The annual tax-free allowance therefore allows making a certain amount of gains each year before you have to pay tax.
In 2016 / 17, the annual exempt amount is £11,100; thereafter the following CGT rates apply:
- 10% for basic rate tax payers
- 20% for higher rate tax payers
Note: Essentially any capital gains are added to your total income and taxed appropriately.
What is Capital Gain
A capital gain arises on the disposal or part-disposal of an asset or part of an asset, in this case property. At its basic level, it is the positive difference i.e. the profit, between what you sold it for and what you bought it for. Equally a capital loss will be where the net sales proceeds are less than the base cost. A capital loss in one year maybe offset against capital gains in that year, and then carried forward to future years.
A ‘disposal’ is deemed to take place as soon as there is an unconditional contract for the sale of an asset. This is not the same as the completion date.
Note: Be careful if you are disposing of an asset around the end of the tax year, 5 April.
Avoiding Capital Gains Tax
It is possible to avoid tax on gain on the sale of a principle residence if it has been owned and used for at least two years during the five-year period ending on the date of sale. If you are single, you may avoid tax on up to £250,000 of gain, £500,000 if you are married and file jointly. If you used the residence for less than two years, you may avoid tax if you sold because of a change of job location, poor health or unforeseen circumstances.
Note: If you use a residence as a vacation home or rental property, an allocable part of your gain may not qualify for the exclusion, even if you meet the two-out of five year ownership and use test.
There are a few cases where it is not appropriate to simply use the cash processed; the three most likely are:
- Transfers between connected persons
- Transaction not at ‘arm’s length’
- Non-cash proceeds
Transfers to a ‘connected person’
Where an asset is disposed of to a ‘connected person’ then the open market value of the asset should be used and not the actual consideration. Connected persons can be any of the following people:
- Husband, wife or civil partner
- Mother, father or grand parent
- Son or daughter
- Brother or sister
- Mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law
- Business partners
- Companies under the control of the other party selling to any of the above
- A trust where there are beneficiaries
Thomas gifts his son his holiday home is Wales. Is generous gift would mean that he made a disposal for Capital Gains Tax purposes and, as the house was worth £250,000, (even though the actual values 5 years ago was £50,000) then that figure is deemed sales proceeds. There are also Inheritance Tax and Stamp Duty Land Tax that will need to be paid.
Transactions not at ‘arm’s-length’
Transactions would be arms length because of the close relationship. Therefore, market value must always be used and not any consideration given or the value of the gift. While it will be fairly clear when people are connected, with unconnected persons HMRC assume that a transaction is at arm’s-length and the onus is on HMRC to prove that it was not at arm’s-length.
Situations where this may be relevant:
- The transfer of an asset between people living together but not married
- The sale of an asset to an employee
- A transaction which is part of a series of transactions
- A transaction which is part of a larger transaction
In certain cases cash may not be exchanged for the asset. In which case the market value of the asset in exchange for the asset sold will be used. Example: Robert sold his home to an investor who pays part in cash £200,000 and transfers a plot of land in the mining village with a market value of £75,000. Robert deemed sale proceeds adjusted for any legal requirements will be £275,000.
Actual Cost of Asset
In calculating any gain we need to deduct the cost of the asset. The higher the cost, the lower the gain and the resultant tax bill. The cost will be made up of:
- The actual amount paid for property
- Incidental acquisition costs including legal fees and stamp duty of appropriate
- Enhancement expenditure including any substantial additions to the property
- Expenditure in preserving or, indeed establishing title
- Interest and other costs associated to raising the original finance
- Survey fees incurred as part of the decision to buy
On death, all assets are included in the value of an estate at market value at around the date of death. Remember that Capital Gains Tax does not apply on death although it’s important to keep in mind the Inheritance Tax. It’s often said that the best way to avoid Capital Gains Tax is to die, but it’s a rather drastic step and as mentioned earlier will trigger an Inheritance Tax issues.
James inherited a house on the death of his father (Edward) which his father had bought for £50,000. On Edward’s death in 2015 the property had a market value of £100,000. In December 2017 the property is worth £200,000 and James decides to sell. The base cost for his Capital Gains Tax computation will be £100,000, that being its value when he inherited it; not when it was initially bought.
Final Thoughts on Tax Strategy
From the day you purchase a property, you as a tax payer, need to know what tax rules apply to the income you receive. Knowing the tax rules familiarises you with the rules the tax inspectors apply to your property business. You can then maintain the correct financial records, make the appropriate tax returns and finally, pay the correct tax.
A tax strategy is not a magic solution that means you pay no tax. What you really need to do is take up the challenge and get tax right. This means taking control of your property affairs instead of reacting to them.