How does capital gains tax on property work?

Capital gains tax is a tax on profits made from the sale of capital assets such as stocks, real estate, or precious metals and in this article, we’ll be looking at how it applies to property.

It is a critical component of working out how to sell a house and it can have bigger consequences for those who do not take this type of tax seriously.

There are many techniques in which to reduce the capital gains tax you owe which will be talked about but at the same time sometimes paying capital gains is simply unavoidable.

So, in this article, we will go over just that, including how the tax differs for buy to let properties and second homes and the current rates of capital gains that is set out by the government.

capital gains calculation

What exactly is capital gains tax?

Capital gains tax is tax that must be paid on the profit made from the sale of a property. For instance, if there is a house that is sold for a profit then the owner of the house will then pay tax on it.

Nonetheless, there are circumstances where this type of tax isn’t eligible to be paid like if you’re paying tax on your primary residence.

How does capital gains tax work?

Capital Gains Tax (CGT) works differently from income tax. Unlike income tax, CGT is not automatically deducted from the revenue that you produce, which means you have to report it yourself. 

It’s important to know what needs to be reported because there are a lot of different types of reasons for capital gains tax being charged. 

So, if you don’t provide accurate reports to the HMRC, you could end up paying a fine that’s worth a lot more than the deduction would have been. So, it makes sense why you may want to avoid this.

What are the CGT (capital gains taxes) rates?

The rates of capital gains tax varies depending on if you’re a higher rate taxpayer or a lower rate one and it also varies depending on if you’re selling a residential property too.

For instance, there are 10% and 20% tax rates for those who are selling property that is non-residential. The lower rate applies to lower rate taxpayers and higher rate taxpayers (40% and above) pay 20% CGT.

For those selling a residential house, if they are a lower rate taxpayer they will have to pay 18% and 28% if they are a higher rate taxpayer.

There are also additional rates. For instance, trustees or personal representatives of a deceased individual pay 20% for the sale of capital assets, excluding residential properties. 

The same individuals pay 28% for the sale of residential properties. 

On top of this, gains from the disposal of a business asset that qualifies for Business Asset Disposal Relief, previously known as Entrepreneurs Relief, are taxed at 10%. 

Finally, properties subject to annual tax are taxed at 28%, and the annual exempt amount does not apply. 

Companies selling UK residential properties are taxed at 20%, with non-resident companies also subject to this tax. These rules are better understood by reading the full terms and conditions here.

A practical example of capital gains tax

The below tables walk you through how capital gains is taxed in real life.

 

Gross profit 30,000 –
CGT allowance £12,300 =
Total profit £17,700

 

In the next step, you would then need to add the income that you earn per year to the property as shown below.

 

Annual income £17,430 +
Total profit £17,700 =
TOTAL £35,130

 

This £35,130 figure is then taxed based on the tax band you’re in. In this case, your income would be still in the range of £12,571 to £50,000 per year so the rate of capital gains tax would be 18%

What is the correct time to pay capital gains tax?

Capital gains tax must be paid and reported to the HMRC yourself. This is after changes after April 2020. 

You now have 60 days in order to report the capital gains tax you owe and then pay it. As a result, capital gains tax is something that a lot of people find it hard to keep on top of.

Missing payments and finding out that there is tax due on a property can cause you to be in tax arrears and the government charges interest tax owed so this should be avoided at all costs.

How do taxes work on second homes and buy to let properties

Second homes and buy to let properties have their own category because there is a greater chance that you’d have to pay tax on these types of property if you sell.

Residential properties are often exempt from capital gains tax because if you have lived in a property for a certain amount of years you will be able to benefit from primary residence relief.

There are some other exemptions too such as if you use a property for the development of additional flats or you only use the property for business. 

Check out the government website using this link if you think you fall into this category. 

How to calculate the capital gains of a property

You can automate the process of working out capital gains by looking at a capital gains tax calculator. Or, you can work it out manually by looking at the rates of capital gains tax.

Based on the laws in the UK, the first step in order to work out how much capital gains you owe is to work out the profit that you receive from the sale of a property.

Then, you would need to determine the annual income that you are on by looking at your annual salary. If you have additional streams of income this can get difficult.

After this, make sure you’re charging yourself the right rate of capital gain for property as assets like cryptocurrency, shares and others are all charged at different rates.

How does capital Gains Tax allowance work?

The capital gains tax allowance is an allowance where profit can be taken from the property completely tax free and this allowance can be taken away from the taxable amount.

In 2022, the allowance was £12,300 and will be slashed to £6,000 in April 2023. Following this, the allowance will be further reduced to just £3,000.

This is in an attempt for the government to tax the UK public more and gain income back from the appreciation of property

Before the decrease in the allowance, a lot of people didn’t report capital gains when selling their house.

a book on capital gains

Does capital gains tax apply to a main home?

It is important to know what qualifies as a main residence when it comes to discussing capital gains tax because main residences are exempt from any type of capital gains.

This is a detail of capital gains tax that a lot of people tend to look over, especially if they have never been involved in the sale of a property before

How can a primary residence be exempt from capital gains tax?

The property must have been the homeowner’s primary residence for the entire period of ownership, without being rented out or used exclusively for business purposes, to qualify.

As well as this, the grounds, including all buildings, must be less than 5,000 square metres in size, and the property cannot have been purchased solely for profit. 

If these criteria are met, homeowners will be able to claim Private Residence Relief and avoid paying capital gains tax when they sell their home.

What length of time do I need to live in a house to avoid capital gains?

As part of UK law, you generally have to live in a property for at least a year or twelve months in order to be exempt from capital gains tax.

You can download the exact regulations known as the government toolkit using this link if you’re interested in the details. Be sure to do this in order to work out if you need to pay tax when you sell a house.

You don’t want to end up on the wrong side of the law where you could have to pay a fine or potentially have tax arrears.

Do you pay CGT on inherited or gifted property?

If you give someone a property in a normal way then capital gains tax is to be paid. Nevertheless, there are ways around this and you can end up paying a lot less capital gains tax if anything at all.

How you can overcome this tax is by registering that you have lived in a home for a long time, giving the property to your spouse or civil partner or registering a property in a trust.

Trusts are the best way to avoid tax because they allow you to register the property before your child is over legal age to take ownership of the house (18 years old) and they will receive it when you pass away.

Not only will the trust protect the property from Capital Gains Tax but it will also protect it from inheritance tax which can be up to 40% in the worst cases.

What are the ways you can reduce the amount of capital gains tax you pay?

As you prepare to sell a property, it is vital you take advantage of all of the ways you can reduce your tax bill like tax allowances or suffering losses and timing your sale.

paying money towards capital gains tax for a property

Deduct costs

Deducting the costs related to an asset is the most straightforward way to reduce your capital gains tax bill. This involved deducting all of the costs associated with the sale.

Things like solicitor fees, stamp duty, estate agency fees and even fees that were used to create an accurate valuation for the property can all be deducted.

Offset your losses

Sometimes when you sell a property it doesn’t go to plan and the property has in fact lost value. This is common in developments where there is a large number of houses being built.

The large increase in the supply of houses causes the buyer demand to be met and this means it is difficult to sell a property for more than you bought it for.

Use your spouse’s allowance

The way this works is by sharing the asset with a spouse by transferring it over to them in the form of an asset transfer. When the property is then also in their name they can also take their personal allowance out of the tax bill.

This is given that the spouse who has been transferred the asset has not used up their allowance elsewhere.

With a combined allowance, a married couple or those in a civil partnership could therefore be able to keep up to £24,600 tax free if they both use all their personal income and are in the lower tax bracket.

Make the most of other allowances

One of the best ways to reduce capital gains owed when managing your investments is your tax allowances. 

Making the most of your individual savings accounts (ISAs) and pensions, such as a self-invested personal pension (SIPP), is part of this.

Surprisingly, ISAs are often overlooked by high net worth individuals. They can help protect your investments from tax for up to £20,000.

So, if you know that you have a lot of money in property and you want the money to appreciate over time, perhaps taking some money out of your property investments is a good idea.

Simply, transfer the fund before there is a large capital gains tax bill due to your ISA by selling a property and then watch your money appreciate in value in the ISA too.

Most people aren’t aware of this and it proves a great way for you to diversify your portfolio.

When an ISA and a SIPP are used well, a diligent investor with an ISA portfolio of £500,000 or more as an example could end up paying very little capital gains tax.

So, it’s definitely worth thinking about how you can maximise your tax allowances to protect your investments and reduce your tax liabilities.

However, the rules governing Bed and ISAs and Bed and SIPPs can be complicated, so consult with a financial adviser or solicitor before making any big decisions.

Time your sale

If you own a property and have been owning it for years. Due to the property market in the UK in general, there is a good chance that the house would go up in value over time.

This means when you do go to sell the property there is an unrealised gain that could crop up and you could end up paying far more in capital gains tax than you thought.

Simply timing the sale and constantly being aware of the rough value of a property is the best way to reduce the chance of this happening.

Paying capital gains tax by card

Have a long term strategy

If you’re looking to avoid a large potential tax bill in the future, there’s a quick trick you can use. Essentially, you sell a portion of your investment and then repurchase it with your annual allowance.

This allows you to reset the cost of the amount of assets you hold at a higher level, lowering your potential profit and, as a result, your future tax liability.

However, there are a few things to keep in mind. To begin, tax rules require you to wait 30 days before repurchasing the same holding. 

If that’s not your thing, you could consider investing in an exchange-traded fund (ETF) that offers similar exposure in the meantime. This way, you can still keep your money in the market and avoid unnecessary risk.

Private residence relief

A great way of selling a home and reducing the amount of tax you pay is by qualifying for Private Residence Relief (PRR) which is automatically applied to capital gains tax in some cases.

To receive the full relief, the property must be your primary residence. You may also be eligible if you are selling a residence that you have bought for a dependent relative.

lettings relief

Company lettings relief is a method of reducing the amount of gain charged when you sell a property that was your only or main residence and was rented out as residential accommodation at some point.

This relief is available if three conditions are met. To begin, you must have made a profit from the property and be eligible for private residence relief. 

Second, you must have rented out a portion or the entire property at some point during your ownership. Finally, the letting must have resulted in a capital gain.

So, lettings relief is often talked about amongst private residence relief for this reason. You cannot have one without the other but it is still a significant relief to take advantage of.

Reduce your income to reduce tax

You may be wondering how reducing an income tax bracket will allow you to reduce the amount of CGT you pay. The truth is because the CGT rate is linked to your income tax bracket.

For instance, if you are a lower income earner and you earn below £50,000 per year, you will be able to pay the lower rate of capital gains tax. Anything over this and you pay the higher rate.

This is because the cost to sell a house is reduced for those who are earning less anyway as a form of relief from the government.

After you begin to understand this the question then becomes, how can you lower your tax rate? The answer is there are two options, increase your pension contributions or donate to charity. 

This is aside from getting rid of the income you already have like leaving a job or asking a business to pay you less. Both will help to reduce your taxable income, which will reduce your CGT bill.

Another way to reduce the amount of capital gains tax you owe is to transfer assets to your spouse, especially if they pay basic tax or do not work. 

By doing so, you could cut the CGT on those assets in half, to just 10%. This was mentioned previously, but it is worth repeating because it can be a great way to save money.

Take an early profit

If you intend to sell assets, keep in mind that the annual capital gains tax allowance must be used in the right time frame or you lose its benefits. 

This means that any unused allowance cannot be carried over to the following tax year because the allowance is being phased out over the next two tax years (until 2024).

This means it is more important than ever to take advantage of the current £12,300 allowance before it is too late.

Spreading a capital gain over two tax years was common in the past, but with the allowance decreasing, it may not be as effective as it once was.

adding figures for capital gains tax on a property

In summary

All in all, the topic of capital gains remains a topic that is hard to understand if you’re a beginner to property investing and perhaps you’re selling a house for the first time.

As a result, if you’re buying a second home, you should be able to form a good understanding of what kind of tax you need to pay as well as if there is a particular type of legal change you can do in order to pay less tax. Especially given the cost it takes to sell a house anyway.

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donnell-bailey

Donnell Bailey

Property expert

Donnell is a property expert focusing on the property market, he looks at a combination of legislation, information from property managers, letting agents and market trends to produce information to help landlords.

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