The private residence exemption is well known. It serves to prevent a liability to capital gains tax arising on the sale of one’s home (or, more precisely, one’s only or main residence), thereby preventing the sale proceeds from being eroded by tax. This allows the property market to function and enables people to move freely and use the proceeds of one property to buy a new property without having to pay capital gains tax each time they move home.
However, what the exemption does not do is to provide relief from tax for speculative gains or gains arising from development. The tax legislation contains provisions to take such gains outside the ambit of private residence relief and within the charge to capital gains tax.
Scope of the Rules
The legislation provided that where a dwelling house is acquired wholly or partly for the purpose of realising a gain from its disposal private residence relief is not in point. Private residence relief is also denied in respect of a gain in so far that it is attributable to any expenditure that is incurred after the beginning of a period of ownership that is incurred wholly or partly for the purposes of realising a gain from the disposal.
The legislation is widely drafted and it is easy to see how common scenarios could easily be caught. Over time, and particularly when the property market is buoyant, people will expect to make a gain on any property that they purchase. Furthermore, when looking for a home, many people look for properties which they can do up or which will appreciate in value (for example those in an up-and-coming area) to enable them to move up the property ladder quickly.
Indeed, one house may be chosen over another because it is thought to offer greater potential to appreciate in value. However, thankfully HMRC apply a commonsense view and do not seek to attack gains which can be attributed to sensible purchasing decisions or a rising property market rather than to an intention to make a short-term gain. Indeed, they concede that it would be unreasonable to apply the legislation in this way (HMRC Capital Gains Manual CG65210).
Instead they seek to use the provision where the `primary purpose of the acquisition or of the expenditure was an early disposal at a profit’. Relief is most commonly restricted where expenditure has been incurred in connection with the reconstruction or redevelopment of a building.
However, before considering whether relief should be restricted, HMRC will consider whether a trade (of property development) is being carried on. If, by applying the usual badges of trade, the individual is found to be trading, any profit on disposal of the property will be taxed as trading income, rather than as a capital gain. Where HMRC can sustain an argument that a person has acquired a dwelling house wholly for the purpose of realising a gain from it, an assessment to trading income will take priority over an assessment to capital gains tax.
Thus private residence relief, and consequently the restriction of the relief, are not in point. The fact that an individual may live in a property whilst developing it will not in itself prevent HMRC from concluding that a trade was being carried on. However, if the property is made into a `home’ and the person lives in it as a home for a period of time, rather than doing it up as quickly as possible and moving on the next development project, a trading argument will carry less weight.
Where a person has incurred expenditure after first taking ownership of the property and that expenditure has been incurred wholly or partly for the purpose of realising a gain from the disposal of the property, HMRC may seek to deny relief. However, relief will not be denied in relation to the whole gain, rather only in respect of the gain attributable to the speculative expenditure. In considering whether any expenditure has been incurred during the period of ownership primarily for the purpose of realising a gain, no account is taken of the cost of obtaining planning permission or the release of any restrictive covenant.
The test is one of primary purpose. Adding an extra bedroom will generally add value to a property. However, if this is done to provide for a growing family and the family continue to live in the property for some time after the extension has been completed, HMRC are unlikely to seek to restrict private residence relief. However, if the work is carried out purely to enhance the gain on sale because the increase in value by adding an extra bedroom is expected to outweigh the costs of creating the additional room, HMRC may take action and deny private residence relief in relation to that portion of the gain attributable to that extra bedroom.
To restrict relief, it is necessary to identify the gain attributable to the additional expenditure and HMRC will normally seek a valuation from the Valuation Office Agency. However, some measure of the value of, say, adding a fourth bedroom, for example, can be gained by comparing the price of, say, three and four bedroom houses in the area.
Billy owns a three-bedroom house. He wishes to move to a more expensive area. To increase the gain on the sale of his property, he builds an additional bedroom over the garage and sells the property as soon as the work is complete. The extension costs £25,000. The property sells for £400,000. Similar three-bedroom properties in the area are selling at the same time for £350,000.
Billy purchased the property five years earlier for £200,000.
HMRC seek to deny private residence relief in relation to the gain attributable to the additional bedroom as the expenditure was incurred for the purpose of increasing the gain on sale.
Less: cost of property
cost of extension
Billy makes a total gain of £175,000, of which £150,000 is covered by private residence relief. HMRC deny relief in relation to the gain of £25,000 attributable to the additional bedroom. This is chargeable to capital gains tax. Subject to other gains realised by Billy in the tax year, this may be offset partially by his annual exemption.
Other situations where HMRC are alert to expenditure being incurred purely to enhance the gain on sale include the acquisition of the freehold or superior interest by a leaseholder, which can often be obtained at a price considerably lower than that which would be payable by a third party. HMRC may also seek to deny relief where a property is converted into a number of smaller residences, such as a large house being converted into flats, prior to sale. In these situations they may act to deny relief on the portion of the gain that can be attributed to the enhancement expenditure.
Don’t Forget the Annual Exemption
The extent to which denying relief will result in a capital gains tax liability will depend on the value of the gain brought into charge, any other gains realised in the tax year and the availability of the annual exemption. For 2008/09 the annual exempt amount was £9,600. This means there where a property was jointly owned, a couple could realise a chargeable gain for that year of £19,200 before paying any capital gains tax.
Or Let the Tax Tail Wag the Dog
Even if relief is denied, it is worth remembering that 82 per cent of the gain is better than 0% of a gain and the fact that some tax may be payable will not prevent the expenditure from being worthwhile.