In a recent article for TAx Insider, Jennifer Adams has an eye to the end of the tax year on 5 April as she explains the principles behind taxing the sale of rental or investment properties.
There is a great deal of truth to be found in the statement that "Timing is everything" - the difference between a good joke and a bad one, for example, is a person's sense of timing. Timing and the recognition of timing also creates advantages and disadvantages in the field of taxation - the date of purchase and subsequent sale of a property will make the difference between whether you make money/profit (and therefore possibly pay Capital Gains Tax (CGT)) or lose money, creating a capital loss (which can either be offset against the gain made from the sale of any other property during the same fiscal year, or be carried forward to be used in future tax years).
Capital Gains are Normally Preferable to Income Profits!
Despite the reduction in value and sale prices of property currently prevalent as a result of the credit crunch there are still some properties that stand at a capital profit which, if that profit is translated into a chargeable gain in excess of £10,600 per person per annum, can produce a tax bill of either 18% or 28% of the gain made (depending upon the seller’s personal Income Tax rate). As a 28% CGT bill is more acceptable than a 40% or 50% Income Tax bill if the seller is a higher rate taxpayer, it is always preferable for the surplus for such taxpayers to be recognised as a capital rather than an income gain, if that can be achieved - best, of course, would be a NIL tax charge.
When is the Disposal for CGT Purposes?
‘Timing’ is thus all-important but practically, what is most beneficial is not always easy to achieve. With most assets, including property, the date of disposal for CGT purposes is the actual date of signature of contract even though the monies may not be debited from the purchasers’ bank account and the asset not conveyed, delivered or physically transferred until a later date. If the contract includes any conditions or perhaps is subject to the exercise of an option then the disposal will not occur until those conditions have been met.
Probably the worse feature of CGT is the many and varied special rules for special cases - no other tax has quite so many complex reliefs for individual situations nor, indeed, so long a list of partial or complete exemptions as are found with CGT. Despite this, tax planning is possible should a property be found to stand at a profit. With any form of CGT planning the principle of law determined in the tax case of ‘Furniss and Dawson’ (1984) should be at the back of the mind. The principle being, broadly, that where there is a scheme put into place comprising a number of steps, one or more of which has no purpose other than to avoid tax, then those steps are to be ignored for tax purposes. So with this in mind, what comprises a tax planning exercise?
In order to save tax it is first necessary to identify when a tax charge actually arises and the basic rules are that before a transaction can give rise to a chargeable gain then all of the following must be present:
- A chargeable person and
- A chargeable asset and
- A chargeable disposal
Generally a ‘chargeable person’ is someone who is resident or ordinarily resident in the UK for at least part of the tax year (TCGA 1992 s 2(1)); a ‘chargeable asset’ includes all forms of property such as land, chattels and legal rights (unless specifically exempt). A ‘chargeable disposal’ occurs when ownership changes or part or the entire asset ceases to exist. Having considered the above and thus identified that a charge does exist, it should now be possible to either bring forward or possibly delay the date of transaction to be taxed in whichever year is more tax beneficial.
Property Improvements are Better for CGT Than Repairs
If it is planned to sell a property which will produce a gain but the property needs some work done on it, this is usually reflected in the price. However, if the work is more in the nature of an improvement than a repair, it may be worthwhile undertaking just the improvement work to reduce the surplus on sale, thereby reducing the tax bill; possibly even calculating a spend that reduces the profit to just below the aforementioned Annual Exemption of £10,600 in 2012/13. You might particularly want to do this if a loss is being incurred on any letting income received, as more repair costs would only increase the Income Tax loss to be carried forward which may then never achieve tax relief!
The Difference Between Repairs and Improvements
The main consideration in this plan is the difference between what is deemed ‘repair work’ (a revenue item and thus allowable as a cost against rental income) and ‘capital improvements’ (a capital item not allowable against rental income but rather an expense for which tax relief is only possible when the property is finally sold). The definition of a repair is not one that has a statutory footing — rather it takes the normal dictionary definition, although this is supplemented by case law on the distinction between repairs and capital improvements.
A ‘repair’ is really a restoration or a replacement of a particular part of a building, rather than of the whole building at one time. A ‘capital improvement’ goes beyond a repair, i.e. more than just replacing like with like. For instance, if a roof suffers storm damage, replacing tiles to take the roof back up to its original standard would be a repair; however, taking off the roof and building another storey would be a capital improvement.
HMRC accepts that items such as mending broken windows, etc., would all normally be regarded as repair works. However, the refurbishment or repair to a property purchased in a derelict state would be regarded as capital expenditure, the assumption being that the purchase price would have been reduced when buying a property in such a state, hence the logic for the repairs to that property being regarded as capital in nature.
But What if There Are Both Repairs AND Improvements?
A problem area is when work is undertaken to a property that is intended to be repair work but includes an element of improvement. This often happens where building materials improve over time, making it impractical to replace like with like. HMRC is generally realistic accepting that the expenditure be regarded as a repair rather than as a capital improvement. This is provided that the improvement element arises only due to the upgrading of materials available and any improvement to performance or capacity is small. Likewise, incidental improvements may often be treated as repairs.
CGT planning should be an ongoing procedure for the whole of your property portfolio. Even if you are not intending to sell, the CGT gains or losses made on the portfolio need to be reviewed on an annual basis and recalculated using current property sale values. This will enable you to plan for any improvements that can be deemed as capital in nature which when undertaken will reduce any capital gain that might be due when a sale is finally made.