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 November 2004. Older articles are accessed through our main Property Tax page.

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Six years ago, my wife and I purchased my father-in-law's house for a reduced price. As a result of his acrimonious divorce he had a shortfall in the divorce settlement and to enable him to remain resident in the marital home, we decided to buy the house in order that he had sufficient capital to pay the settlement in full. We bought the house for £35,000, though at the time it was valued at £80,000, the difference between the figures being a gift without reservations.

At present the current market value of the house is £225,000. I intend to allow my father-in-law to remain in it until death. He makes a nominal contribution towards the mortgage. When he dies, are we liable for Capital Gains Tax (CGT), or can the house still be regarded as part of his estate?

Maggie Fleming writes:

CGT is chargeable when someone sells an asset they own. As you and your wife own the house, you will therefore be liable to CGT when you sell it.

The gain will be based on the difference between the price you get for it and its value at the time you bought it; £80,000. This figure will be used instead of the £35,000 you paid, because, in a sale between close relatives, the market value must be substituted for the price actually paid.

There are a number of reliefs and exemptions available. One of the most important is taper relief, which rewards long-term ownership of assets by reducing your chargeable gain for each year you own the property. After 10 years' ownership, only 60 per cent of the gain is chargeable. There may also be a small amount of indexation allowance if you acquired the property before April 1998.

Of more importance is the personal exemption. This increases each year, usually in line with inflation, and is currently £8,200 per person. As you and your wife are joint owners of the property, you each have your own personal exemption. Also, if neither of you fully uses your basic rate band in the year of sale, you will minimize any higher rate tax payable on the sale.

I am a 55-year-old married woman with two grown-up children. My husband and I own our house jointly.

I have two other houses, in my own name, which are let out to tenants in the Greater London area: house one bought in 1994 for £87,000, today's value about £200,000; house two bought in 1997 for £80,000, today's value about £180,000. I am planning my retirement and wish to reduce inheritance tax (IHT) liability. I have two queries:

1) Is it possible to gift those two houses to my children and continue to receive rental income as my pension?

2) If not, I should like to sell the houses and invest the cash in a portfolio which will produce a pension. How should I sell the two houses without incurring a huge Capital Gains Tax (CGT) bill?

My husband and I intend to downsize when we reach 60. Would it help if we chose to live in one of the rented houses for a time before selling it?

Maggie Fleming writes:

The short answer to the first part of your question is that it is not possible to give the properties away but continue to receive rent from them. The Inland Revenue would regard that as a gift with reservation of benefit and it would be ineffective for IHT purposes.

There are several steps you can take to minimise CGT on the sale of the two properties. First, it is likely to be beneficial for you to gift a half-share in each property to your husband prior to sale. Secondly, you should not sell both properties in the same tax year – if you sell them either side of April 6, you and your husband will be able to make use of four annual exemptions (currently £8,200 per person) rather than two and it is likely that less of the gain will fall into the higher rate tax band.

You do not mention if you have a salary or self-employed earnings. If you do, you will be able to invest 30 per cent of your earnings in a pension scheme in the current tax year. If you are not earning, you can only pay a maximum of £2,808 net (£3,600 gross) to a pension scheme. Unless you are a high earner, therefore, exchanging the properties for a portfolio of investments is not going to be of much help in reducing your estate for IHT purposes – apart from the obvious fact that your husband will own half the portfolio. I suggest that you contact an independent financial adviser who may be able to suggest alternative strategies.

Continuing our 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 Capital Gains Tax:

We have been in our present place for five years and seen its value more than double. How will Capital Gains Tax (CGT)affect us when we come to sell?

Basically, CGT is a tax on the increase in value of an asset between purchase and disposal. Surprisingly, it has been around only since 1965. Before that, gains made on the sale of capital assets normally escaped tax.

Does that mean we will lose most or even all of our profits?

No, far from it. There are a wealth of reliefs to CGT. One of the most important is Principal Private Residence Relief, which exempts the gain on the disposal of a person's home.

This relief is extended to cover gains of up to £40,000 where a person has at some stage rented out their home. There is also an annual exemption, currently £8,200 per person, and any gains above this figure are taxed at the individual's marginal rate.

Is any allowance made for the effects of inflation? After all, it is not just houses that have risen in price...

Yes. Until 1998, indexation allowance, based on the Retail Prices Index, stripped out the inflationary element of the gain – now that inflation is under control, this has been replaced by Taper Relief which, instead, rewards long-term investment by reducing the gain the longer you have owned the asset.

Are there any other ways to reduce the amount that ends up with the taxman?

For married people, a sensible approach is to own assets jointly. On sale, each is taxed on half the gain and so the couple can make use of two personal allowances and possibly lower tax rates. A married couple can transfer assets between themselves freely and so a higher- rate taxpayer who transfers shares to his spouse prior to sale is likely to save a considerable amount of CGT.

What if I "gifted" property to my children? Does that fall outside CGT?

No, CGT (as well as Inheritance Tax) applies to gifts or sales at undervalue, too. Where the disposal is between "connected persons" – basically close family members – market value is always used in assessing the transaction.

My wife and I jointly own a property originally inherited by my wife and her sister, but I have now bought out her sister with the help of a buy-to-let mortgage.

The property is let at a commercial rent, the income from which we each share.

In order to protect our two nil-rate inheritance tax (IHT) bands we should like to transfer 25 per cent ownership of the property to each of our two sons.

While this should not present a problem, my wife and I would like to continue to let the property and retain the income from it, as we do at present; that is, our sons would not receive any income from the rent.

While we appreciate that taking this action could raise a number of other issues, would it meet our objective, or could this be classed as a gift with "reservation of benefit" and not accepted by the Inland Revenue?

Would any capital gain on the transferred portion, accrued by my wife and me, attract gifts holdover relief?

Maggie Fleming writes:

The arrangement you propose is very clearly a gift with reservation of benefit and therefore it would be ineffective for IHT purposes.

You would clearly be deriving a benefit (rent) from the property you are ostensibly gifting. Therefore, the property would remain yours for IHT purposes until you renounced the rent. If you wish to reduce your estates, you should either gift property which does not produce an income or, if that is not possible, you will have to sacrifice your right to the rent.

Capital Gains Tax (CGT) gifts holdover relief applies only where a person makes a gift to a discretionary trust – it does not apply to gifts to individuals or to any other type of trust. The purpose of the relief is to avoid a double charge to IHT and CGT – gifts to discretionary trusts are immediately chargeable to IHT (even if within the nil rate band) and therefore relief applies.

As gifts to individuals and trusts other than discretionary trusts are PETs (Potentially Exempt Transfers), and do not attract an IHT charge (provided the donor lives for seven years after making the gift), there is no relief from CGT. Any gift to your children would be chargeable to CGT based on the growth in value since you and your wife acquired your respective shares in the property.