Main Residence CGT Exemption - How To Lose It!

James Bailey highlights a potential problem with some claims for capital gains tax main residence relief.

The capital gains tax (CGT) legislation which provides for relief on the disposal of a private residence includes a provision (in TCGA 1992, s 224(3)) which appears to deny the normal exemption for capital gains on a ‘main residence’ if you hoped to sell it at a profit when you bought it.

At the first reading, section 224 (3) seems to do away with almost all the CGT exemption. It says the main residence exemption:

“...shall not apply in relation to a gain if the acquisition of, or of the interest in, the dwelling-house or the part of a dwelling-house was made wholly or partly for the purpose of realising a gain from the disposal of it, and shall not apply in relation to a gain so far as attributable to any expenditure which was incurred after the beginning of the period of ownership and was incurred wholly or partly for the purpose of realising a gain from the disposal” (emphasis added).

Notice those two uses of ‘or partly’- most of us hope to sell our homes at a profit one day, and adverts for home improvements like conservatories often make the point that this will increase the value of the property concerned. So are we all doomed to pay tax when we sell our homes? Fortunately, HMRC’s Capital Gains manual instructs its staff to behave reasonably and not use the legislation in cases like these:

“It would be unreasonable and restrictive to apply the legislation in this way. The subsection should only be taken to apply when the primary purpose of the acquisition, or of the expenditure, was an early disposal at a profit” (CG65210).

HMRC generally use the legislation in three situations:

1. Quasi property development

It is difficult for HMRC to establish that someone who buys a run-down house, does it up, and then sells it in a short period of time is trading as a property developer if he genuinely lives in the property while he does so, and he has no other residence at the time, but they may use section 224(3) to charge CGT on the profit made.

2. Leasehold Enfranchisement

Tenants under a lease may get the opportunity to buy the freehold from their landlord. This is generally a sensible investment, but if you then sell the freehold shortly afterwards, you may find section 224(3) rears its head, as far as the gain attributable to the freehold is concerned.

3. Extensions and conversions

A house divided into flats will often sell for more than the same house undivided. If you do this (or build an extension) shortly before sale, then some of the gain may not be exempt.

4. Calculating the lost exemption

Except in the case of the ‘property developer’, it is not all of the gain that is taxed; it is only the part relating to the offending expenditure. This involves a valuation exercise. 

For example, imagine a house converted into three flats and immediately sold. Each flat sells for £150,000, whereas the unconverted house would have sold for £350,000. The conversion work cost £50,000. The taxable gain is as follows: 

 

The longer the period between the expenditure and the sale, the less risk there is of section 224(3) being trotted out, especially if you can show another reason for the expenditure (an extension for a growing family, for example).

Practical Tip:

Do not let section 224(3) put you off sensible expenditure to enhance the value of your home. In the example above, assuming the £11,000 annual CGT exempt amount is available, the CGT payable is, at worst, under £11,000 (less if the property is jointly owned), so you are still better off for doing the conversion.