Property Rich - Tax Poor!

Mark McLaughlin warns property investors not to forget about potential tax liabilities when expanding their property ‘empire’. 

A large number of investors have expanded their property portfolios using a simple investment strategy. This strategy broadly involves withdrawing equity from an existing property to fund the next purchase. 

Though many landlords have successfully used this strategy to grow portfolios and increase the number of ‘property millionaires’, it can have unfortunate capital gains tax (CGT) implications in some cases.

It might be argued that previous slumps in property prices make the potential CGT problem outlined below seem unlikely. However, even if that is true, the next property boom may be just around the corner and forewarned is forearmed.   

 

 

It is worth noting that there is no CGT when the first property is remortgaged. Any CGT liability only arises when the property is sold or transferred. This effectively allows Robert to extract a large sum of money in respect of his first investment property, without paying a single penny in tax. Even if Robert had not used the equity release proceeds for his property investment business (e.g. if he instead used it to fund university fees for his children), there would still be no CGT liability at that point. However, this is a risky strategy.

Following on from Example 1, suppose that Robert continues to grow his property portfolio:

 

 

Now the bad news…

In the above examples, Robert has grown his property portfolio and in a relatively short space of time has become a property millionaire, at least on paper. 

However, what is the CGT position?

 

 

In Example 3, Robert only has equity of £20,000 in the property, due to the mortgage of £180,000. He would therefore be required to find an extra £17,800 just to pay HMRC. He has made no actual net profit, and would either need to dip into his savings (if he has any) to pay the CGT bill on the sale of the property, or incur additional debt paying HMRC. 

Could he sell his second property to pay the CGT on the first?

 

What can be done?

On the face of it, Robert is caught in an ‘equity trap’. However, all is not necessarily lost.

For example, Robert has some equity in the apartments, resulting from the release of equity in the first two properties. The apartments are not standing at a gain, so if Robert needs to sell any properties, he should first consider selling one or more of the flats.   

Alternatively, Robert may decide to keep all of the properties, and not purchase any additional ones. He could continue holding his existing properties in the hope that they increase in value, or if purchased with repayment mortgages, until enough of the loans have been repaid. Hopefully, the sale proceeds might cover any tax liabilities quite comfortably. However, this may take a few (or more) years. 

Change to a company?

It is not difficult to envisage much larger property portfolios than in Robert’s case, with considerable inherent gains and substantial tax liabilities on disposal. If Robert’s CGT problem was greater (i.e. due to a larger property portfolio) consideration might be given to relieving it in some way. 

For example, if Robert’s rental activities were considered to be a ‘business’, he could consider transferring the property business as a going concern to a company in exchange for shares, and claiming incorporation relief for CGT purposes, if certain conditions are satisfied (in TCGA 1992, s 162). The effect of the relief is broadly to ‘roll over’ chargeable gains against the base cost of the shares acquired. The company acquires the properties at market value for tax purposes. This means that the company could sell the properties with little or no tax liability. 

However, there are several problems with this strategy. These include: 

• whilst rental properties have been held to constitute a ‘business’ for incorporation relief purposes (Ramsay v HMRC [2013] UKUT 226 (TCC)), HMRC could argue that Ramsay was decided in the taxpayer’s favour based on the particular facts and circumstances of that case, and challenge the claim for incorporation relief on Robert’s business. He may therefore wish to consider asking HMRC for clearance on this point before doing anything;
• even if HMRC accepts that incorporation relief is due, if liabilities are relatively high (and are being transferred), the net asset value of the business (which equals the value of the shares issued) may be low. Where properties have large inherent capital gains, it may be impossible to roll over all of those gains – the base cost of the shares cannot go below zero! Do the sums first; and 
• where properties are transferred to a company and the parties are connected, stamp duty land tax (SDLT) is normally charged based on market value (FA 2003, s 53). Where several properties are transferred in a single transaction (or a series of linked transactions), the company’s SDLT liability can be considerable (FA 2003, s 55(4)). 

Robert should seek expert professional advice on incorporation relief, and/or to establish whether any alternative planning strategies may be suitable in the circumstances.   

Practical Tip :

The above examples have been ‘manufactured’ to illustrate a simple tip for property investors; ensure that enough equity remains after refinancing to pay the tax liabilities on any inherent profits on your property portfolio – unless you have deep pockets!