Most people are aware that there is an exemption from capital gains tax (CGT) on a gain made from selling your home (your “only or main residence”, as the law calls it).
What is less well known is that there are some exceptions to this rule, which could result in CGT being due when you sell your home.
One of the more obscure restrictions is contained in Section 224 (3) of the Taxation of Chargeable Gains Act 1992. This denies or restricts relief in two situations:
- If you bought your home “wholly or partly for the purpose of realising a gain from the disposal of it”, the exemption from CGT is withdrawn and you will pay CGT on the sale just as you would with any other property
- If, after buying your home, you spent more money on it “wholly or partly for the purpose of realising a gain from the disposal”, then that part of the gain on the sale “attributable to” the improvements is not exempt from CGT
Having read the above, you may be thinking it is so widely drawn that everyone will find themselves paying CGT when they sell their home. After all, when we buy a house, one of the things we take into consideration is the likelihood that it will increase in value in the future. The companies selling loft conversions or fitted kitchens always make the point that spending money on such improvements will increase the value of your home.
And notice that the taxman only has to show that we bought the house or did the improvements “partly” in order to make a profit when we sell.
Fortunately, the legislation is not applied as rigorously as that. Refreshingly, HM Revenue & Customs’ instructions to their inspectors say that to do so would be “unreasonable and restrictive”. The instructions go on to summarise when inspectors should and should not use this legislation to collect CGT when a home is sold:
Buying to Realise a Gain
If you buy something intending to sell it again in the short term and make a profit, you may well be trading, and as such liable to income tax, not CGT, on the profit you make. The difficulty for the taxman is that where the asset you buy is also your home, it is very difficult to argue that the purchase and sale was actually a trading transaction. This is where section 224 (3) can be used to tax short term profits made by buying and selling a property that is temporarily used as your home. When I was a tax inspector, I had a case involving a builder who worked his way down a run-down street of houses, buying one, living in it while he did it up, then selling it as quickly as possible and buying the one next door, and so on. Because he was genuinely living in each house as his home (he didn’t have any other house to live in), it was impossible to argue that he was trading, but we wheeled out section 224 to deny him exemption from CGT.
This is not to say that all cases of homes bought and sold in the short term will be caught. Where you genuinely intend to occupy the home you buy for the long term, but then your circumstances change (or you get an offer you can’t refuse) and you sell the property having only owned it a short time, there should be no restriction of the exemption.
This is why we tax advisers always avoid answering the question “how long do I have to live in this house to be sure of the main residence exemption?” Our favourite reply is that it is the quality of occupation, not the duration, which is important.
It’s rather like the luxury yachts at the Boat Show – if you want to know the price, you probably can’t afford one. If you want to know how soon you can move out and sell the house, you are probably going to get caught by section 224!
Spending Money on Improvements to Realise a Gain
This restriction is applied far more often than the “buying to realise a gain” one. It identifies the part of the gain you make when you sell that can be attributed to money you spent to improve the property, and taxes that part of the gain. Like the other restriction referred to above, it does not apply in all circumstances:
You will not lose any of the exemption if all you do before you sell is:
- Get planning permission (say, for conversion into flats)
- Get a restrictive covenant lifted
The two commonest situations where the restriction does apply are:
- “Enfranchising” a leasehold property by buying the freehold from your landlord
- Converting the house into flats and selling them
How does the Restriction Work?
Joe lives in a large detached house, with a market value of £300,000. He wants to sell it, and decides he will get a better price if he converts the property into three flats, each of which will sell for £150,000. The conversion work costs him £50,000.
Because Joe did the conversion “wholly or partly” to make a gain on the sale, section 224 comes into play. The way the restriction works is:
Sale proceeds of 3 flats
Less market value of house before conversion
Gain “attributable” to conversion
Less cost of conversion
Gain taxable under section 224 TCGA 1992
As with most tax problems, there are always grey areas – for example, what about converting your house to include a “granny flat”? If that increases the sale value, will section 224 bite you?
It depends on the timing – if you do it immediately before you sell the property, and especially if you haven’t got a granny to put in the flat, then I think you are caught. If you do have a granny who moves into the flat and lives there for some years, then I would argue that to apply the restriction would be “unreasonable and restrictive”.
Once again, it is a matter of quality, not quantity. Given the nature of grannies, it may be that the granny flat is only occupied by her for a short time before she dies. If your circumstances then change so that you decide to sell the property, again I would argue that your relief should not be restricted – but I cannot promise you that the tax inspector would agree with me!
Exactly the same considerations apply if you convert part of the house into a flat, but continue to live in the rest of it. Whether the restriction will apply depends on what you do with the flat – if you sell the flat on a 999 year lease when the conversion is finished, then the gain will be caught by Section 224. If you let it on a shorthold tenancy for a number of years, then although some of the eventual gain may be taxable (because after three years, the increase in value of the flat will stop being eligible for relief as it is no longer treated as part of your main residence), once again I would argue that section 224 should not apply.
Should I do that Conversion?
If you reckon it will make you a profit, then don’t decide not to do it just because some of that profit may be taxable. Any fool can avoid tax by not making any profits or gains!