Landlords: Beware The Deferred Capital Gains Tax Pitfall

Alan Pink highlights a tax issue that landlords often forget; and points to some potential ways out of the pitfall.

Capital gains tax (CGT) is arguably in many cases nothing more than a tax on inflation. Landlords tend to get so used to the idea of their property portfolios effortlessly moving upwards that they forget there is likely to be a price to pay in the end. 

It’s easiest to illustrate the problem by way of a hypothetical (or perhaps not so hypothetical) example. 

Ian is an active and clever property investor. Clever enough, anyway, to realise that you can ride on the back of a rising property market by refinancing, and hence lift yourself up by your own bootstraps, so to speak. He started a few years ago with a small legacy from his mother and put down the deposit to buy a small flat above a shop in a depressed high street in the South West of England. 

As this flat increased in value, he saw the opportunity of refinancing it in a larger amount than the initial mortgage he took out, thus freeing up some money to put down as a deposit on a second flat. This second flat was also largely financed by a mortgage, up to the maximum that the lenders would allow at that time. Because the depressed area in which he bought moved up in the world, he experienced significant increases in the amount of his equity, over the amount of the money he had originally put in, and all of this equity increase formed the basis for further loans, and so on. After a few years, he has managed to build up a portfolio with a gross value of no less than £5 million. 

Ian knows how to live, as well. Not all of the money he’s received from taking out new loans on the security of his existing portfolio have been used to buy new properties. He’s also, and understandably, used the money to live on, and the size of his portfolio has enabled him to live quite high. As a result, his £5 million portfolio is now mortgaged to the extent of 75%, i.e. he has loans of £3.75 million, and the other number to take into account is the original cost of his properties, which is the amazingly low figure of £2 million (Note - these figures are based on a real-life example.)

Then a property ‘crash’ comes along. Overnight, almost, the gross value of his portfolio plunges to the point where he is in an almost nil equity position, with the gross value of the portfolio being only about £4 million on a good day, that is nearly equal to the amount of the loan secured. 

That’s all very well until Ian wants to sell the properties. Let’s say, for the purpose of this illustration, that he decides, for whatever reason, to sell the whole portfolio. After paying off the loans, he has peanuts left in the bank account. The problem is, selling the properties at £4 million, when they originally cost him only £2 million, gives rise to the CGT liability which is triggered on disposal, having lain dormant in the asset, so to speak, like some dreaded disease, until that point. 

The tax on the gain of £2 million which he’s treated as making, at the 28% rate, is £560,000. And, of course, Ian has almost no money to pay the tax with. 

That example illustrates the position where an entire portfolio is sold. However, it’s just as likely, or perhaps more likely in practice, that a very similar problem would arise on the sale of a single property or a few properties out of a larger portfolio. If the landlord is already geared up to the hilt with borrowing, there won’t be any spare liquidity left to pay the tax after the property has been sold and the mortgage on that property paid off. 

The moral is: if at all possible, always keep at least enough equity in your property portfolio to pay the CGT charge. On residential properties, under current rules you should, therefore, allow for a 28% bite being taken out of your CGT profit. 

But is there anything that Ian could have done to save himself from this financial disaster? 

Although this certainly comes under the heading of a ‘don’t try this at home’ idea, that is, it should always be done with the benefit of proper tax advice, Ian could have considered incorporating his whole portfolio into a limited company. By using the provisions of ‘incorporation relief’, the transfer of the properties to the company might well avoid some CGT by the gain being ‘rolled over’ into the cost of the shares in the company, these shares having been issued in return for the transfer to the company of the property portfolio. Stamp duty land tax can also be avoided if the position can be brought within the relief for transfers from partnerships to connected companies. 

The ‘trick’ here, if it is one, is that from the company’s point of view it is acquiring the properties at their current market value, even though, from Ian’s point of view as the individual transferor, he has a gain rolled over. The gain is actually rolled over against the cost of his shares for the purpose of any future disposal of those shares, by way of sale or liquidation. The company itself has no rolled over gain, and therefore the portfolio could in principle be sold the next day without triggering any tax charge at all. It’s true that the net proceeds, if there are any, from selling the portfolio are then ‘stuck’ in the company, and can only be taken out at the expense of paying tax. However, as a ‘quick fix’ this could just have saved Ian’s bacon.

Alternatively, Ian could have mitigated the tax by converting properties into furnished holiday letting properties. These have to be let as holiday accommodation on short-term lets of no more than 30 days each for a minimum of 105 days a year, and be available for such letting for twice that time. If what is being sold is a property letting business, which is treated as a trade for CGT purposes, entrepreneurs’ relief could be available, reducing the CGT rate from 28% to 10%. 

The interesting facet of the rules here is that the relief appears to be available even if the property portfolio has only been treated as a ‘trade’ for the last 12 months minimum period of ownership. The fact that the portfolio has been an ordinary buy-to-let portfolio let on six month assured shorthold tenancies before this period doesn’t seem to reduce the availability of entrepreneurs’ relief in any way. 

As always, the key is planning before the event, rather than after the event. Too often as tax advisers, people come to us after they have made a sale and realised a capital gain, and then ask us for ways in which they can reduce or even avoid the tax. It’s very much easier, if it is possible, to do this if you have the ability to prepare for the sale, as the two mitigating ideas above illustrate very clearly.