Tax-Free Assets: Property
Developing Your Home
MOST PEOPLE benefit from the principal private residence exemption at least once in their life – often several times. The exemption ensures that the gain arising on the sale of your own home escapes tax.
In most cases, the owner simply benefits in a completely passive way: enjoying the tax-free capital growth brought about by general house price inflation (not so much over the last couple of years, of course, but usually).
But, since your home is your greatest tax-free asset, you might want to increase your tax-free profits by developing it. This can be achieved in a number of ways, but there are also a few pitfalls to watch out for!
Starting at the simplest end of the scale, you could consider adding value to your home by adding an extra bathroom, building an extension, or adding other features such as a garage or a swimming pool. As long as you continue to use the house for a reasonable period (say a year or two) after the new additions are built, you will be exempt from tax on the extra growth in value.
You could even move out of the house and rent it out for several years before selling it and still benefit from tax-free capital growth. (You can always rent out a former home for at least three years and still be exempt from Capital Gains Tax (CGT); usually the tax-free period is even longer due to private letting relief.)
The one thing you have to avoid is selling the property immediately, or very soon, after the new features or additions are added: that could make you a developer subject to both Income Tax and National Insurance on the extra profits generated by the building work.
Planning a Profit
Simply obtaining planning permission for the development of your home will often increase its value. If you then simply sell it without carrying out the development, you will enjoy this additional ‘profit’ tax-free.
Another way to enhance the value of your property may be to convert it into a larger number of dwellings – e.g. convert a detached house into two semi-detached houses or convert a large house into a number of flats.
A sale immediately after the development will again make you a developer subject to Income Tax and National Insurance on the additional profits generated by the conversion. If, however, you retain the new dwellings for a reasonable period, you will only be subject to CGT.
For CGT purposes, you will continue to be exempt on the growth in value of your home up to the point when the conversion work started. You will also be exempt on the proportion of any subsequent increase in value which relates to one of the new dwellings that you adopt as your new home. By moving around between the new dwellings, you may be able to exempt a significant proportion of the capital gain on the entire project.
Donna has a large house which she has lived in for many years. It is currently worth £750,000. She now develops the house into three, equal-sized, luxury apartments at a cost of £150,000.
Following the development, Donna lives in Apartment 1 for a year. She then moves to Apartment 2 where she lives for a year before moving to Apartment 3 for three years. Throughout this time, Donna rents out the two apartments which she is not living in. Five years after completing the development, Donna sells all three apartments for £500,000 each.
Donna can deduct £250,000 from each apartment’s sale proceeds in respect of the value of the original house (£750,000 x 1/3) plus £50,000 in respect of the conversion work (£150,000 x 1/3). This leaves her with a capital gain of £200,000 on each apartment.
For Apartments 1 and 2, Donna is exempt from CGT for the year she lived in them plus the last three years of ownership. Hence, for each apartment, she is exempt on four fifths of her gain, leaving just £40,000. This is covered by private letting relief, giving her a completely tax-free profit on these two apartments.
For Apartment 3, Donna is exempt on three fifths of her gain and can also claim £40,000 of private letting relief plus her annual exemption of £10,100. This leaves her with a taxable gain of £29,900 and a CGT bill (at 18%) of just £5,382.
Donna’s tax bill amounts to less than 1% of her total gain of £600,000 since starting the development and she’s still fully exempt on the gain arising on the original house before then.
Note that up to £40,000 of private letting relief is available on each apartment on the basis that each dwelling has a separate legal title after the conversion. This is unaffected by whether Donna sells all the properties in the same tax year.
As we can see from the example, the tax benefits of developing your own home can be enormous. Remember though, that it is absolutely essential to hold on to the developed property for a reasonable length of time in order to avoid being classed as a developer with a total tax burden of up to 51%.
Something in the Garden
For those with large enough gardens or grounds, another good way to generate extra tax-free growth from your home is to either sell off a building plot or to develop another property yourself.
Where the total area of your garden or grounds is no more than half a hectare (including the ground on which the house itself stands), all of the land will enjoy the same level of principal private residence exemption as your home. Hence, if your house is fully exempt from CGT then so is any part of your grounds which you sell.
When selling off a building plot, however, it is absolutely vital to ensure that the land is still in private use as part of your garden at the time of sale. Don’t even fence it off: this would mean that you lose your exemption on the plot.
Alternatively, you could develop a new property in your own grounds. Here, the issues are much the same as for a conversion: firstly, you need to ensure that you retain the new property for a reasonable period in order to avoid being taxed as a developer; secondly, you can avoid or reduce the CGT on the new property by adopting it as your home.Avoiding CGT on the new property means moving out of your old home but remember that you can rent out the old house and still be exempt from CGT for at least three years.