Sarah Bradford explains how relief can be obtained for capital expenditure when working out the gain or loss on the disposal of an investment property.
There is no tax to pay on any gain that a person makes when they sell a dwelling that has been their only or main home throughout the time they have owned it.
However, gains made on second homes or on investment properties (e.g., buy-to-let properties or holiday lets), are liable to capital gains tax (CGT). When working out the gain, not only is the initial purchase price deductible, but a deduction is also given for other allowable expenditure. In this way, relief may be available for capital expenditure that has not otherwise been relieved.
What expenditure is allowable?
Expenditure is only deductible in computing any gain or loss on sale if it is incurred:
- on acquiring or creating the asset;
- enhancing the value of the asset;
- establishing, preserving or defending title or rights over the asset; or
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is an incidental cost of acquiring or disposing of the asset.
Further, a deduction is only given once for the same expense. Thus, if relief has already been given for income tax purposes, the expense is not an allowable expense for CGT purposes.
Cost of acquisition
The cost of acquisition will normally be the amount that the owner paid for the property. However, this will not always be the case; with every rule, there are exceptions.
If the property was acquired from a spouse or a civil partner, the no gain/no loss rules mean that the acquiring spouse simply takes over their partner’s base cost, regardless of the amount actually paid (if any). From a tax planning perspective, it may make sense to transfer all or part of an investment property to a spouse or civil partner prior to the disposal to a third party to make use of their annual exempt amount or basic rate band.
Example: Inter-spouse property transfer
John has owned a holiday let for five years. He purchased the property for £200,000. He wants to sell the property, but has already used his annual exempt amount for 2022/23. John is a higher rate taxpayer. His wife Julie is a basic rate taxpayer. She has made no gains so far in the tax year.
John transfers the property to Julie. The no gain, no loss rules apply. Julie takes over John’s base cost of £200,000. She pays nothing for the property. The property is sold to a third party for £300,000. Julie can deduct the £200,000 paid by John in calculating her capital gain.
Where the property was acquired by way of a gift or a transaction other than at arm’s length, market value is used to work out the donor’s chargeable gain. Likewise, the recipient’s base cost is the market value at the date of acquisition, not the amount, if any, paid for the property. The market value at the date of acquisition is allowable expenditure when calculating the gain or loss on disposal.
If the property was built by the person who is disposing of it, they can deduct the cost of the land plus the cost of building the property.
Enhancement expenditure
During the period that an investment property is owned, money may be spent on enhancing the property. This may take the form of an extension, or the property may be renovated and upgraded.
While enhancement expenditure is allowable in computing any capital gain or loss on disposal, the expenditure must pass certain tests.
The first test is that the enhancement expenditure is spent on the asset. It should be clear whether the expenditure is spent on the asset; however, some caution should be exercised – expenditure in connection with the asset is not the same as expenditure on the asset. For example, if, as a gesture of goodwill, a person builds a wall for a neighbouring property when undertaking building work on their property, the expenditure on the neighbour’s wall is not expenditure ‘on the asset’, and as such, is not allowable in computing any gain or loss on the disposal of the asset.
The expenditure must be incurred for the purpose of enhancing the asset and must also be reflected in the state of the asset at the time of its disposal.
Enhancement expenditure is capital in nature, and a distinction is drawn between improvement expenditure and repairs. The cost of repairs and maintenance is a revenue cost which is deductible in working out the taxable profit for income tax purposes. Essentially, a repair maintains the state of a property. By contrast, enhancement expenditure improves the property. This is capital expenditure and is not deductible in calculating profits.
Enhancement expenditure is only allowable if it is reflected in the state of the property at the time of disposal. For example, if a conservatory is added to a property, but prior to the disposal, the conservatory is knocked down and an extension built in its place, the cost of the conservatory will not be allowable when working out the gain or loss on sale as it does not form part of the property at the time at which it is sold. However, the cost of the extension is allowable expenditure and this can be taken into account in calculating the capital gain.
Other examples of enhancement expenditure include the cost of upgrading kitchens and bathrooms, building a garage, adding superior windows and doors, landscaping the garden, and suchlike.
Incidental costs of acquisition and disposal
It costs money both to buy a property and to dispose of it. There are legal fees to pay on both the acquisition and the disposal, stamp duty land tax (or equivalent) is likely to have been paid when the property was purchased and estate agent’s fees are generally payable when it is sold.
The tax legislation recognises this, and certain incidental costs of acquisition and disposal are allowable expenditure for CGT purposes. Allowable incidental costs are limited to:
- fees, commission or remuneration paid for the professional services of surveyors, valuers, auctioneers, accountants, agents and legal advisers;
- the costs of transfer or conveyance;
- stamp duty land tax (or, as appropriate, land and building transaction tax in Scotland or land transaction tax in Wales);
- the costs of advertising to find a buyer; and
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any costs reasonably incurred in making a valuation or apportionment for the purposes of the CGT computation.
There are some things to watch here. Fees paid to a professional adviser are only allowable for CGT purposes to the extent that they relate directly to the acquisition or disposal of the property; fees relating to general advice or market conditions do not count as allowable expenditure. As far as accountant’s fees are concerned, these are allowable to the extent that they relate to ascertaining the market value of the asset or of any apportionment needed to compute the gain. However, the costs of preparing the CGT computation or associated compliance costs are not allowable expenditure.
Expenditure on the incidental costs of acquisition or disposal is only allowable if it has been incurred wholly and exclusively for the purposes of acquiring or disposing of the property.
Gain on disposal
The gain is simply the disposal consideration (or, as appropriate, the market value at the time of disposal) less the allowable costs (purchase cost, enhancement expenditure and incidental costs of acquisition and disposal). In certain circumstances, reliefs may be available (for example, if the property has been a main residence at some point), but these are not discussed here.
To the extent that the gain exceeds the annual exempt amount (£12,300 for 2022/23), it is taxable at the residential property rates (18% where taxable income and gains do not exceed the basic rate band of £37,700 for 2022/23, and at 28% thereafter).
Residential property gains must be reported to HMRC within 60 days and a payment on account of any CGT due must be made within the same time frame.
Practical tip
Keep a record of all work done on the property, together with invoices and receipts, so that it is not overlooked when calculating the gain on disposal.
