If home is where the heart is, it's also where the taxman cannot, for once, reach us. If we own our own home, we can sell it free of tax; at least, that's the impression most of us are under. But, in fact, there are several circumstances where individuals are at risk of incurring a hefty tax bill when they come to sell what's probably their biggest asset, so it's well worth knowing every get-out clause available to avoid having to share your profit.
First of all, you should know that it's not that homes are exempt from capital gains tax (CGT); it's that a relief called Private Residence Relief (PRR) kicks in when we sell them. If you buy a property and live there, either by yourself or with your family, until the day you sell it you will almost certainly be entitled to full PRR. You don’t even have to bother the taxman with details of the sale if you qualify for full PRR.
THE TRAPS
But full PRR is not always available. This is likely to be the case if you end up living somewhere else for a number of years, take in lodgers, sell an outbuilding, or work from home. In all these and other cases you could find yourself having to write out a large cheque to Her Majesty’s Revenue and Customs (HMRC) when you sell up. However, you will only pay CGT in proportion to the time that your home was not used solely as your home.
Another trap is where you get married, or enter a civil partnership, and you and your spouse both own a property. In this case, you will automatically lose PRR on one of the properties, creating a potential CGT bill.
All property developers, even if they are amateurs doing it as a sideline or hobby, should expect to be tapped for tax. If you buy a property with a view to developing it and selling for a profit, you may not be entitled to PPR relief. Even if you live in it for a short while, if the property was bought wholly for the purpose of making a profit, tax will be payable (at rates up to 50 per cent).
Tax is not an issue that's addressed, or even mentioned, by TV programmes which focus on property development, says Gary Heynes, head of private client at accountant Baker Tilly, but it should be. "First, there is specific anti-avoidance legislation targeting cases where there is no intention for a property to be your main home: your intention rather is to buy, do it up and sell for a profit." The taxman's attention would be drawn by the speed of sale after purchase and the size of your profit, he warns.
"Second, if developing properties is your trade, you won’t qualify for exemption and you will have to pay income tax on your profits. The tax you pay could be as high as 50 per cent [45 per cent from April 2013]. Developing a property three or four times or in quick succession would qualify as a trade."
If you have more than one home, either because you buy a second property or you inherit a house, you could fall into a CGT trap. Private residence relief will be allocated either to the property you spend most time at or the one you nominate as your main home - generally this will be the one with the highest resale value. When you nominate, it doesn't actually matter which one you spend, or have spent, most time in (as long as no-one is living in the one you've nominated as your main residence). You must make the nomination to HMRC within two years of acquiring the second property. After that time, you won't be allowed to choose and the facts will be used to determine which one is your main home. "But if you buy a further property," says Mr Heynes, "a new two-year period begins, allowing you to select any one of the three properties as your main home."
If you inherit a house, and sell it on, there should be no liability as its value for capital gains tax purposes will be calculated from the point you inherited it, not the original point of purchase. But if you don't sell it immediately, CGT will be payable on any subsequent gain even if inheritance tax has also been paid.
Finally you might be lucky enough to have a garden big enough to build houses on, but if your garden is bigger than half a hectare (modern developers can squeeze around 25 houses into a single hectare) and you choose to sell part of it, you will almost certainly be liable for CGT on that slice of profit.
If you fall into one of the categories above, you will be required to work out the amount of relief due and to declare any tax owing on your annual tax return. It's advisable to come clean, say tax lawyers who warn that Land Registry changes and Stamp Duty Land Tax transactions trigger notifications to the Revenue. And if you’re tempted not to report a CGT liability, remember the Revenue can open an investigation for up to 20 years afterwards.
THE GET-OUT CLAUSES
The penalties for letting your home are harshest on those who have never lived in the property and those who let for long periods. But in most cases there are provisions that can help cushion the blow. These include a letting relief allowance of up to £40,000, which could wipe out any tax owed, and the right to count the last three years of your ownership as if you had lived there, even if you hadn't.
If you've notched up an absence
If you haven't always lived in your home, how much CGT will you have to pay? It depends on how long you were absent and the reason why. You might buy a house that needs renovating, in which case your first year, and sometimes the second year too, will be counted as if you were living in the property. If you are having difficulty selling the property after you have moved out, you have three years in which to complete a sale and those three years will count as if you had lived in the property even if you are living elsewhere. That last-three-years rule can be used by anyone who has lived in their property at some point.
If you have to move out of your home for work reasons, for example because your employer relocates to another city or requires you to work in a different part of the UK, you are allowed to be absent for up to four years before you are at risk of losing PRR. But the house must have been your main home before and after the period of absence, and you must not build up PRR entitlement on another property. If your employer requires you to work abroad, however, you will be entitled to full PRR, no matter how long you are away. These work-related exemptions also apply if the reason for your absence is the requirement of your spouse's employer.
You can also be absent for any reason for up to three years (including letting your home) without suffering any loss of PRR - but, again, you cannot build up a PRR entitlement on another property.
In summary, then, you can live away from your home for up to three years for any reason, up to four years for work-related reasons and for an unlimited time for working abroad without suffering any loss of PRR.
If you're a landlord
Landlords are particularly vulnerable to CGT, but those at risk of losing out on PRR should qualify for Letting Relief of up to £40,000 instead. This relief is given where a property or part of a property has been let and will be the lowest of either £40,000, the amount of the capital gain arising or the amount of private residence relief given (see the table above). Letting relief is only available to landlords who have used the property as their home.
If you can live in the property for a time, you should, as this will bump up the amount of relief given. If you live in the property for a year, for example, four years in total would be covered by PRR thanks to the last-three-years rule. A landlord who buys a house, never lives in it and sells at a profit after 10 years will create a gain that is 100 per cent unsheltered. If he lived in the property for one year, 40 per cent of the gain in this case would be sheltered.
Married couples and civil partners who jointly own the property can use additional allowances and reliefs to soak up even more of the tax bill. Each spouse can claim Letting Relief and their own annual exempt allowance. That means a chargeable gain for a married couple could be shrunk by as much as £101,200. It is also possible to arrange the ownership so that a spouse paying a lower rate of tax bears the brunt of the bill. As mentioned previously, if you limit the letting period on a property that has otherwise been your main residence to no more than three years, no PRR will be lost.
Letting relief and joint ownership
A dwelling house is jointly owned by a husband and wife. It's sold in 2012 at a gain to each of them of £75,000. It has been lived in by them as their only or main residence throughout their period of ownership. A proportion of the property, agreed at 60 per cent, has been let throughout the period as residential accommodation.
| Here's how Letting Relief would be applied: | Husband | Wife |
|---|---|---|
| Net gain | £75,000 | £75,000 |
| Less private residence relief | £30,000 | £30,000 |
| Gain after PRR | £45,000 | £45,000 |
| Less letting relief allowed, in this case the amount of PRR | £30,000 | £30,000 |
| Chargeable gain | £15,000 | £15,000 |
Landlords who are worried about the prospect of large inflationary gains in future years, have the option of holding their buy-to-let properties in a company. "It is still possible to index corporate capital gains against inflation," says Mr Heynes. The other big benefit would be that you would pay a lower rate of corporation tax. However, you could run into problems accessing cash from the company and when trying to raise mortgages.
If you share your property with a lodger, you will still qualify for full relief. You will, however, lose PRR if you have more than one lodger. Let's say you own a four-bedroom house and rent out three rooms. When you sell the property three-quarters of the gain will be liable for CGT, although you can then apply Letting Relief and your annual exempt amount.
Landlords who make a loss on the sale of a property can offset those losses against capital gains made elsewhere, although you cannot offset losses on properties qualifying for full PRR.
If you work from home
If you work from home but do not have a dedicated area for this work, for example an office or consulting room, you won't need to worry about CGT. In other words, if you use all of your house as a home, no PRR is lost. It's only when part of your dwelling is used exclusively for your work, trade or business that some residence relief is sacrificed and, as with lodgers, it will be calculated on the fraction of your home given over to the business.
There are other special business-related reliefs that might be available to you, including Business Asset Roll Over Relief. You can find out more here: http://www.hmrc.gov.uk/cgt/businesses/reliefs.htm.
CASE STUDIES
Case study 1: We rented our house
Q: "My husband and I bought our house in 1985 for £100,000. We lived in it until 2000 when we rented it out for four years, after which we moved back in. We want to sell the house next year and think we can sell for £400,000. What will our capital gains tax liability be?"
A: In this example, the gain will be over 29 years, four years of which don't qualify for Private Residence Relief. So 4/29ths of the assumed gain (£41,379) is subject to capital gains tax. Two amounts of Letting Relief can be applied and as a result there would be no chargeable capital gain.
Case study 2: I had lodgers, then moved out
Q: "I bought a flat when I graduated and moved to London in 2007. I lived in the flat for two years, renting out two of the three bedrooms to friends. In September 2009, I decided to move in with my boyfriend and rent out the entire property to students at a nearby college. This works well for me as the rent covers both the interest and the capital repayment elements of my mortgage. But have I unwittingly chalked up a tax liability?"
A: In this case, PRR relief would be available on the property while it was the owner's only or main residence and the final 36 months regardless of whether the owner was living at the property. During the period that two of the rooms were let, any relief would need to be apportioned. As the property was used as the only or main residence at some point during the ownership, letting relief can apply to the period when the rooms were let and the period when the property was completely let. If the owner never lived at the property again before selling, no further relief would be available and a capital gain may arise.
Q: What would happen if we tie the knot at some point?
A: Married couples and civil partners who jointly own property are treated in the same way as two individuals who are joint owners and therefore Letting Relief would be applied separately on their individual gains. But HMRC points out that if the husband (to be) never used the property as his only or main residence during his period of ownership then there would be no reason why letting relief should extend to him. For more information, go to www.hmrc.gov.uk/manuals/cgmanual/CG64650+.htm.
Case study 3: We're selling our holiday home
Q: We own a holiday home abroad and will sell it at some point. What capital gains tax will we have to pay if we sell at a profit?
A: Capital gains tax extends to disposals of overseas property (assuming the property is held by an individual). There might be a capital gains tax charge in that other jurisdiction as well as a liability to UK tax. If that is the case you will have to settle the tax bill with the authorities in that country first and apply to have that amount of tax deducted from your UK bill if one arises. Double taxation relief ensures the same gain is taxed no higher than the amount due at the highest rate of the two countries, with tax being apportioned between them. Find out more at: www.hmrc.gov.uk/international/dta-intro.htm.
Case study 4: We bought two flats and converted them back into a house
Q: In 1998, I moved into my boyfriend's flat, the whole upstairs of a terraced house, which he had bought 10 years before. In 2001 we bought the downstairs flat and converted the property back into a single dwelling. In 2002 we married and moved abroad, and have rented out the property since then. If we sell the property, can we claim private residence relief from 1988?
A: Although this couple would have separate capital gains tax calculations, they would both qualify for any private residence relief from when the boyfriend first held an interest in the property, ie from 1988. Any enhancement expenditure for example the building work to convert the flats back into one property, could be set against the calculation of any gain. Letting Relief will also be available to set against the gain.
