December 7th, 2016
Which rate of tax applies to a capital gain on residential property?
While every attempt will be made to ensure that information provided is accurate at the time of publication, it should be treated as guidance only and does not constitute legal or professional advice. Tax law and guidance changes frequently and readers are advised to consult the current relevant product for the most up-to-date information on this topic.
This article was originally produced for Taxation on the 7 December 2016.
Author: Mark Wallace
- Different rates of tax now apply to upper rate, special rate and other gains.
- The importance of understanding the definition of a 'residential property' gain.
- The Valuation Office guidance on residential properties and dwellings.
- TCGA 1992, Sch B1 has no 'permitted area' test.
- Allocating rates and exemptions in a worked example.
Finance Act 2016, s 83 introduces the changes to the rates of capital gains tax from 6 April 2016. Capital gains are now allocated into three categories. These are as follows.
1. 'Upper rate gains'. These arise from:
- residential property;
- non-resident's residential property, and
- carried interest.
These gains are taxed at 28%, subject to any unused element of the basic rate band, in which case the gain that would fall into the basic rate band is taxed at 18%.
- 'Special rate gains'. These are 'entrepreneurs' relief' or 'investors' relief' gains, taxed at 10%.
- All other gains. These are taxed at 10% or 20%, depending on the individual's level of income.
Let us put these rates into practice in an example.
Imagine a client, Andrew, telephoning about the disposal of a property that he had inherited in March 1990. This consisted of a house, an orchard, a garden backing on to the house, and a 20 acre field. He explains that, when he inherited the property, it had a tenant and that the previous owner had allowed the house to fall into disrepair. After the tenant moved out, the house became 'derelict' after a fire in 1996. It was not until a builder approached him that he decided to sell the property, rather than spend funds to renovate it to make it habitable again. At no point had he lived in the property. He is considering selling it, although contracts may not be exchanged until March 2017.
If the disposal had taken place before 5 April 2016, the capital gains computation would have been relativity simple: the gain arising would have been the difference between the net sale proceeds after the costs of sale and the probate valuation. As Michael Blake explained in 'Peculiar entities' (Taxation, 3 November 2016, page 12) the computation is now somewhat complicated.
So which rate applies as far as Andrew is concerned?
Finance Act 2016 introduces Sch 4ZZC into TCGA 1992 which defines a 'residential property' gain.
The starting point is to consider whether the asset being disposed of consisted of 'a residential property interest' (RPI) at any point during its ownership. If it had never been an RPI, the capital gains rate will be the lower rate of 10% and 20% depending on the taxpayer's level of income. A UK RPI is defined in TCGA 1992, Sch BA1, while Sch B1 defines a non-UK RPI.
An RPI is:
- 'land that has at any time in the relevant ownership period consisted of or included a dwelling'; or
- an 'interest in land which subsists for the benefit of land that has at any time in the relevant ownership period consisted of or included a dwelling.'
Schedule B1 para 4 explains that 'a building counts as a dwelling at any time when:
(a) it is used or suitable for use as a dwelling; or
(b) it is in the process of being constructed or adapted for such use.'
There is no definition of the word 'dwelling' or 'suitable for use as a dwelling', but the section sets out several exceptions. These include residential accommodation for children, the army, prisons, hotels, inns and similar establishments.
Schedule B1, para 4(10) says: 'A building which (for any reason) becomes temporarily unsuitable for use as a dwelling is treated for the purposes of sub-paragraph (1) as continuing to be suitable for use as a dwelling.'
There is, however, an exception. If there is temporary damage to the dwelling the property will not be regarded as an RPI if the damage was for at least 90 days and it was either:
- accidental; or
- otherwise caused by events beyond the control of the person disposing of the interest in UK land.
In Andrew's case, the house had been damaged, but has it fallen into such disrepair that it was not suitable for use as a dwelling? Was the damage permanent? The stamp duty land tax (SDLT) legislation dealing with disadvantaged area relief used similar phrases as the capital gains tax legislation. HMRC issued Statement of Practice 1/2004 to explain the department's view for SDLT purposes. It stated: 'If a building is not in use at the effective date, but its last use was as a dwelling, it would be taken to be "suitable for use as a dwelling" and treated as residential property, unless evidence was produced to the contrary.'
In a different context, the Valuation Office has issued guidance as to when it may remove residential properties from the council tax register. It differentiates between properties that have fallen into disrepair and can be repaired, and those that cannot be repaired. Its guidance states:
'A property can deteriorate so badly over a long period that it is no longer capable of being repaired without very significant reconstruction … In these circumstances, the VOA may delete the band so that the taxpayer will not pay any council tax. The rule of thumb test will be "is the property wind and watertight?" Where the intrusion of the weather, rot or severe vandalism means that only substantial structural work would make the property habitable, the band can be deleted. The property would not be habitable and the "dwelling" will have ceased to exist.'
It is therefore likely to be difficult for a taxpayer to argue that a property was 'unsuitable for use as dwelling' unless there were exceptional circumstances, and the bar is set very high.
Orchard and garden
Schedule B1 para 4(2) notes: 'Land that at any time is, or is intended to be, occupied or enjoyed with a dwelling as a garden or grounds (including any building or structure on such land) is taken to be part of that dwelling at that time.'
This wording is the same as that used in TCGA 1992, s 222(2), although there is no 'permitted area' test as there is with the only or main residence relief definition. It will be important for taxpayers to keep records to demonstrate the use of any land attached to any residential interest so that the tax liability can be calculated correctly. In Andrew's case, it is likely that the gain in relation to the garden and ground would be taxed at the higher 'upper' capital gains rates.
Change of use and mixed use
If there is a change of use, the gain is pro-rated on a time basis. Let's assume that Bert buys some land for £50,000. He holds this for three years before he begins to construct a house. The building costs amount to £100,000. He sells the house seven years after the initial construction date for £200,000. Three-tenths of the gain, £15,000, would be taxed at the 'normal' lower capital gains tax rates, while the balance of £35,000 would be taxed at the higher 'upper gain' rates.
It should be noted that if the asset was held on 31 March 1982 it is only the use since that date that is relevant. Further, if there is a spousal transfer the period of ownership is not transferred; the calculation is based on the history of the property during the recipient spouse's ownership.
If the capital gain relates to a property that is partly residential and partly non-residential, the capital gain is to be apportioned on a 'just and reasonable' basis. In Andrew's case, it would be prudent to apportion the probate value between the two-acre field and the rest of the property, and to do the same with the sales proceeds.
Annual exemption and ordering
The annual exemption can be allocated to the advantage of the taxpayer and it will usually be preferable to allocate the annual allowance to the RPI gains first to minimise the tax payable.
Any entrepreneurs' relief or investors' relief gains are allocated against any unused basic rate tax band first.
The legislation also contains detailed provisions indicating that the taxpayer can then choose whether the RPI or other gains are taxed next, but this is a rather odd provision given that the order will make no difference to the overall tax liability.
Based on the above, it is likely that Andrew would pay capital gains tax at the 'upper rates' on the element of the gain relating to the house and the land, but only for the period that the house could be used as a residence. He would pay capital gains tax at 'normal rates' on the gain in relation to the 20 acre field. As the example of Colin shows, the calculation of capital gains tax payable has now become more complex when there is a 'dwelling' involved. It will be important to keep detailed records to apportion costs and values, and when there has been a change in the use of properties.