With stock markets showing little sign of recovery, more people are looking at investing in property. However, it is no easy option and there are numerous tax issues to overcome which need to be explained to those clients seeking property expressly to make money.
For private investors, as well as ordinary pensioners, the past few years have been disastrous. Traditional investments in equities and bonds have both suffered. Major equity markets have fallen by at least 30% from the highs of early 2000. While this was partly caused by a natural slowdown in global economies, it has undoubtedly also been exacerbated by terrorist attacks, the threat of war and various accounting scandals that have rocked investors’ confidence. Other investment avenues, such as bond markets, have performed much better, but corporate bonds have looked increasingly harried as companies ratings have been slashed by leading providers of fund intelligence and financial research, such as Standard & Poor’s and Lipper.
For better or worse
And yet investors still cannot be certain the worst is over. Markets have been readying themselves for a revival for the past year at least. But despite the optimism of fund managers and politicians, what at first appeared to be an upturn have turned out to be bear traps, allowing the market to test new lows.
The contrast with the performance of the property market is stark and has immediately offered excellent marketing opportunities for the mortgage industry.
The tangible qualities of bricks and mortar have again proved reassuring in troubled times. And while parts of the media have been predicting a property crash for some months, it has not yet happened and a repetition of the negative equity seen in the early 1990s looks unlikely. The cost of mortgages in real terms is still cheaper than it has been for years, due to sustained low interest rates, and house-price growth has outstripped all expectations.
Nevertheless, in terms of a viable alternative to traditional investments capital returns on property investment are not the only factor affecting overall returns. Any astute investor will want to know how much an investment will cost them in tax before committing. Therefore tax, and the various means of avoiding it, is an important marketing tool for any adviser.
Unfortunately, there are no clear-cut answers to questions of how to reduce tax liability on any investment, property or otherwise. Tax liabilities will depend on the status of the individual in terms of whether they are married, their domicile status, other investments and income, their occupation, net worth and, importantly, the investment method.
Dividing the wealth
Tax can be divided into three liabilities: Income Tax, Capital Gains Tax (CGT) and Inheritance Tax (IHT). Income from any investment in property ‘ be it rental income or income from a property fund ‘ is added to other income streams and will be taxed at the higher rate for all income over £30,000.
IHT, while generally regarded as a wholly inefficient tax that possibly costs as much to collect as the Treasury receives, usually hits property investments hardest. While homes are exempt from CGT under the principal private residence rule, and income is not applicable, all investments worth over £250,000 will be subject to IHT.
CGT is liable on the gains made from the sale of an investment for any UK domicile, resident in the UK. All UK citizens are termed UK-domiciled, regardless of where they live in the world.
Domicile status can only be lost by adopting another country as your main residence and by convincing the UK tax authorities your centre of interest is now no longer the UK. This is no easy matter and would be virtually impossible to achieve while maintaining a property investment in the UK.
Foreign investors, however, avoid all CGT liability on investments in UK property and expatriates can enjoy the same benefits if they realise the gains while they are overseas and remain there for at least five years.
However, the ‘principal private residence’ rule is quite clear and there is little chance here for investors to exploit tax loopholes.
Simon Farrant, a financial adviser at advisory group Tow- ry Law, says: ‘If you convert a large house into flats and live in one of them, the others will not qualify for principal private residence relief. Also, it depends on how long you live in the property ‘ if it is only for six months of the year, then only half will get relief, and half will not.’
The situation is the same if land is sold off or used to build another house that is then rented out.
‘Permanent UK residents need to be careful,’ says Farrant. ‘The Inland Revenue can ask you questions about selling on some land from the bottom of the property. If you sell some land for another house, you should not assume it will qualify for principal private residence relief. It depends on your necessary use and enjoyment, or if you argue you are short of money. If you build and keep the house and rent it out, the rental will be subject to Income Tax and the property to CGT from the moment you started building it.’
For the average investor, however, who will want to realise their gains at some point, CGT and Income Tax are the initial concerns and investors who purchase property through the buy-to-let market will face both.
‘The biggest problem will be CGT,’ says Ray Boulger, senior technical manager at Charcol. This is because only the first £7,700 will be tax-free. Married couples can of course group their tax-free allowance together to jointly claim £15,400, and can freely gift the property to each other to maximise the benefit that selling the property will bring when each individual’s other capital gains are added.
Property is subject to ‘taper relief’ as well, which allows a reduction of the taxable charge the longer an asset is held. For property this is especially useful as it is a non-volatile asset class that can be safely held on to. Taper relief kicks in at three years when there is a 5% reduction, increasing to 40% after 10 or more years.
Keeping up appearances
For the ordinary investor, both CGT and Income Tax can be offset against costs of upkeep and improvements. Income Tax liability can be offset against the costs of upkeep, while home improvement costs can be offset against CGT when the property is sold.
Farrant says: ‘The issue is that if you sell a property, you could offset important expenses. Building a conservatory is an improvement and the cost of building it could be offset against any potential CGT liability when the building is sold.’
However, the lines between what constitutes maintenance costs and improvements can become blurred. For example, if double glazing windows are installed, can these be offset against CGT? The answer is they probably can, as they improve both the energy efficiency and sound insulation of the asset.
To simplify the process of accounting for maintenance costs, landlords can opt for a one-off allowance, says Boulger: ‘For furnished property you have an allowance of 10% of the rent. If your income is £10,000, you get £1,000 allowance, rather than adding up the costs of individual maintenance bills.’
Beyond utilising the normal relief measures commonly applicable, any investment can be protected with structures and the best one by far in terms of tax benefits and flexibility is a pension.
‘You can hold one or more pieces of property in a pension and it’s a good pension asset for younger people who have time to manage the liquidity of the fund,’ says Farrant. ‘Property also scores well over equity as you get full tax freedom on the income, which makes it better than equity income.’
Phillip Wood, senior manager, pensions funds planning at PricewaterhouseCoopers, agrees property is a good pension fund asset and says he is seeing increasing amounts of private clients opt for this asset class.
‘If you hold it in a pension fund it will not be subject to CGT and for those at the 40% threshold, this will make one hell of a difference,’ he says.
The only ‘buts’ ‘ and they are important ‘ are that the property held in the fund must be a commercial property and it cannot be bought from someone known by the investor.
It can still be subject to rental income. Rental income from the property will normally be paid into a bank account and interest received on it is free of tax because it is owned by the pension fund.
Wood says most of his clients who put property assets in a pension fund have a fund worth about £500,000, as below this amount it is difficult to achieve a suitably diversified portfolio ‘ unless, of course, the investment is in a property fund, which itself spreads the risk.
But once property has been sheltered in either a self-invested pension scheme or a self-administered pension, there are no limits on the management of the portfolio. Property can be bought or sold every six months if desired, although Wood says while commercial property has risen in price recently, but not on the same massive scale as residential property, most of the return will be in income. A pension fund is not for everyone, but then neither is domicile status. However, a growing number of clients will become interested in property investment in some shape or form as equities continue to falter.
Will Foggon is a freelance journalist
The tax liability will vary significantly according to the client’s status and type of investment.
Principal private residence relief is not applicable in a block of flats you are renting out.
Income tax and CGT can be offset against maintenance and home improvements