Property and Tax Issues

Isis' Maggie Fleming answers readers questions in Saturday's Daily Telegraph newspaper for the Property Clinic section.

The questions and answers are reproduced for you here.

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This week, Maggie Fleming returns to do battle with the on-going saga of pre-owned assets income tax (Poat)

This new tax has been with us a year now. Has the taxman finally worked out who and what it applies to?

There has been progress, but sadly it is still as confusing as ever. You will remember that the charge was introduced because many people had gone in for very clever (and expensive) trust schemes in an attempt to avoid the Inheritance Tax (IHT) "gift with reservation of benefit" rules on their home.

HM Revenue & Customs' (HMRC) response was to say, if you successfully avoided IHT in this way at any time since March 1986, you now have the choice of opting back into the IHT regime or paying Poat. Of course, one problem is that nobody has ever been quite sure whether or not some of these fancy schemes did successfully avoid IHT.

So it just affects people with very clever (and expensive) accountants?

Not quite. Poat is a very blunt instrument and it is not just people who have indulged in sophisticated estate planning who fall into the Poat net. Other people who are unlikely to know that they could be liable to Poat are co-habitees who lent money to their partners, interest-free, in order to purchase a property that they both occupy. There are also problems where someone sells part of their home to another family member at full market value. Despite the fact that the purchaser has paid the going rate, Poat will apply unless the sale took place before March 7, 2005. Poat would not, however, apply if the sale was of the whole property, rather than just part.

At least HMRC has confirmed that Poat will not apply to people who sell a part share of their homes to a commercial provider of equity release schemes.

I am sure they have their reasons… Any other areas of confusion?

Well, in the past, you could gift money to your children and they could then purchase a property for you to live in without being caught by the reservation of benefit rules. Poat now catches such monetary gifts. But HMRC has confirmed that, because of the way the legislation has been worded, only gifts made after April 5, 1998 will be caught. So, despite some tinkering at the edges, Poat is still ridden with anomalies and as illogical as before.

In 1993 I bought a second property to live in during the week, returning to my family home at the weekends. In 2000, this arrangement ceased, but I retained the property for the family to use at holiday times.

In 2003, I transferred my interest in the property to my two adult children for nil consideration and we still just used it for holidays. At the time the value was £45,000 more than the original purchase price.

The property has now been sold for £75,000 more than the purchase price. Can you advise on the Capital Gains Tax (CGT) position for myself and my children, who owned the house as tenants-in-common?

Maggie Fleming writes:

I am sorry to have to tell you that you had a sizeable CGT liability in 2003 when you gifted the property to your children. It is a mistake to think that a gift has no CGT consequences, only Inheritance Tax (IHT) implications. This is true if it is a gift of cash but, if it's a gift of a chargeable asset, such as a property or shares, there is a charge to CGT based on the difference between the acquisition cost and the open-market value at the date of the gift.

The gain should have been included on your tax return for the year in question. As you did not do this, you should inform HM Revenue & Customs of the gain at the earliest possible opportunity. You should ask a qualified tax practitioner to draw up a computation of the gain and to negotiate with HMRC on your behalf.

You mention a gain of £45,000 but you will be entitled to the usual reliefs, such as indexation allowance and taper relief, as well as the personal exemption applicable to the year of gift. I am assuming that you never elected for the property to be treated as your principal residence - if you did, further relief would be due.

Your children will be taxed on the difference between their acquisition cost (open market value in 2003) and the sale price - roughly £15,000 each. They will each be able to set their personal exemption (£8,500 per person in 2005-06) against the gain. I am assuming that neither of them lived in the property as their main residence.

In 1995, I signed a deed of gift of my house to my daughter. Our solicitor insisted this should be a "gift with reservation" so that my wife and I could continue to live in it for the rest of our lives.

I now understand that in order to avoid my daughter paying Inheritance Tax (IHT) and Capital Gains Tax (CGT), I should have paid her rent for the duration of the our occupation. I was under the impression that the gift would be free of IHT providing I survived seven years from making it.

Although I have not paid rent for the property, I have paid for its upkeep and also given my daughter financial help as she has a disability which prevents her from working full-time.

As our circumstances have changed, is it possible to cancel the deed of "gift with reservation" and return the house to my ownership? I am considering moving and if the house were in my name, I could buy another one near my daughter without CGT coming into it.

Maggie Fleming writes:

Your solicitor should have explained to you that, as you had reserved a benefit (ie the right to live in the house), the gift was ineffective for IHT purposes. This means that the seven-year potentially exempt transfer "clock" would only start to run if and when you moved out of the house.

Unfortunately, you cannot simply "cancel" the original gift. You are correct in thinking that you would be exempt from the IHT rule if you had paid a full market rent from the outset, although this would not have helped your daughter's CGT position.

The situation is complicated because, while the house is still in your estate for IHT purposes, your daughter is the owner when it comes to CGT. If she gifted the house back to you now, she would be subject to tax on the gain.

While there are some measures she could take to mitigate this gain (such as gifting a share to a husband or civil partner, if appropriate, before transferring it to your ownership) there is still likely to be a hefty tax charge, given the increase in property values in the past 10 years.

You seem certain that this is in fact a gift with reservation but you may wish to check with your solicitor that the position is not more complex. Prior to the recent introduction of the Pre-Owned Assets Tax (POAT) legislation, there were many schemes being marketed to people in your situation which aimed to get round the reservation of benefit rules.

Any such schemes entered into since 1986 have now been rendered redundant by the POAT legislation and people affected need to seek specialist legal advice.

With it starting to feel more like spring, we are about to embark on some work on our holiday cottage but are concerned that any increase in value will be wiped out by CGT.

You will not be alone in perhaps planning to convert a loft or extend a kitchen. Of course, if it is your only or main residence, the work will increase the value of the property without any CGT problems, but it is a different matter for a holiday home or investment property.

So we lose out on any investment when we come to sell our second home?

Not necessarily. Where a property disposal is subject to CGT, you can deduct the costs of improvements, provided they are of a capital nature and are still apparent in the state or nature of the asset when you sell or gift it.

What does that mean? Do you still have to have receipts attached to any work you have done?

No, nothing that glib. What it entails is that, if you decide to dig a swimming pool in the grounds but then fill it in again before you sell the property, you cannot claim the cost of the work, as the pool no longer exists.

We also rent out our cottage from time to time. Does that change things?

Yes. If you are selling a property you previously rented out, you should go through your old builders' bills with your accountant. Some expenses, such as redecoration, may already have been claimed against income tax as repairs, but other items that could not be claimed in previous years on the annual tax return, such as the cost of a new bathroom or kitchen, may be allowable against CGT on sale.

What if we do the work ourselves? Can we "pay" ourselves for tax purposes?

Sorry, no.You cannot claim the cost of your own labour - you can, of course, claim the cost of materials.

Any other useful advice?

Don't forget that if you are taking out a loan to fund building work on an investment property, you can claim the interest against rental income and thus reduce your income tax. It makes more sense to have mortgages and loans on your investment property rather than your home, as interest on the latter no longer attracts tax relief.