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Tax - May / June 2005

Don’t be a multimillionaire investor who can’t afford to sell a property: Daniel Feingold and Amer Siddiq discuss Capital Gains

In the property boom of recent years, investors have quickly grown portfolios by using a simple strategy – withdrawing equity from an existing property to fund the next purchase.

But this has caused severe Capital Gains Tax implications. Consider the following:

Aleesha buys her first two-bed terrace 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 it.

Her lender allows her to increase her mortgage borrowing to £80,000 (ie, 80 per cent of the property value) and she is able to buy a £150,000 three-bedroom detached property with the 20 per cent deposit funded by the equity release.

There is one important point to note: there is no CGT liability due when the property is remortgaged. CGT is only due when the property is sold or transferred. So Aleesha is able to extract large sums of money from her property without paying tax.

However, this is a very risky strategy, as we are about to realise.

Competitive market

In 2002, Aleesha’s first property is worth £150,000 and the second property, £200,000. Again she decides to grow her portfolio and she remortgages the existing properties. She releases equity to fund the purchase of five new apartments at £125,000 each in the north of England.

Due to the competitive buy-to-let market she is now able to remortgage the properties to 85 per cent 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 bought it for.

So Aleesha now has five properties with a market value of £125,000 each, one at £150,000 and another at £200,000. Her total portfolio is worth £975,000 – almost a property millionaire!

By 2004, the north has had two years of excellent property capital growth. The apartments are now worth £175,000 each, her two-bed terrace property is now valued at £175,000, and the three-bed detached property is valued at £250,000.

Growing portfolio

Again, Aleesha is keen to continue the growth of her property portfolio and once again takes advantage of the 85 per cent equity release available and remortgages all the properties to 85 per cent loan-to-value and invests in three villas, one each in Spain, France and Cyprus for £250,000 each.

So to summarise, this is now Aleesha’s property portfolio:

Two-bed terrace 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 her portfolio is now worth over £2 million and she has become a multi-millionaire.

Growing bill

But what does all this mean? Well, firstly it means that Aleesha has grown a sizeable portfolio in a few years and has indeed become a property millionaire – on paper, anyway.

However, she has never considered her CGT position, and this means that on each of her UK owned properties she now owes more than 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 first investment property, 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 £8,200) and could be liable to pay tax of 40 per cent (ie £42,720) 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 £16,220 just to pay the taxman, thus meaning she has made no actual profit and could incur additional debt in paying the taxman.

She may think that she can sell another of her properties to fund the required £16,220, but again she will face the same problem, where the sale of the property will not cover its own CGT liability.

If for some reason she needed to sell all her properties, she could end up paying the taxman a considerable amount and have nothing to show for it herself at the end of it.

Her foreign properties do not help her either, as there is local CGT (often a compulsory withholding of a percentage of the sale proceeds) with the balance due to the taxman here after deducting the foreign tax she has had to pay.

Solutions There are ways to tackle this tax problem.

Firstly, she could decide not to purchase any more properties and hold what she has until they have increased in value, or if purchased with repayment mortgages, enough of the loans have been repaid; then the sales proceeds could cover any tax liability quite comfortably. However, this may take five, ten or 20 years!

One tax advantage of waiting is that after ten years of ownership of each property, by virtue of taper relief the CGT rate will reduce from 40 to 24 per cent.

Secondly, she could leave the UK for five complete tax years and then sell the properties in the tax year following her year of departure and any of the next four tax years. By doing this she would wipe out any UK CGT liability.

Given that six million UK residents are expected to emigrate by 2020, this could be her chosen option. Also, she may quite like the idea of living in one of her three 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 per cent in Spain. In France, she would at present have no CGT on her UK properties (this may change) and in Cyprus she would have to pay 20 per cent.

We have identified one European country where Aleesha could reside for one complete year only and then sell her entire UK property portfolio without any CGT liability. Furthermore, it is not Belgium!.

Thirdly, she could 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.

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