Residential relief on property sales – settling with the tax authorities

Mr. and Mrs. Kowalski bought a house in Bathgate in January 2015 for a gross price of £250,000. They lived in this house continuously for 5 years, then bought another property and moved into it in May 2020. The house stood empty for half a year, during which time the Kowalskis carried out a number of modernizations, including adding a garage and converting the attic space into a room. They then rented out the house, initially for residential purposes, and subsequently for business purposes – as offices. In January 2022, the property was sold for £350,000. The question arises: how should Mr. and Mrs. Kowalski settle their tax affairs, and what reliefs can they claim?

What is Capital Gains Tax?

If you sell a house and the price you receive for it is higher than its purchase price, then the profit is the basis for taxation. This tax is called Capital Gains Tax (CGT). However, it can be reduced to zero, or in part, if the taxpayer meets the statutory conditions.

How to reduce CGT?

Often, the amount of tax payable is really high, and nobody likes that. How can it be reduced?

Principle Private Residence Relief (PPR)

This relief can be applied to the entire taxable amount if the property sold was the taxpayer's sole or main residence for the entire period of ownership, as well as in certain legally defined situations where the owner did not live in the property for some time but later made it their main residence again. In the case described above, this was not the situation, as the Kowalskis did not move back into their home after leaving it. In such a situation, they will not be able to deduct the entire tax amount.

Letting Relief – relief for letting out your home

Individuals who let out their property may be able to deduct the full CGT amount. However, those who sold their property on or after April 6, 2020, can only claim this relief if they lived in the property at the same time it was being rented out. This was not the case for the Kowalskis, so this option does not apply to them.

So what can be done to avoid the full CGT liability?

Calculating the tax liability

We have established that in the Kowalskis' case, it is not possible to deduct the full tax liability because the property was not their main residence for the entire period of their ownership.

In this situation, we must divide the amount obtained from the sale of the property into an amount that qualifies for PPR relief and an amount that cannot be deducted from taxation. Such a division is called "apportionment of consideration" and, according to legal regulations, should be made using a “fair and reasonable” method.

What does this mean? Taking the Kowalskis as an example, who owned the house for 7 years, during 5 of which it was their main residence, PPR relief applies only to the period of actual residence, and therefore approximately 76.19% of the profit from the property sale will be exempt from CGT. It is worth remembering that the profit relating to the final period of ownership – usually the last nine months – is always covered by PPR relief.

It is crucial to know that the increase in property value is treated as accruing evenly throughout the entire period of ownership, and not tied to the actual timing of the market value increase, which can occur in a brief moment due to, for example, property modernization or a general rise in property prices on the market.

In the Kowalskis' case, the sudden increase in property value undoubtedly occurred at the time of modernization completion (adding a garage and converting the attic), however, under the regulations, this is irrelevant. The increase in value is treated as accruing evenly throughout the entire seven-year period during which the Kowalskis owned the house.

Using the Kowalskis' example, the determination of the tax-exempt amount will be as follows:

The property was purchased for £250,000 and served as the Kowalskis' main residence for five years. After moving out, the Kowalskis renovated the house, which significantly increased its value. Later, the house was rented out and then sold for £350,000 (after deducting costs, i.e., legal and real estate agency fees), thus the sale of the property yielded a profit of £100,000.

Calculations made based on information regarding exactly how long the Kowalskis were both owners and residents of their home, and for how long they were only owners, allow us to determine that the tax-free amount under PPR relief is £76,190. This means that out of the £100,000 profit, under the given circumstances, only £23,810 will be subject to taxation.

The specific amount of CGT depends on the income tax bracket the taxpayer falls into and can be 10% or 20%; however, it's important to remember that if the capital gain arose (as in the example given) from the sale of property, these amounts will increase and will be 18% and 28% respectively.

However, these are not all the reliefs that can be utilized in this case. To get full information, contact a tax advisor.