Capital Gains Tax:
Basic Rate Planning
CGT - Basic Rate vs Higher Rate
UNDER THE previous capital gains tax rules everyone paid the same flat rate of 18%. Under the new rules that apply from 23rd June 2010 there are two tax rates:
- 18% for basic-rate taxpayers
- 28% for higher-rate taxpayers
From now on, the amount of capital gains tax you pay will depend on how much income you have earned during the tax year.
The amount of tax you pay will also depend upon the size of the gain itself. Your capital gains are added to your income, so even someone with very little income but a big capital gain could end up being taxed in part at 28%.
The maximum amount of capital gains that you can have taxed at 18% in the current tax year is £37,400. This is the amount of the basic-rate tax band for 2010/11.
Basic-rate taxpayers pay 10% less capital gains tax than higher-rate taxpayers. This means the basic-rate tax band can save each person up to £3,740 in capital gains tax this year:
£37,400 x 10% = £3,740
This creates some interesting tax planning opportunities:
If you expect to realize a large capital gain, for example by disposing of a buy-to-let property, you may be able to save quite a lot of tax by making sure the disposal takes place during a tax year in which your taxable income is quite low.
Company owners can manipulate their incomes more easily than regular employees, sole traders or business partners.
The company itself can keep trading and generating profits but the company owner can make sure that very little of these profits are extracted and taxed in his or her hands.
Richard, a company owner, sells a buy-to-let property, realizing a net gain of £50,000 after deducting all buying and selling costs. Deducting his annual CGT exemption of £10,100 leaves a chargeable gain of £39,900.
Richard hasn’t paid himself any dividends during the current tax year and decides to postpone paying any so that £37,400 of his capital gain will be taxed at 18%. The remaining £2,500 will be taxed at 28%. This simple piece of tax planning has saved Richard £3,740 in capital gains tax.
Note that Richard can still pay himself a tax-free salary of £6,475 to utilise his income tax personal allowance. The income tax personal allowance does not interact with the capital gains tax calculation. (In practice he would probably be better off paying himself a slightly smaller salary of £5,715 to avoid national insurance as well.)
Other income earners may find it more difficult to control their earnings in this manner.
Regular employees (those who aren’t company director/shareholders) could consider selling assets during years of redundancy, sabbatical years or during tax years in which they set up a business.
Sole traders or business partners could consider selling assets during years in which their profits are lower than normal, for example during an economic downturn.
They should also consider selling assets during tax years in which the business is making healthy profits but also has large tax deductions. An obvious example would be spending on machinery, equipment and vehicles which qualifies for the £100,000 annual investment allowance.
Melissa is a sole trader and earns profits of £60,000 per year. In March 2011 she spends £60,000 on equipment and vehicles for her business. All of the spending qualifies for the annual investment allowance. As a result her taxable profits are £0 and she has no income tax to pay.
In April 2011, after the next tax year has started, she sells a buy-to-let property, realizing a taxable gain of £40,000, after deducting the annual CGT exemption. If she once again has £60,000 of profits from her business but no investment spending to offset, she will be a higher-rate taxpayer and her entire capital gain will be taxed at 28%.
If she had sold the property during the previous tax year, or purchased the equipment during the following tax year, her entire basic-rate tax band would have been available for capital gains tax purposes, saving her up to £3,740 in tax.
Selling Assets When You Retire
It’s may be a good idea to sell assets like investment properties when you retire and have no earnings.
Rebecca is a 60 year old self-employed architect who has recently retired. When she was working she was a higher-rate taxpayer and would have paid capital gains tax at 28%.
She has accumulated £250,000 in her personal pension and also owns five investment properties with a net gain, after deducting buying and selling costs, of £50,000 per property.
She doesn’t want to be a landlord forever and decides to wind down her property business by selling one property per year for the next five years.
Fortunately the pension rules do not require her to withdraw any money from her personal pension, although she should consider withdrawing just enough to use up her tax-free income tax personal allowance. She can keep the rest of her pension money invested and growing tax free.
Withdrawing just a small amount of pension income frees up her basic-rate tax band for capital gains tax purposes. And selling just one property per year allows her to use her basic-rate tax band and annual CGT exemption five times instead of once.
When she sells the first property during the current tax year her chargeable gain will be calculated as follows
£50,000 - £10,100 = £39,900
Her capital gains tax bill will be calculated as follows:
£37,400 x 18% = £6,732
£2,500 x 28% = £700
Total tax £7,432
This means her effective tax rate on the £50,000 profit is just 15%.
It’s impossible to say how much tax she will pay on the remaining four properties because the basic-rate tax band and CGT exemption will change from year to year.
However, based on current tax bands and allowances, her total bill on the £250,000 of capital gains from the five properties will be approximately £37,000.
If Rebecca had sold all of the properties in one go when she was working she would have been able to use just one CGT exemption and all of her gains would have been taxed at 28%, producing a tax bill of £67,172.
This strategy –selling one property per year and postponing the sales until she has no earnings – could save Rebecca just over £30,000 in capital gains tax.
Transfers to Spouses
Many of the potential tax savings you can enjoy by keeping your taxable income low and spreading asset sales over several tax years could potentially be doubled up if the asset is owned by both you and someone else, such as a spouse or relationship partner.
Pre-sale transfers of properties and other investments are therefore likely to become more popular under the new capital gains tax regime.
Prior to the recent CGT changes the maximum tax saving possible from owning an asset like a buy-to-let property with someone else was just £1,818 (£10,100 CGT exemption x 18%).
Now the maximum tax saving possible is £6,568, calculated as follows:
- £2,828 (£10,100 CGT exemption x 28%), plus
- £3,740 (basic-rate band saving)
The potential saving for a property eligible for private letting relief is £17,768.
In summary, it is not always possible to manipulate your taxable income but there are times in life when your income will be lower than normal. This is when you should consider selling assets like investment properties.