It is true that there is no tax to pay when you release equity by remortgaging, whereas there may well be CGT to pay if you sell, so the “never sell – never pay tax” proposition is I suppose true, as far as it goes, but before you decide to adopt this strategy, there are a few potential pitfalls to consider:
The CGT Trap
This was covered in detail in an article in December 2005 by Daniel Feingold and Amer Siddiq: http://www.property-tax-portal.co.uk/taxarticle47.shtml Basically, the problem arises when the level of debt secured against the property is such that if you sell it, once you have repaid the debts you will not have enough of the sale proceeds left to pay the capital gains tax charged on the gain you will make on the sale.
But the whole idea of the strategy is not to sell the property, isn’t it? True, but you never know when circumstances may dictate that you want to sell – or for that matter, the property may get caught up in some development project and be compulsorily purchased.
A successful business needs to be flexible if it is to survive, and getting yourself into the CGT Trap is the opposite of being flexible.
Relief for Interest Paid
If you own a property and let it, you can release equity from it up to its market value on the day you first let it, and the interest payable on the borrowings can be deducted from the rent received for tax purposes.
If you release more equity, however, so that the loans become greater than the market value of the property when it was first let, the interest on that additional borrowing will not qualify as a deduction for tax purposes – unless you use the money to fund the purchase of another property.
Because of this limitation on the interest you can deduct from your rental income, as property values rise (and you follow your plan of releasing equity accordingly) and rents rise as well, there may come a point when you are in the unpleasant position of making a taxable profit on your rental income from the property, while your actual expenses (including the interest on the equity releases above the original market value, which you cannot claim as a deduction against the rent) are greater than the rental income you receive. You will be paying tax on a “profit” from the property, while you are in fact making a loss!
Death is one way out of the CGT trap, of course:
When you die, inheritance tax (IHT) is charged on the net value of your estate, after deducting any debts. There is no CGT on death, but for CGT purposes your heirs are treated as acquiring your property at its market value on the date of your death.
In other words, if you die owning a BTL property you bought for £100,000, which is now worth £300,000 and has a mortgage of £250,000 secured against it, for IHT purposes the net value of this would be only £50,000 (IHT of £20,000 payable, assuming the legacy is not exempt for any reason and you have used up your “nil rate band” on the rest of your estate). Your estate now has a base cost of £300,000 for the property, so if it is sold immediately, the estate will clear £30,000 from the deal:
|Less mortgage repaid||-250,000|
The IHT rules concerning debts can be quite complicated, and in some cases the above would not apply. For example, if you had used the equity released to make a gift to one of your heirs, it is possible the debt would not be allowed as a deduction from your estate. In a simple case, however, where the equity released is used to fund your living expenses, the above example should hold true.
When Not to Sell
There are some situations where not selling a property makes perfect sense – indeed, where it would be foolish to do so:
Buster and Izzy are a young married couple, living in their house in the Westcountry with their new baby. Buster’s employers want him to move to the Midlands, so he and Izzy sell their house (no CGT as it is their main residence) and use the money left over after paying off the mortgage (and the estate agency fees!) to fund the deposit on a house at the new location. The equity in the old house has gone up since they bought it, and so they are pleased to find that they make a profit of £75,000 on the sale of the old house.
If, instead of selling the old house, they had released equity from it to fund the deposit on the house in the Midlands, and let the old house, they could have deducted all the interest on the mortgage on the old house from the rental income they would have received. As the old house appreciated in value, they could have continued to release equity (up to the market value on the day they first let it) and deducted the interest from the rent. In a short time they would have found themselves in the same financial position they were in after selling the old house, but with an income producing asset (the old house) that would still have been appreciating in value, and which in the future it would have been possible to sell with little or no CGT to pay, given a little careful tax planning.
Beware of Simple Strategies!
“Never sell – never pay tax” has a catchy ring to it, and in many circumstances there is quite a lot of truth to it, but like many “simple” ideas, it has severe limitations.
I come across a lot of “sound bite” tax advice, where a simple proposition is presented as the way to minimise tax, and in most cases, as here, my reaction is “Well, yes, but…”, and the “but” usually involves several unpleasant side-effects of the strategy concerned.
Oscar Wilde said “The truth is rarely pure and never simple”, and that is certainly true about tax.
Let me end with my own “sound bite”:
In tax planning, if you think the solution is simple, you probably haven’t understood the problem!