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.

This page contains Questions & Answers from April 2005. Older articles are accessed through our main Property Tax page.

There is a wealth of information on these pages. If you have a specific interest, please use our Search facility.

I am in the process of buying a house. I intend to keep my old flat and let it. The flat has a very small mortgage and it has been suggested that I can increase this mortgage to help buy the new property and claim, for tax purposes, the mortgage payments as an expense against the rents I receive. This sounds too good to be true - is it?

Maggie Fleming writes:

In the situation you have outlined, you should be able to claim all the mortgage interest (not repayment of capital) against rental income. Renting out your property is a business and, if you choose to fund your business by means of a loan, the interest is an allowable business expense.

In your case, your flat will enter the business at its current market value and you can claim tax relief on interest payments on a loan up to that value. However, if the property increases in value in the future and you increase your borrowing correspondingly, the Revenue will not allow interest on the increase.

The rules on mortgage interest relief changed in 1995 but it has been my experience that tax districts have been slow to catch up. Previously, interest was only allowable on a loan taken out to purchase or improve a property - i.e., you could not buy the property for cash and refinance later with a mortgage. There are people in the Revenue who seem to think that this is still the position. Indeed, even the tax return notes are unclear, as they refer only to a loan to buy a property. However, interest relief is now obtainable in a wider range of situations than before and it is always wise to check with a qualified tax practitioner as to whether or not the interest will be allowed.

We own two properties, both as joint tenants, one being a flat valued at about £175,00. Neither property is mortgaged. I am nearly 60 and my wife is some years younger.

We currently have "mirror wills" and my share of both properties will pass to my wife on my death. For tax reasons, most of our other assets are in her name and my estate will therefore be very small. It seems we will not be able to make much use of the IHT nil-band on my death with the consequence of increasing the IHT payable on my wife's estate.

I am wondering whether I should own the flat outright and leave it in my will to my wife? She could then rent it out to supplement her income or, presumably, execute a deed of variation on my own will to transfer ownership of the flat from my estate directly to our children. This would decrease the value of her estate for IHT purposes but, importantly, means my wife can delay a decision about passing on ownership of the flat until she knows her own financial position after my death.

I am not sure whether there are pitfalls with this approach or whether there are better ways to protect my wife's position while still reducing the IHT liability on my wife's estate.

Maggie Fleming writes:

The course of action you propose is perfectly feasible, as the law stands at present. If your wife needs the income, she can retain the flat. If she does not, she can, as you suggest, execute a deed of variation (also known as a deed of family arrangement) within two years of your death.

One problem with this plan is that you can't be sure that this or a future government won't abolish deeds of variation. This was tried by the Conservative government in 1989 and it only backed down at the last minute - I am surprised that there have been no subsequent attempts to change the law.

You could consider other options which may suit your requirements. A flexible discretionary will trust could be a better way of achieving the same result but suffers from the same problem - if a future government attacks deeds of variation, it is likely to attack this kind of post-death planning, too. If you adopt either strategy, you should review your will regularly to make sure that it is still tax effective.

I recommend that you and your wife consult a solicitor to have your wills reviewed. You seem to assume that you will die first but this may not be the case. Ideally, you should each have sufficient assets in your estate to use up your own nil rate band. It may be possible to rearrange your joint assets in a better manner but it is impossible to advise you further without knowing more about your financial circumstances.

My sister (a minor at the time) and I inherited from our maternal grandmother in 1995 a modest ex-council house, which we have let out since. My sister is now looking to buy her first house, while I am living with my parents. Although the value of the house we inherited is still modest, say £75,000, the sale may fall under Capital Gains Tax (CGT) as neither of us own what may be termed a principal residence. I thought becoming a co-owner of my sister's new house might help. Can you advise us?

Maggie Fleming writes:

As neither you nor your sister has ever lived in the property as your only or main residence, you cannot benefit from Principal Private Residence relief on its sale. The fact that you do not own a residence does not affect the tax position; nor would co-owning the property your sister intends to buy help in any way.

However, as you have owned the house since 1995, you will benefit from a number of reliefs. The base cost of the property will be its probate value when you inherited it and you will also be able to deduct indexation allowance of between 8 and 10 per cent of the probate value for the period up to April 1998. You can also deduct the incidental costs of sale, such as legal fees and estate agent's charges. If there was any capital expenditure on the property over the years, this may also be deductible, provided it is still reflected in the state of the property at the time of sale.

Having calculated the gain, you will also be able to claim taper relief based on the number of years you have owned the property since this relief replaced indexation allowance in April 1998. If you sell in the present tax year, this will reduce the gain by 30 per cent. And, of course, you will each be able to use your personal exemption of £8,500 against the gain.

I am assuming that your sister is not married. If, however, she is, she could gift part of her interest in the property to her husband before selling it. In that way, he too could make use of the £8,500 annual exemption also.

Continuing the series in which our Clinic experts provide a guide to those thorny property issues that can leave the unwary out of pocket. This week, Maggie Fleming on the advantages of including your property in your pension:

I have started to hear a lot about SIPPs pensions and some change that allows you to put your house into them. What is it exactly?

The initials stand for Self Invested Personal Pensions and they are simply a more sophisticated type of personal pension into which you can put a wider range of assets. They have always been able to invest in commercial property but from April 6, 2006, assuming the proposals in the Finance Bill are enacted, they will also be able to invest in residential property.

How exactly will it work?

From April 2006, you will be able to contribute up to 100 per cent of your earnings (subject to an annual limit of £215,000) into a SIPP. You will get tax relief of up to 40 per cent on the contribution you make. The entire SIPP fund can be used to purchase a property. In addition, the fund can borrow up to 50 per cent of the value of its assets - so a fund worth £400,000 could borrow an additional £200,000 and buy a property worth £600,000. Once inside the pension, any rental income from the property is tax-free, as are capital gains made on the sale.

This sounds an excellent investment. Any drawbacks?

Yes. Don't forget that there is likely to be a Capital Gains Tax (CGT) bill when you sell an investment property (at market value) to your pension plan. And if you or your family are living in the property, you will have to pay a market rent to your pension fund for it. Other facts to consider are that you won't own the property any more and it may have to be sold to provide you with an income in retirement.

But is it still a worthwhile scheme?

Yes - especially if you are wealthy. You will be able to reduce your estate by making large pension contributions and paying a market rent and will even be able to take advantage of new provisions which mean that, if the individual chooses to opt for pension draw-down rather than to purchase an annuity, any assets remaining in the fund on death can be transferred to other members of the scheme without incurring an Inheritance Tax (IHT) charge. In this way the family home could, in theory, be passed to the next generation tax-free. I say 'in theory' because the Government has just announced that it is reconsidering the IHT consequences of such plans and this feature might not survive.

We are in our late fifties and are planning to leave the United Kingdom permanently to live in the Maldives or Sri Lanka. We bought our main property for £240,000 in 1997. It is estimated that if we sell, it will fetch about £700,000. We have an outstanding mortgage of £140,000.

Our elder son recently graduated as a doctor, and our younger son is at university. Will we be allowed to sell this property to our sons, say for £245,000? Would there be any problems with Inheritance Tax (IHT)?

I have negotiated with my bank, which is prepared to offer a mortgage for £245,000 to both our sons, knowing their potential to earn a decent living.

We both have a combined pension of £40,000 and a lump sum of £100,000 will easily fetch a good house in the Indian Ocean islands. We do not plan to live off our present assets as we wish to pass it on to the boys. We also do not want to buy any more properties in our names. Should we decide to come back to Britain, we hope to rent a retirement flat.

Maggie Fleming writes:

There are two taxes concerned here - Capital Gains Tax (CGT) and IHT. For CGT purposes, it does not matter whether you sell or gift the house to your sons - in either case, the transaction will be deemed to take place for the market value, £700,000.

Provided that it has been your only or main residence throughout your period of ownership (except for the past 36 months, which is always deemed to be exempt), you will have no CGT to pay. Even if there were a CGT liability, you would not have a problem, as you could avoid it by selling the property while abroad, provided you lived outside the UK for five years.

Whatever your sons actually pay for the house, their CGT acquisition cost will also be market value. This will be to their advantage if the property does not become their only or main residence (perhaps because they let it out to provide a rental income) and they have to pay CGT when they eventually come to sell it.

For IHT purposes, the difference between market value and the sale price, £455,000, will be treated as though it were a gift. If you have made no gifts in this or the previous tax year, £6,000 of this amount will be exempt - if the property is owned jointly with your spouse, he or she will enjoy the same exemption.

The balance of the £455,000 will be a Potentially Exempt Transfer - this means that, provided you survive for seven years after the sale, it will fall out of your chargeable estates.