Example 1: Buying a second property
Robert buys his first
investment property (a three bedroom semi-detached house) in May 1992 for
£65,000. This was funded by a £25,000 deposit and a £40,000 buy-to-let mortgage.
In March 2010, the property is valued at £150,000.
Robert decides to buy a
second buy-to-let property, which is partly financed by releasing equity from
his existing one. He buys a three bedroom detached property for £200,000. The
£80,000 deposit is funded by the equity release. Robert’s mortgage on the
second property is £120,000.
It is worth noting that there is no CGT when the first property is remortgaged. Any CGT liability only arises when the property is sold or transferred. This effectively allows Robert to extract a large sum of money in respect of his first investment property, without paying a single penny in tax. Even if Robert had not used the equity release proceeds for his property investment business (e.g. if he instead used it to fund university fees for his children), there would still be no CGT liability at that point. However, this is a risky strategy.
Following on from Example 1, suppose that Robert continues to grow his property portfolio:
Example 2: Becoming a property millionaire
Robert’s first property
has increased in value to £200,000 by November 2013, and the second property is
worth £260,000. He decides to expand his property portfolio, and remortgages
the existing properties. He again releases equity to buy six new apartments at
£130,000 each (i.e. £780,000 in total).
As Robert’s property
lettings business is now well established, his lender allows him to remortgage
the first and second properties to 90% of their value. This means that on the
first property he is able to increase the borrowing to £180,000. Robert’s
mortgage on the second property is increased to £234,000.
Robert now has a house
worth £200,000, another worth £260,000, and six apartments worth £780,000 in
total. His property portfolio is therefore worth £1,240,000. Robert has become
a property millionaire!
Now the bad news…
In the above examples, Robert has grown his property portfolio and in a relatively short space of time has become a property millionaire, at least on paper.
However, what is the CGT position?
Example 3: CGT problem
Robert is considering
selling the first house during the current tax year (2014/15). None of the
properties have materially changed in value since November 2013.
Robert’s first investment
property was bought in 1992 for £65,000. If he sells it at the current market
value of £200,000, his capital gain will be £135,000. Assuming that Robert is a
higher rate taxpayer (and ignoring the annual CGT exemption), his CGT liability
on disposal would be £135,000 x 28% = £37,800.
In Example 3, Robert only has equity of £20,000 in the property, due to the mortgage of £180,000. He would therefore be required to find an extra £17,800 just to pay HMRC. He has made no actual net profit, and would either need to dip into his savings (if he has any) to pay the CGT bill on the sale of the property, or incur additional debt paying HMRC.
Could he sell his second property to pay the CGT on the first?
Example 4: Escape route?
Robert’s second property
was bought in March 2010 for £200,000. If he sells the property at its current
value of £260,000, his capital gain will be £60,000. His CGT liability on the
disposal will be £60,000 x 28% = £16,800.
His equity in the second
property (i.e. after repaying the mortgage of £234,000) is £26,000. After
paying his CGT bill on the property, he is left with £9,200.
Selling the property would
therefore help to pay the CGT on the first property. However, overall he is
still £8,600 out of pocket (i.e. £17,800 - £9,200).
What can be done?
On the face of it, Robert is caught in an ‘equity trap’. However, all is not necessarily lost.
For example, Robert has some equity in the apartments, resulting from the release of equity in the first two properties. The apartments are not standing at a gain, so if Robert needs to sell any properties, he should first consider selling one or more of the flats.
Alternatively, Robert may decide to keep all of the properties, and not purchase any additional ones. He could continue holding his existing properties in the hope that they increase in value, or if purchased with repayment mortgages, until enough of the loans have been repaid. Hopefully, the sale proceeds might cover any tax liabilities quite comfortably. However, this may take a few (or more) years.
Change to a company?
It is not difficult to envisage much larger property portfolios than in Robert’s case, with considerable inherent gains and substantial tax liabilities on disposal. If Robert’s CGT problem was greater (i.e. due to a larger property portfolio) consideration might be given to relieving it in some way.
For example, if Robert’s rental activities were considered to be a ‘business’, he could consider transferring the property business as a going concern to a company in exchange for shares, and claiming incorporation relief for CGT purposes, if certain conditions are satisfied (in TCGA 1992, s 162). The effect of the relief is broadly to ‘roll over’ chargeable gains against the base cost of the shares acquired. The company acquires the properties at market value for tax purposes. This means that the company could sell the properties with little or no tax liability.
However, there are several problems with this strategy. These include:
- whilst rental properties have been held to constitute a ‘business’ for incorporation relief purposes (Ramsay v HMRC [2013] UKUT 226 (TCC)), HMRC could argue that Ramsay was decided in the taxpayer’s favour based on the particular facts and circumstances of that case, and challenge the claim for incorporation relief on Robert’s business. He may therefore wish to consider asking HMRC for clearance on this point before doing anything;
- even if HMRC accepts that incorporation relief is due, if liabilities are relatively high (and are being transferred), the net asset value of the business (which equals the value of the shares issued) may be low. Where properties have large inherent capital gains, it may be impossible to roll over all of those gains – the base cost of the shares cannot go below zero! Do the sums first; and
- where properties are transferred to a company and the parties are connected, stamp duty land tax (SDLT) is normally charged based on market value (FA 2003, s 53). Where several properties are transferred in a single transaction (or a series of linked transactions), the company’s SDLT liability can be considerable (FA 2003, s 55(4)).
Robert should seek expert professional advice on incorporation relief, and/or to establish whether any alternative planning strategies may be suitable in the circumstances.
Practical Tip :
The above examples have been ‘manufactured’ to illustrate a simple tip for property investors; ensure that enough equity remains after refinancing to pay the tax liabilities on any inherent profits on your property portfolio – unless you have deep pockets!
