How using leases can reduce the capital gains tax on the disposal of your investment property
Note - This is an archived article and does not reflect the recent tax changes. Visit the members area for an uptodate version of this article.
A common theme in tax planning is the distinction between capital and income.It's an important issue as they are taxed totally differently. Any gain made on the sale of a property is usually classed as a capital receipt.
Usually this would be advantageous for the purchaser as this would allow them to offset the annual CGT exemption as well as access the 18% rate of CGT.
However capital treatment may not always be the best option. What if for example there were rental losses. In this case crystallising the profit on disposal as an income receipt rather than a capital receipt may be advantageous as this could then allow the losses to be offset.
Rental losses arise when rental expenses are higher than rental income. This is usually a result of high repairs costs, high finance costs or exceptionally low income.
It's important to realise that all properties let by a landlord are treated as a single rental business. Therefore if the rental expenses exceed that years rental income the excess costs are simply carried forward for offset against future rental income. If this position arises for a number of tax years the rental losses that are carried forward can easily mount up. (Note there is a provision to allow any loss attributable to capital allowances for offset against the landlords other income or gains - but this is very unusual in practice).
When a rental property is sold if the landlord has other rental properties that he still owns and lets, the disposal will be treated as a part of his rental business. Any rental losses still remain with the rental business and can therefore be offset against rental profits that arise on the other properties (even if the rental income arises from properties that are bought after the disposal).
This carry forward of the rental losses arises providing the rental business still continues. If the rental business ceased then the losses would cease with it. They'd then be lost forever. It would only be if any cessation was only a temporary break in the rental business (so it couldn't be regarded ceasing) that the losses wouldn't be lost.
Selling the investment property
So, if the investment property is sold, you'll need to consider CGT. There will be the annual exemption to offset. There will though be no offset for any rental losses against the gain. This is made worse if the disposal of the property represents the end of the rental business (ie there were no other let properties) as in this case the rental losses would be lost as well.
It would make sense in this situation to try and ensure that part of the gain arose as rental income - This could then allow the offset of the rental losses.
The way to do this is to grant a short lease at a premium with an option for the purchaser to buy the remaining freehold interest at the end of the lease period.
Treatment of lease premium
Where a premium is paid for a short lease (this is defined as a lease of less than 50 years) part of that premium will be charged to Income Tax. The amount taxed as income is calculated by the following formula:
P * Y/ 50
P is the amount of the premium;
Y is the number of years, other than the first, in the term of the lease.
This therefore means that the shorter the lease is the higher proportion of the premium is treated as income.
Of course simply classing the premium as income will have no benefit unless it also reduced the capital gains tax charge on a disposal of the property. This is achieved because the amount of a premium paid for the grant of a short lease is excluded from the proceeds taken into account for CGT purposes.
Therefore there can be significant advantages in granting a short lease if there are brought forward rental losses as it converts some of the proceeds into income and allows the losses to be offset.
This is clearer with an example.
David owns the freehold interest in a property which he lets. He has rental losses brought forward of £29,000.
The property is to be sold for proceeds of £150,000 which would result in a capital gain of £40,000. The CGT on this would be £7,200.
Being a savvy property investor David offers the buyer a 4 year lease for no rent and a premium of £30,000. Using the formula above 94% of the premium is taxed as income.Therefore the income element income would be £28,200 would but would be offset by the £29K rental income. The proceeds of £150K would be reduced by the income element of £28,200 reducing the gain to £11,800. CGT on this would be £2,124. Therefore the effect of the granting of the lease is a tax saving of around £5,000.
Will the Revenue allow this?
Well there is no specific prohibition. Any objection by the Revenue would need to be on the basis that the whole arrangement had an air of uncommerciality about it. You'd therefore need to ensure that the tax avoidance motive was sidelined where possible. Examples could be:
- Showing that the freehold interest in the property had not previously sold
- Evidencing that the overall proceeds received for the lease and freehold option was a good market value receipt
- Showing that the lease allowed you benefits in terms of upside potential (eg to renegotiate for any uplift in value)
Note if you're non UK resident the granting of the lease would not offer any advantages as you'd be exempt from UK CGT in any case.