Very Nice Advice

Last year we wrote a Very (brief and) Nice guide to how capital gains tax applied to property, as we get questions on this all the time. It used a very basic example to show how tax was applied in principle.

In actual fact, most of our clients don’t have property empires as such, but rather second homes which they once lived in, and are now renting out (usually because they’ve begun (gasp!) co-habiting). Although most people have got to grips with the fact that if you sell the home you live in, you don’t usually have to pay tax on any capital gains, how this treatment applies to once-lived-in-and-now-rented property is a bit more obscure. Specifically there are a number of ‘reliefs’ you can claim to reduce the amount of profit you have to pay tax on, and a special ’3-year’ period. So, taking a hypothetical flat-owner ‘Annabel’, these are the things to think about, and a sample calculation to show how tax might be worked out.

Assumptions:

• Annabel bought a flat 10 years ago for £100,000. She lived in it for 4 years, and then, after moving in with her partner, began renting it out (that’ll be 6 years renting then).
• The flat’s now worth £175,000 (nice work if you can get it).
• She’s now decided to sell the flat to raise money towards a deposit for a joint property, but is not sure if she’ll have a big capital gains tax bill to pay. She thinks the tax rate is 40%.
• She earns about £30,000 and so is a basic-rate tax payer.
• A back of the envelope calculation suggested she’d have to pay a bill of about £30,000 (ie profit of £75,000 x 40%). This is wrong!

The key steps to run through are:

• Reducing the profit made: Annabel’s profit is basically £75,000 (£175,000 – £100,000). But she can also take into account the costs of her buying and selling the flat, as well as any money she has invested in big works on the property (such as a loft extension). Let’s say she’s put an additional £20,000 into the flat in costs and building work: that reduces her profit (or ‘capital gain’) to £55,000 (£75,000 – £25,000).
• 1) Claiming Private Residence Relief: Annabel owned the flat for 10 years. The tax man assumes that the last 3 years qualify for Private Residence Relief (PRR), if she’s lived there AT ANY TIME. She does not have to move back in before she sells. She can also claim PRR for the first 4 years, when she was actually living there. So for 7 (3+4) out of the 10 years of ownership – or 70% – Annabel qualifies for PRR. That means she does not have to pay tax on 70% of the gain.
• 2) Claiming Letting Relief: As the flat was being rented out for the rest of the time when Annabel wasn’t living there (6 years out of 10, or 60% of the time), she can claim ‘Letting Relief’, which is: the lowest of: a) £40,000; OR b) the amount of Private Residence Relief due; OR c) the amount of gain she’s made on the let part of the property. In this example, the amount of PRR she’s getting is £38,500 (£55,000 x 70%), and the amount of gain made on the let part of the property is £33,000 (£55,000 x 60%). Both are lower than £40,000 – and so as the lowest, the £33,000 figure applies – basically cancelling out any tax due.
• Using your annual capital gains allowance: If there had been still a capital gain due, Annabel would then have been able to subtract any unused capital gains allowance for the year, which for 2010/11 is £10,100.
• Paying tax at the right rate: This is currently (tax year 2010/11) 18% for basic rate taxpayers, and 28% for higher rate taxpayers. If you’re on the cusp between the two rates, you may find yourself having to pay some at 18% and some at 28%.

Sample calculation:

IMPORTANT POINTS!

• Letting Relief does NOT apply for rented properties you’ve bought on a buy-to-let basis; you have to have lived in the property as your home in order to qualify.
• As time goes by, the proportion of time over which the flat is rented obviously increases, and the amount of PRR you get decreases – so the longer you hold on to your property, the  higher the chance is of a CGT liability.
• Annabel may, or may not, have a mortgage on this flat. For the purposes of capital gains tax calculations, A MORTGAGE OR LOAN ON THE PROPERTY IS IRRELEVANT.
• See more on the tax man’s website here (CGT on your own home) and its PRR factsheet here.

And that’s enough capital letters and bold for today. Any questions, drop us a line.