Updated on: Aug 13, 2023
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We have several clients who have their own buy-to-let property. The property is either owned by them personally, shared ownership with their spouse, or is owned by their limited company. In this article “Reduce your capital gains tax when selling a rental property”, I wanted to take a look at the impact of capital gains tax when the property is sold along with some mitigation measures that will help reduce the amount of capital gains tax that is due.
What is capital gains tax?
Firstly, let’s cover off what capital gains tax is. Capital Gains Tax is a tax on the “profit” you make when you sell your rental property. It’s this profit you make that’s taxed, not the amount of money you receive. The tax rate you pay depends on your income and the size of your gain, and you may also be entitled to a tax-free allowance that reduces your capital gains tax due.
Note; you only need to pay capital gains tax when you have made a profit from selling a personally owned property. If your rental property is owned by your limited company, then no capital gains tax applies. In this case for any gain from the sale of the property, your company will pay corporation tax at a rate of 19% (please see our corporation tax article here because the tax rate could be between 19 and 25%).
Once you sell your rental property you have 60 days to report and pay for any capital gains tax due to the HMRC.
How is capital gains tax calculated?
This is a two-part calculation. In the first part you need to calculate the capital gain itself and this is where having good financial records comes in extremely handy. Broadly speaking the calculation is the sale price of the rental property less the purchase price of the property. However, there may be numerous other elements to this calculation because costs directly incurred through the purchase or sale process need to be factored in along with any capital improvements that have been made to the property.
The purchase cost of the property includes not just the property itself but also associated costs such as stamp duty, estate agents fees, and solicitors fees. When you factor these in the “purchase cost“ of the property, then for the purposes of calculating the capital gain it boosts the overall purchase cost which in turn helps reduce your capital gains tax.
Likewise, the costs associated with selling the property are deducted from the actual sale price for the purposes of the capital gains tax calculation. Again, this will include things such as the estate agent fees, and solicitors fees.
Finally, the cost of any improvements or enhancements that have been made to the property are deducted from the capital gain calculation. These are direct costs that you incurred in improving the property, but things such as maintenance costs and mortgage costs are excluded. For example, replacing parts of your roof after storm damage would not be included here because the cost was for replacing something that already existed. If, however, you completed a loft conversion then all the costs related to this work can be included.
So finally, you are left with the calculation of:
Capital gain = Sale price – purchase cost – improvement costs
The second part of the calculation is the actual capital gains tax itself. There are two rates of capital gains tax in the UK when it comes to the sale of residential property. If you are a basic rate taxpayer it’s 18%, and if you are a higher rate taxpayer it’s 28%.
Reduce your Capital Gains tax when selling your rental property
If you are reading this article and are considering selling your buy-to-let property in the next few months then there is not much else you can do to avoid capital gains tax. Have a read of the points below but you will see that the best way of reducing your capital gains tax is with some forward planning. If you have a rental property at the moment and are not looking to sell, or you are thinking about buying one shortly then pay particular attention to the points below, because with a little bit of planning you can save thousands in tax.
Principal Private Residence Relief
We see this a lot on the Internet as a good way of saving capital gains tax on the sale of your rental property because capital gains tax is not applicable when you actually live in the property yourself (due to Private Residence Relief). However, let’s work off the assumption that you already have your own property and that you do not plan to live in your rental property (which then would not really make it a rental property would it?). We feel that this makes any discussion around whether you can claim private residence relief not all that useful.
Transfer to a Spouse
In a lot of cases married couples who have a rental property will already share the ownership of it. However, where this is not the case there are significant tax advantages in splitting the ownership of the property with your spouse. In particular the advantages are significant where your spouse (a) is in a lower income bracket than you, and (b) is not using their capital gains allowance for anything else.
Let’s do a really quick example. Nico has had his own rental property since his late teens and is now looking to sell it. He estimates that he faces a capital gain of £200,000. Nico is a higher rate taxpayer, and is married to Billie who is a stay at home mum with no taxable income.
After selling the property Nico will face a capital gains tax bill of £54,320 which includes using his full £6,000 capital gains tax allowance and paying capital gains tax at the higher rate tax band of 28%.
An alternative to this is for Nico to investigate gifting half of the residential property to his spouse. Gifts between spouses trigger no capital gains tax and there are no inheritance tax issues either. Now lets revisit their capital gains tax bill.
Nico will pay tax of £26,320 which includes using his full £6,000 capital allowance and paying capital gains at a tax rate of 28%.
Billie faces a capital gains tax liability of £22,550 which includes using her full £6,000 capital allowance, and paying capital gains of both 18% (using up her basic rate limit) and 28%.
Combined, the overall capital gains tax due is 26,320 + 22,550 = 48,870, giving them an overall tax saving of £5,450 through the simple process of splitting ownership of the rental property. In terms of cost and time, this represents a very good return on investment.
Use a Limited Company
For a lot of our clients who use their own limited company for contracting, they’re already familiar with how a limited company works and its reporting requirements. Some of our clients own rental properties through their contracting company and others will set up a new company specifically to own and run their rental property portfolio.
The main point here is that owning a rental property through a limited company excludes you from any capital gains tax. As we mentioned above, capital gains tax applies to property that is owned by you personally and does not apply to companies. If a company were to sell a rental property at a profit it would just get taxed at the usual corporation tax rates. Plus, there is no requirement to report and pay any capital gains tax within 60 days of the sale.
Turn it into a Furnished Holiday Let (FHL)
This option may not suit everyone, but we see it as a particularly nice and efficient way of significantly reducing any capital gains tax due on the sale of a rental property. What this method does is it changes the capital gains tax rates from the usual rates of 18% and 28%, to a different type of rate that relates to Business Asset Disposal Relief (BADR), where the tax rate is just 10%.
To use this preferential rate of 10%, the rental property must become a Furnished Holiday Let (FHL). There are a few conditions here.
(1) It must be a furnished holiday let for at least two years.
(2) The property must be available to be let out for at least 210 days per year.
(3) If the property is let to the same person for more than 31 days, the total length of these “longer lettings” must not exceed 155 days.
(4) The property must be rented out to the public for at least 105 days in the year (any “longer lettings” mentioned above are excluded from this).
For example, you might investigate listing your property with Airbnb for the last two years of ownership which will help you achieve these conditions.
Another indirect benefit you’ll notice immediately is that the full amount of mortgage interest payments on the property can be deducted from profits. For your normal buy-to-let property this relief has been tapered out and is now restricted to the basic rate of income tax (20%).
Now when the property is sold after two years of being a furnished holiday let, any capital gains tax due is calculated at a rate of 10%.
So let’s take another look at the example above where Nico sells his rental property. In this case however in the final two years of ownership let’s say he ran it as a furnished holiday let. This particularly useful tax planning work that was undertaken by Nico has meant that the capital gain over the entire period of ownership of the property is now taxed at 10% even though it was only run as a FHL for the final two years of ownership.
After selling the property, Nico faces a personal tax bill of £19,400 which includes using his full £6,000 capital allowance and paying capital gains at a tax rate of 10%.
This represents a huge tax reduction of £34,920, a 64% saving in his capital gains tax bill. Admittedly there is a little more work to do in running a furnished holiday let, and Nico will need to ensure he is meeting the furnished holiday let requirements, but for a tax saving of nearly £35,000 it’s hard to argue that it’s not a good idea.
Because the capital gains tax rate of 10% is already so low, there is only a minor reduction in the total capital gains tax due if the ownership of the property was split with his wife Billie as per the example above. Having the property jointly owned would reduce the overall capital gains tax bill by a further £600.
Here we have covered off the main considerations for a rental property landlord when it comes time to sell the property and address the issue of capital gains tax.
What we have found is that a lot of people have a lot of different extenuating circumstances which means one size does not fit all and there are a lot of pro’s and con’s to consider when it comes to property ownership and disposal.
At the moment, particularly where the property has been held for a long time, we really like the fact that turning it into a furnished holiday let for the final two years of ownership can significantly reduce the capital gains tax rate that is applied across the entire period the property was owned. For us that looks like a win.