Given the property boom over recent years, a huge number of investors have quickly and successfully grown portfolios by using a very simple investment strategy. This strategy involves withdrawing equity from an existing property to fund the next purchase.Though this strategy has been successfully used to quickly grow portfolios and increase the number of millionaires in the country, it is has already caused and continues to cause severe CGT implications for a growing number of investors.
Consider the following case study:
Aleesha buys her first two-bed terraced investment property in January 1996 for £60,000. This is funded by a £12,000 deposit and a £48,000 buy-to-let mortgage. In January 2000, the property is valued at £100,000, so she decides to fund her next investment property by releasing equity from the existing one.
Her mortgage lender allows her to increase her mortgage borrowing to £80,000 (i.e. 80% of the property value) and therefore she is able to buy a £150,000 three bedroom detached property with the 20% deposit funded by the equity release.
There is one very important point to note about the above case study. That is that there is no capital gains tax (CGT) liability due when the property is remortgaged. CGT is only due when the property is sold or transferred. So what this effectively means is that Aleesha is able to extract large sums of money from her property without paying a single penny in tax. In fact, even if she had used the equity release proceeds for a cruise around the world then still no CGT liability would have been triggered.
However, this is a very risky strategy as we are about to realise.
Aleesha continues her portfolio growth
Continuing with the case study…….
In 2002, Aleesha’s first property is worth £150,000 and the second property is worth £200,000. Again she decides to grow her property portfolio and remortgages the existing properties. She again releases equity to fund FIVE new apartment purchases at £125,000 in the North of England.
Due to the competitive buy-to-let market she is now able to remortgage the properties to 85% of the property value. This means that on her first property she is able to increase her borrowing to £127,500 – more than twice what she originally purchased the property for.
So Aleesha now has FIVE properties with a market value of £125,000, one at £150,000 and another at £200,000. Her total portfolio is worth £975,000 – almost a property millionaire!
Aleesha becomes a property millionaire!
By 2004, the north has had two years of excellent property capital growth and the apartments purchased at £125,000 are now worth £175,000 each, her two bed terraced property is now valued at £175,000 and three bed detached property is valued at £250,000.
She is now a property millionaire!
Again, Aleesha is keen to continue the growth of her property portfolio and once again takes advantage of the 85% equity release available and remortgages all the properties to 85% loan to value and invests in three Villas, one in each of Spain, France and Cyprus for £250,000 each.
So to summarise this is the current state of Aleesha’s property portfolio:
Two bed terraced property: Purchased for £60,000. Current value of £175,000 with outstanding mortgage of £148,750
Three bed detached property: Purchased for £150,000. Current value of £250,000 with outstanding mortgage of £212,500
FIVE Apartments: Purchased for £125,000 each. Current value of £175,000 each, with an outstanding mortgage of £148,750.
THREE villas in non-UK countries valued at a total of £750,000.
So in total here portfolio is now worth over £2million and she has become a multi-millionaire.
So what does all this mean?
Well, firstly it means that Aleesha, has grown a very sizeable portfolio in a few years and has indeed become a property millionaire (well on paper anyway!).
However, she has never considered her capital gains tax position during her continued investment, and this means that on each of her UK owned properties she actually now owes more than what she originally paid for the property.
This in turn means that unless she has a considerable amount of savings, she is unlikely to be able to pay the CGT bill on the sale of the property from the actual sales proceeds.
Let’s take the example of her very first investment property, which she purchased in 1996 for £60,000. If she sells at the current market value of £175,000 then she has made a £115,000 capital gain (minus her annual CGT exemption of £8,800) and could be liable to pay tax of 40% (i.e. £42,480) of this amount (ignoring the deductions for indexation and taper relief and costs).
However, given that she only has £26,500 of equity in the property she will be required to find an extra £15,980 just to pay the taxman, thus meaning she has made no actual profit and could incur additional debt through paying the taxman. She may think that she can sell another of her properties to fund the required £15,980, but again she will face the same problem, where the sale of the property will not cover its own CGT liability.
Now, if for some reason she needed to sell all her properties then you could see how she could end up paying the taxman quite a considerable amount of money, and have nothing to show for it herself at the end of it.
So, although Aleesha is a millionaire property investor, she could end up without a penny to her name and with significant debts if she decides to sell.
Her foreign properties do not help her either, as there is local CGT (often a compulsory withholding of a percentage of the sale proceeds) and the balance due to the taxman here after deducting the foreign tax she has had to pay.
How to overcome the problem?
There are a number of ways to tackle this tax problem and these are outlined below:
Sit and Wait
Firstly, she could decide not to purchase anymore properties and continue to just hold the properties and wait till they have increased in value, or if purchased with repayment mortgages, enough of the loans have been repaidthat the sales proceeds could cover any tax liability, quite comfortably. However, this may take 5, 10, or 20 more years!
One key tax advantage of waiting is that after 10 years of ownership of each property (from its purchase date); by virtue of non-business asset taper relief, the CGT rate will reduce from 40% to 24% maximum.
Leave the UK
Secondly, she could leave the UK for 5 complete tax years and then sell the properties in either the tax year following her year of departure and any of the next 4 tax years. By doing this she would wipe-out any UK CGT liability. Given that six million UK residents are expected to emigrate by the year 2020 this could be her chosen option.
Also, she may quite fancy living in one of her foreign properties. She would also have to consider local CGT in her new country of residence, on her UK property sales. This would be 15% in Spain going up to 18% in 2007, with some planning it may be possible to avoid Spanish CGT! In France, she would at present have no CGT on her UK properties (this may change!) and 27% on her French property reducing to nil after 15 years of ownership.
In Cyprus, she would also have no CGT on her non-Cypriot property and 20% with some allowances and a small exempt amount on her Cypriot property.
Use Incorporation Relief
Thirdly, she could possibly avoid CGT if her properties taken together were considered to be a “Business”. She could then transfer them into a Company and claim Incorporation Relief. This would have the effect of enabling the Company to sell the properties with little or no CGT liability.
To find out more about the second and third strategies and how you can overcome the property capital gains tax trap please go to the consultancy section at: www.taxinsider.co.uk.