When the sale of a property will be liable to Income Tax rather than Capital Gains Tax
By Kevin McDaid, Oct 11 2016 10:07AM
In the previous blog ‘Capital gains on BTL to be taxed as income – don’t worry it is not going to happen’ I drew attention to the concerns of no less a body than The Law Society that an unconsulted upon piece of legislation had been ‘sneaked’ into the Finance Bill 2016 that could result in landlords being liable to Income Tax (IT) rather than Capital Gains Tax (CGT) on the ultimate disposal of their buy to lets at a gain/profit.
Eventually, it was determined that it was not the Government’s intention to tax landlords in such a manner. However, there are instances where the sale of property will be subject to income tax rather than CGT. And I am not just talking about obvious property developers.
Even where a property can, on the face of it, qualify as a Principle Private Residence (PPR) which would normally mean that the gain would be entirely exempt from CGT (never mind being subject to income tax) this relief can be denied and the seller of their own home become liable to pay income tax (and, potentially, NIC). Imagine the sensational headlines this could create.
The relevant legislation has been around for donkeys’ years. (Where do such phrases come from?) This is why it surprises me when I see programmes such as ‘Homes under the hammer’; I do wonder whether some of the purchasers have taken tax advice before appearing on the programme.
This is because the tax treatment of the sale will be determined by the intention of the outset at the project. So if the purchaser clearly intends to refurbish and sell, this would be subject to income tax under the Income Tax Act 2007 s.756 where ANY of the conditions in subsection 3 are met:
a) The land is acquired with the sole or main object of realising a gain from disposing of all or part of the land.
b) Any property deriving its value from the land is acquired with the sole or main object of realising a gain from disposing of all or part of the land.
c) The land is held as trading stock
d) The land is developed with the sole or main object of realising a gain from disposing of all or part of the land when developed.
Consequently, if you purchase a property for, say £200,000 as a married couple (in a civil partnership) and you are 40% taxpayers, and spend £30,000 renovating, then sell for £252,000, there would be a gain of £22,000 (ignoring SDLT and professional fees). If both spouses had their annual CGT exemptions in place for 2016/17 of £11,100, there would be no CGT to pay and they would be better off to the tune of £22,000. Whoopee!
Unfortunately, if their intention at the outset was to renovate and sell, they would fall foul of the above legislation and find themselves subject to income tax. As 40% taxpayers they would pay £8,800 in tax between them, leaving them with only £13,200 proceeds (NIC has been ignored but would be chargeable if it was deemed that the activity amounted to a trade. This would be chargeable at 9% or 2% depending upon the other income of the individuals).
Clearly, CGT treatment is preferable.
Is there anything that can be done to sway the tax treatment away from Income towards capital?
If the above property had been let out for a period of time prior to sale, this could be treated as a gain because the conditions in the legislation could be refuted in that it was not the sole or main intention to dispose of the property at a gain. Instead, the intention was to let the property out and make taxable profits that way. If circumstances change that precipitate the sale of the property then any gain/profit should be treated as being liable to CGT.
The HMRC manuals on the subject of the availability of Principle Private Residence Relief (PPRR) to exempt a gain from CGT on the disposal of a property that has, at some point during ownership, been regarded as your home, begins at https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg65200. ‘The purpose of private residence relief is to relieve gains arising on the disposal of an individual’s residence so that the whole of the disposal proceeds are available to be used to buy a new residence of a similar standard. It is not intended to relieve speculative gains or gains arising from development’.
Consequently, if a property is purchased with the sole or main intention of selling at a profit, PPRR, will be denied on any gain arising on disposal. This does not mean that you cannot purchase a rundown property knowing that you will need to spend £50,000 renovating but in so doing you increase its value by £90,000. You may have continued living in your existing home whilst the bulk or all of the renovation was taking place. When the renovation is completed you sell your existing home, move in to the new place but find that you don’t get on with the neighbours and decide to move on in a matter of a few weeks/months, disappointed that it has turned out not to be your ‘forever home’ but content in the knowledge that you are £40,000 better off.
There is no doubt that HMRC should look closely at any such transaction if they felt that the main reason for purchasing the property in the first instance was to create a gain. The fact that you lived there as your home for a short period of time (with no other PPR) would be irrelevant. Of course, if you could show that it was your main intention to live in the property as your home, then PPRR should be available. Consequently, it is usually only when a recurring theme occurs that HMRC may seek to invoke the relevant piece of legislation, Taxation of Capital Gains Act (TCGA) 1992 s.224(3) to deny relief. They may even apply to seek Income Tax treatment via Income Tax Act (ITA) 2007 s.756.
The case of Hartland v Revenue & Customs  UKFTT 1099 (TC) is a very good example of where HMRC would seek to deny PPRR on gains on the sale of dwellings that the owner thought would be CGT free because they were his home. Not only did the case consider TCGA 1992 s.224(3) and the denial of CGT PPRR, HMRC also sought to subject the gains to income tax under ITA 2007 s.756.
The facts of the case are as follows:
• Mr Hartland worked in the building trade.
• Between 1996 and 2005 Mr Hartland purchased 4 properties that he lived in, refurbished then sold at a profit. The length of time he lived in each property diminished with each purchase/sale, i.e. he sold property 1 after 4 years ownership whilst property 4 was put up for sale after about 9 months of ownership.
• HMRC sought to charge income tax on the profits/gains of all the disposals as though Mr Hartland was a property trader.
• Unsurprisingly, Mr Hartland claimed that no tax (income or capital gains) should be payable because his intention when purchasing each property was to live in them as his home.
• The tax tribunal considered various case law concerning the badges of trade. It concluded that Mr Hartland had purchased the earlier properties as a home and therefore the gains on these were exempt from CGT because of PPRR. However, for the last property the Tribunal concluded that the acquisition, demolition, rebuilding and sale were undertaken in the course of a property development trade. The evidence showed that he sold it almost as soon as the works were completed, and there was no evidence that he ever lived in it. The profit on disposal was, therefore, subject to Income Tax.
It would be wrong to conclude that HMRC would only ever seek to apply ITA 2007 s.756.where the taxpayer worked in the building trade. However, such an individual is likely to be able to purchase, refurbish and sell a property and make a greater gain than the average person because of their ability to complete much of the work personally. The greater the gain/profit, the more tax is likely to be at stake and the greater the interest HMRC will show in a case. Where transactions are occurring frequently and the period of occupation as a home is non-existent or minimal, HMRC are much more likely to cast an interested glance.
Whilst income tax is the outcome for an individual trading with a view to a realisation of profits, capital gains tax treatment will be applied but with PPRR denied/restricted if HMRC can show a desire to make a profit was a significant driver behind any purchase/sale.
The second arm of TCGA 1992 s.224(3) seeks to restrict PPRR in cases where a dwelling has clearly been a home but a profit motive prior to sale has emerged. The legislation reads as follows:
• where there is subsequent expenditure on the dwelling house wholly or partly for the purpose of realising a gain from its disposal.
• Where the second part of the subsection applies no relief is due on any part of the gain attributable to the expenditure.
One of the examples HMRC give for the above is for a large house acquired as a home, subsequently concerted into two flats.
The disposal of a plot of land for building that was once part of the home’s garden could trigger TCGA 1992 s.224(3) or even ITA 2007 s.756 if the sale is not structured tax efficiently. At https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg65243 HMRC indicate that the cost of obtaining planning permission is to be ignored in triggering a restriction to PPRR. Any costs incurred thereafter, for instance clearing the land for sale, would be denied PPRR. If you actually build the new property yourself or in a joint venture with the builder, income tax will, ultimately, be charged on any profit made on the sale.
The case studies at http://www.propertytaxadvisers.co.uk/case-studies/4591698202 consider some of the issues raised in this blog in greater detail.
What our clients said about us:
I have a portfolio of over 50 residential properties throughout the North of England.
I first came across Kevin in 2010 when he was performing capital allowances valuations in respect of houses of multiple occupation (HMO). At that point, not many accountants that I spoke to, had much of a clue about the ability to claim the allowances whilst many of those organisations who were in the know, were keen to do the valuations for a hefty fee but then really did not instil me with any confidence about the tax implications.
Kevin was different; we had an initial chat over the phone, there was no big sell and no hefty fee. Because he has a tax and surveying background, not only was he able to undertake the valuations he was able to liaise with my accountant to fully explain the tax implications and talk him through the reporting procedure.
There is no question that the tax savings I made hugely outweighed his fees.
Fast forward 5 years and there is no surprise that, once again, he seems to have a far greater understanding of the latest tax changes than the accountants of other landlords that I regularly speak with.
He has kept me fully updated on the tax implications of the loss of wear and tear and the changes in the allowability of loan interest. He has provided me with an in depth report showing how much post tax income I would have from the present day right through until 20/21 when the restriction is fully in force. It did not paint a pretty picture. In fact, I would go so far as to say, that I would almost certainly no longer be able to continue to operate as a property investor by 20/21 in a sole trader capacity. Consequently, as of 01/04/16, I am now operating as a limited company, Kevin guiding me and my accountant through the tricky incorporation maze and explaining the best profit extraction method going forward.
I would point out that we had been discussing the SDLT implications of incorporation on the run up to the Budget on 16/03/16. With over 50 properties this was going to be a hefty charge for me. We had anticipated there would be a relief for the transfer of more than 15 properties into company ownership. When it was announced in the Budget that this would not apply, Kevin contacted me on Budget day whilst I was in South America to break the news and to push for the transfer to take place by 31/03/16 in order to save an extra 3% SDLT, which I duly did.
Once again, big tax savings for reasonable costs but, most importantly to me, I know exactly where my business is going, how much money I can personally extract from the company & how much should be left in to help pay off existing mortgages or to expand the business.
It really is a no brainer to work with Kevin whether you are a large or small property investor.
We first used the tax services of Kevin almost 10 years ago when he was working for a local firm of chartered accountants. Having received an excellent service from him for a number of years (including expanding from a partnership to a limited company) we were delighted to hear that Kevin had set up on his own and had no hesitation in signing up as a client in 2012. He continues to offer a very personable and cost effective service. We would absolutely recommend him to any other small company like ours.
In addition to our company, we have a small residential property portfolio and were contemplating disposing of one of the properties in 2014/15. Had we not consulted with Kevin prior to the sale, we would have been facing an unwelcome Capital Gains Tax Liability. However, by transferring the property from sole into joint ownership we were able to benefit from a second CGT exemption which saved us almost £2,000’.
Mrs S (Company Director, Bingley)
I first met with Kevin in July 2015 because I was worried that I had been receiving rental income for 3 years but had not declared anything to the tax man. The reason I had not done so was because I had spent quite a bit doing it up when I first purchased it and, by my calculations, I had only just started to make a profit in the tax year ended 05/04/2015.
Kevin explained that not all the expenses would be allowable because some counted as improvements. He provided a fact sheet on ‘Revenue versus Capital’ indicating that those costs that counted as improvements would, ultimately, be available to set against any gains on disposal of the BTL. He also clarified the other expenses I was entitled to claim.
He calculated the net profit from letting. Even though no tax was payable he advised that the income still needed to be reported to HMRC which he duly did via a letter as, he said, the amounts involved were below the level for which a tax return was required. Apparently, this saved me penalties for failing to submit tax returns by the due date.
A tax return will be required for 2015/16 and I will be using Kevin to prepare this as, last year, he took away my concerns in sorting out my tax in a professional manner. He is not expensive and I feel comfortable dealing with him.
I would be happy to recommend him based on my experience.
BLOG INDEX - PLEASE SCROLL DOWN TO VIEW INDIVIDUAL ENTRIES.
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Mortgage Interest Relief Restrictions - Are you ready?
Making Tax Digital (MTD) & the cash basis for landlords
Landlords lose legal challenge over BTL tax changes
When the sale of a property will be liable to Income Tax rather than CGT
CGT on BTL to be taxed as income - Don't worry, it is not going to happen
The Statutory Residence Test - Working full-time abroad
Replacement Furniture Relief.
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