CAPITAL GAINS TAX PLANNING
Synopsis: The publicity surrounding the subject of MPs “flipping” properties may well have brought the CGT second residence rules under closer scrutiny. Here, we consider how those rules work.
There has been considerable publicity over MPs “flipping” their choice of private residence for expenses purposes. As a result it would seem more likely that the capital gains tax (CGT) rules on nominating a private residence will be tightened up. This would be somewhat bizarre given that it would be the Government – in the shape of MPs – who would introduce this legislation to block a loophole that they had been abusing!
As advisers may well be receiving more questions about private residences and the CGT relief, we thought it might be helpful to give you an update on the rules in a simple question and answer guide.
How MPs have used the rules
MPs are allowed to claim expenses for their second home. It is the claiming of those expenses to refurbish and improve a property that has created all the uproar.
What MPs have then been doing is selecting that second refurbished home as their main residence – the so called “flipping”. This means that, on a later sale, a good part of the capital gain then arising will be covered by principal private residence relief. In particular, provided a property has at some time been a private residence, the last 3 years of ownership will always count as “residence” for the purposes of the relief – see below.
What is the principal private residence relief?
The principal private residence relief means that no CGT is payable on any gains arising when a person sells their residence. However, for those who have more than one property, they are able to switch from one property to another. But to switch to another property, you must actually occupy that property as a residence. In cases where a person lives in two properties (ie. in a flat during the week) and in the country (at weekends) he can designate either one as his private residence.
Do you get relief for your whole period of residence or ownership?
In general, relief applies to the period during which you have occupied the property as a residence. But in order to help people who have difficulty in selling a house when they move, the tax rules state that the last 3 years of ownership count as a period of residence even though the owner may not have been living there then.
Jock bought his home in Surrey in January 1998. In January 2004 he buys a house in Scunthorpe and goes and lives there leaving the Surrey property empty. He struggles to sell the Surrey property but eventually does so in January 2010. He sells at a profit of £100,000.
Jock has owned the Surrey property for 12 years, nine of which count for principal private residence relief. This means that 75% (ie. 9/12ths) of the gain is exempt from CGT. After deducting his annual exemption, the residual taxable capital gain is £14,900 (£25,000 – £10,100) on which CGT at 18% produces a tax bill of £2,682.
How can you use the three-year relief with second properties?
The availability of the three-year ownership relief can be particularly useful for those people who have two private residences. It provides a way in which a person can get a substantial amount of relief with only a relatively short period of residence.
Consider an example.
Sam owns a London property which he has elected as his main residence but also has a country cottage he has owned for three years and which has gone up in value from £400,000 to £450,000 in that time. Without planning Sam could find himself facing a CGT bill of up to £9,000 (ie. 18% of the £50,000 gain).
However, if he altered the election in favour of the cottage even for, say, 6 months and then flipped back to his London property, for that 6 month period the cottage will be regarded as his main home and will therefore qualify for the three-year relief. This means that instead of having a CGT liability on £50,000, three fifths of that, or £30,000, will drop out of account. This leaves Sam with a chargeable capital gain of £20,000.
Sam´s annual CGT exemption, currently £10,100 (double that if he is married or in a civil partnership and the property was in joint names) should be available to reduce the taxable gain. If this was available in full the taxable capital gain would be reduced to £9,900.
At present the rules state that when Sam sells the London home, he loses the CGT relief on it, but only for the period he flipped it – in this case, 6 months. However, the gain reflecting this period of ownership should be covered by his annual CGT exemption for the year in which he sells.
Do you have to spend the most time in the property chosen as your residence?
No – you can elect either of two residence provided you actually do use both as a residence. As proof you have to show utility, bank or electoral details.
Is there any time period for the election when you own two properties?
It is generally stated that you must elect your main residence within two years of acquiring the second property. In fact that is not the case – you must elect within two years of using the second property as a residence. This means that if you buy a property, let it out for 3 years and then start occupying as a residence you have two years from that commenced date of occupation to make the election. In general, if you do not elect within 2 years of acquiring a second property, HM Revenue and Customs will make this decision for you based on the facts.
The acquisition of a third property would reopen the 2 year window to make an election.
Does it matter that a property has previously been let?
No – see above. But you must at some stage occupy it for a reasonable period as a residence.
Can husband and wife elect for different properties?
No, a husband and wife must have the same residence. However, an unmarried couple can each elect for their own private residence.
Can you switch between properties?
Provided you make the first election within 2 years of occupying the second property as a residence you can switch (flip) between different properties as much as you like, provided you do in fact then occupy the new elected property as a residence.
Given the adverse publicity associated with MPs expenses and flipping, the three-year rule (and possibly the second property election) may be modified or amended. These are the provisions which give rise to most scope for abuse – particularly, it seems, if you are an MP!