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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In 1987, I supplied the funds for my mother to buy her one-bedroom council fl at under the right to buy. She signed a deed of gift so that in the event of her death the fl at would pass to me. She died in 1991 and I duly became the owner. My elder daughter lived in the fl at for a couple of years and when she moved out, my younger daughter moved in. She stayed until last year and has now also moved on. It was valued last year at about £185,000. As it is not needed by my family, please advise me of my position with regard to Capital Gains Tax (CGT) if I sell it now. I intend the money to be used to supplement my state pension.

Maggie Fleming writes:

On the assumption that your mother was both the legal and beneficial owner of the property until her death, you will have acquired the flat at its probate value at the date of death. Basically, the capital gain will be the difference between probate value and what you sell it for.

You will be able to take advantage of various reliefs when working out the tax. For example, you will be entitled to indexation allowance for the period from your mother’s death until April 1998, when the allowance was abolished and replaced by taper relief.

Indexation allowance is calculated by reference to the acquisition cost and for the period in question I estimate that it will reduce the gain by approximately a fi fth of the probate value. You will also be able to deduct the incidental costs of selling the fl at, such as solicitors’ and estate agents’ fees.

If you did any renovations of a capital nature which are apparent in its current condition, you may be able to deduct these as well. Having calculated the gain in this way, you can knock off a further 35 per cent taper relief before deducting your personal allowance of £8,800.

The balance is taxable and the rate of tax will depend on your income level. It is likely that part will be taxed at 10 per cent, part at 20 per cent and, if the gain exceeds the basic rate band, the excess will be charged at 40 per cent. Unfortunately, you are not entitled to principal private residence relief (PPR), as you never lived in the property.

If you are married, you may be able to reduce the overall tax bill by gifting a half interest to your spouse prior to sale. Alternatively, you could rent the property out and supplement your pension that way.

After taking advice, we gifted a small house which we owned jointly to our daughter over a period of several tax years. It was originally bought as an investment and we did not live in it at any time. We now retain a total of only 10 per cent (that is, 5 per cent each). We intended to hold on to this small percentage, but does it mean that we would be liable for Pre-Owned Assets Income Tax (POAT)?

Am I correct in assuming that children cannot carry out the same transaction in reverse; that is, gifting property in stages to parents?

If we decide to downsize and move to her house, can she move into ours, and how could this be managed? Would we need to buy her house and sell her ours? Would it be better to keep it an informal arrangement/swap? We are both in our mid-60s, so further gifting might be risky, given the seven-year rule.

Maggie Fleming writes:

There is a good deal of confusion about what is and what is not covered by POAT. The good news is that you are not liable for the charge. It only applies where you are "in occupation" of the property and, although the term is not defined in the legislation, one would assume that you have to be living in the property, at least part of the time, in order to be caught.

I assume that your daughter is living in the property. If so, on a future sale, her gain would be exempt but yours would be chargeable - although, as you own only 5 per cent each, this may be within the annual Capital Gains Tax (CGT) exemption. There is no point in her gifting part of the property back to you - from an estate planning point of view, that would be a retrograde step.

If you swap houses, there are unlikely to be adverse CGT implications, assuming that you would each be disposing of your only, or main, residence. As you note, if you gift the properties, there are inheritance tax (IHT) implications. The value of your daughter's house would immediately become part of your estate while the value of your current, presumably more valuable, property would not drop out of your estate entirely until seven years had elapsed. However, mid-sixties is relatively young so, unless you suffer from poor health, it may well be worth the risk.

Continuing the series in which our Clinic experts provide a guide to those thorny issues that can leave the unwary out of pocket. This week, Maggie Fleming on the "Rent a Room" scheme:

We have a bedroom going spare in our house and were wondering about letting it out. A friend suggested ''Rent a Room''. How does it work?

Launched to much acclaim in the early 1990s by the last Conservative government, the ''Rent a Room'' scheme was intended to encourage people like yourselves to rent out the spare room. The scheme applies only if you let out furnished accommodation in your only or main home. It can apply to tenants, as well as owner-occupiers. Provided the annual gross rental income is £4,250 or less - £2,125 if the accommodation is let out jointly - it is totally exempt from tax.

I like the sound of that. Any potential downside?

Bear in mind that the ''Rent a Room'' scheme takes no account of expenses. If the gross rental income exceeds £4,250 in any tax year, you have a choice. You can opt to pay tax on the excess of gross rents over £4,250 or you can choose to ignore ''Rent a Room'' altogether and be taxed on the profit in the normal way (ie, on rents less expenses).

Hmm… now it is getting tricky. What calculations should we make before making a decision?

Which method you choose will depend on the precise circumstances. If, after expenses, you have made a loss, you will be better off with the normal method of calculation, as the loss can be carried forward to future years. Say, for example, your gross rental income is £6,000 but your expenses are £7,500. Choosing the standard method gives you a loss of £1,500 to carry forward. Opting for the alternative method means you would be taxed on £1,750 (£6,000 less the £4,250 exemption).

Can we just switch between methods depending on how much rent we get each year?

Where gross rents exceed the limit, the standard method is the default method of calculation. If you want the alternative method to apply, you need to elect for it within a year of the tax return filing date - so, for 2005-06, the deadline would be January 31, 2008. Once an election is made, it remains in force until you revoke it - the same deadlines apply.

Anything else to do before advertising for a lodger?

Yes. If you are thinking of letting out a spare room, remember to let your mortgage lender and insurer know what you plan to do.

In March 1994 our mother gifted by deed of gift six-eighths of her property equally to my brother and me, making the three of us tenants in common.

When she died in June 1999, we inherited her quarter but had to pay Inheritance Tax (IHT) on the current value of the entire property. This was because she lived in the house until her death without paying us rent, therefore retaining benefit.

We are now selling the property, which has increased in value considerably due to its development potential - thereby incurring Capital Gains Tax (CGT). Does the CGT liability on our six-eighths start from 1994 or is the whole capital gain due from the 1999 valuation?

Maggie Fleming writes:

I am assuming that neither you nor your brother lived with your mother. Unfortunately, if that is the case, the capital gain on your six-eighths will be calculated on the growth in value since 1994, when it was gifted to you. I'm sorry to say that your family has fallen into a classic trap - the gift was not recognised for IHT purposes because of the reservation of benefit rules but it was a perfectly valid transaction for CGT purposes.

If your mother had not gifted the bulk of the property to you in 1994 but had died as sole owner, the same amount of IHT would have been payable but your CGT base cost for the whole property would have been the probate value - this is sometimes referred to as the ''free uplift to market value on death''.

The gain will be split between you and your brother equally. For each of you, three-eighths of the gain will be calculated using the open market value of the property in 1994, while the remaining eighth will be calculated using probate value.

You will each be able to use your personal exemptions (currently £8,800 per person) and will benefit from both indexation allowance (on part of the gain) and taper relief.

If you and your brother have spouses/civil partners, you could consider transferring a share to them prior to sale. Provided this is a genuine gift, it might reduce the tax liability, especially if either or both of the partners pays tax at a lower rate. Whether or not this would be beneficial will depend on your precise circumstances and you should therefore consult a tax adviser to crunch the numbers on your behalf.