There's No Place Like a Former Home
By Nick Braun MSc PhD
Most tax shelters come with a catch.
For example, venture capital trusts offer massive income tax relief. but you have to give your money to companies that are more likely to go bust.
Commercial property offers massive capital gains tax savings. but only if your tenants are unquoted companies (in other words, small and risky).
Pensions offer an extremely attractive cocktail of tax savings. but only if you keep your money tied up until you retire.
So most tax shelters are designed to make you do something that you wouldn't normally contemplate, such as invest in high-risk assets, take on less reliable customers or tie your money up for many years.
And that's why Governments sanction them in the first place: to influence our economic decisions.
However, at Taxcafe this is what we call letting the 'tax tail wag the investment dog'. We also call it spending £1 to save 40p in tax.
Very rarely should you let tax be the number one factor influencing your investment decisions. It rarely works out for the best.
There is, however, one tax shelter that is not designed to make you do something risky or out of the ordinary.
If you want to invest in residential property and enjoy some handsome tax savings you should consider renting out a former home.
If you sell an investment property which used to be your main residence, some of the profit - representing the time you lived there - is tax free. This is what's known as the principal private residence exemption (PPR). Most people know this.
That's not the interesting part, however. There is an extra PPR concession that could save you a small fortune in capital gains tax.
What it says is that the last 36 months of your ownership of the property are regarded as being a period of private occupation, irrespective of whether you actually lived in the property during that period.
In other words, you can move out of your home, rent it out for three years, and not pay a penny in capital gains tax.
If you hold on to the property for more than three years capital gains tax will again come into play. However, if you're renting out the property you will also qualify for something called private letting relief. The calculation of this latter relief can be quite complex, but, under the right circumstances, the maximum relief of £40,000 per person can be obtained.
Quite a few people know about these reliefs but very few, in my experience, realize just how powerful they are.
The following example illustrates what I mean.
Example
Mr and Mrs Blenkinsop acquire a second property in their neighbourhood for £300,000. They can either rent out the new house or move into it and rent out their old house, which is also worth £300,000.
There may be a host of reasons why they would want to live in either property. However, capital gains tax should be near the top of their priority list.
Let's say they decide to stay where they are and rent out the new property. They sell it 10 years later for £600,000. (This assumes that property prices rise by around 7% per year which is probably a reasonable long-term growth rate).
After deducting 40% taper relief and their annual capital gains tax exemptions their combined capital gains tax bill is likely to be in excess of £60,000.
Let's say they decide instead to move into the new property (Mrs Blenkinsop likes the jacuzzi bath at the new property) and rent out their old house.
What will the capital gains tax bill be when they sell their old home in 10 years time?
Once again they are entitled to deduct 40% taper relief and two annual capital gains tax exemptions. This time, however, they also qualify for principal private residence relief, not only for their period of occupation of the property as their own private residence but also for the last 36 months of their ownership (even though the house has been an investment property for a whole decade).
Furthermore, they also each qualify for £40,000 private letting relief (because they are renting out a property that used to be their main residence).
Their combined capital gains tax bill will now be somewhere in the region of £20,000 (at most) - a saving of over £40,000.
Clearly old homes are much better tax shelters than ordinary buy-to-let properties.
It's a mouth-watering tax break and one that should be made use of whenever you get the opportunity.
So next time you move house try your level best to hold onto your old home. It might be the best investment you ever make.
