Property letting can generate a useful income stream for a spouse who has little or no other income to soak up the annual tax-free personal income tax allowance (£7,475 for 2011/12). However, property ownership needs to be arranged correctly to gain the maximum tax advantage.
In England and Wales property may be owned by a couple as ‘joint tenants’ (where each party holds an equal interest in the whole property), or as ‘tenants in common’ (where each party holds a separate and identifiable share in the property – for example, one party holds a 10% share and the other a 90% share).
Where a married couple (or civil partners) own property as joint tenants, any rental income must normally be split equally between them for tax purposes. If the property is held in unequal shares, as tenants in common, the couple can make a declaration on HMRC form 17 to have the rents taxed in the proportion that they hold the beneficial interest in the property. Without the form 17 declaration, the couple will be taxed on an equal share of the net rents from a jointly owned property.
The election takes the form of a declaration of the respective beneficial entitlements of both the income and the underlying property, and must be notified (on the form 17) to HMRC within 60 days of it being made. It has effect in relation to income arising on or after the date it was made and continues in effect unless and until a change occurs in the beneficial entitlements in either the income or the underlying property.
For couples who already own a property as joint tenants it is quite simple to change the ownership status to tenants-in-common but there may be a stamp duty land tax charge where the property is mortgaged.
Capital Gains Tax (CGT)
Transfers between husbands and wives and civil partners are generally exempt from inheritance tax (IHT) and capital gains tax (CGT).
The basic rule for CGT purposes is that inter-spouse (or inter-civil partner) transfers (assuming the couples are living together) take place at ‘no gain/no loss’ and at the date of the transfer. It is, however, important to note that although the transfer takes place at no gain/no loss, a disposal for CGT purposes does still occur.
Broadly, the spouse or partner to whom the property is transferred acquires the interest in the property at the original cost to the transferor spouse or civil partner.
The acquiring spouse or civil partner is deemed to have acquired the asset at the transferring spouse or civil partner’s original cost (plus indexation for pre-5 April 2008 transfers). Where a person who has acquired an asset under these provisions disposes of it after 5 April 2008, indexation allowance will continue to be included in the cost (where applicable) and will not be stripped out.
This provision is of benefit to wealthier married couples and civil partners as it allows them to make optimum use of both their CGT annual exemptions. Transfers between spouses and civil partners can also be used to:
• avoid the situation arising where one spouse or civil partner has gains in excess of their annual exemption and the other spouse or civil partner unrelieved losses; and
• to reduce a capital gains tax (CGT) liability where one spouse or civil partner pays tax at a lower rate than the other.
Although spouses and civil partners are connected persons for CGT, transactions between them are not considered to take place at market value unless they are divorced or their partnership dissolved. If the parties become permanently separated during the year, the relief continues to apply to transfers made between them until the end of the tax year.
When spouses and civil partners transfer assets between them, the transfer must be an outright gift with no conditions attached to it. The transferring spouse or civil partner must not continue to control the asset or derive a benefit from it after the transfer, otherwise it will fall foul of the ‘settlements’ anti-avoidance provisions.
There is, however, nothing to stop the spouse or civil partner who received the gift giving it back to the other spouse or civil partner at a later date, leaving it to them in a will, or making another different gift to the transferor spouse or civil partner at a later date.
It should also be remembered that such transfers could be challenged by HMRC under what is known as Ramsay principle. In this famous tax case it was held by the House of Lords that the courts must look behind the individual steps of a transaction to ascertain the legal nature of the series of transactions as a whole.
The decision in the case was interpreted as meaning that the courts were entitled to disregard steps in a transaction (whether or not achieving a legitimate commercial end) inserted for no commercial purpose other than avoidance of tax liability.
In relation to transfers of property between spouses or civil partners, for Ramsay to apply, the inter-spouse/civil partner transfer would have to form part of a series of transactions designed to produce a tax benefit, or be a sham. For example, this could occur where the transferee spouse or civil partner agrees to return an equivalent sum to the transferor rather than keep the asset as would be the case with an outright gift.
A transfer made only shortly before an eventual sale to a third party could also come under scrutiny by HMRC.
As highlighted above, the gift of a property is taxable even if no money changes hands. If the exemption for transfers between spouses and civil partners does not apply, it may be possible to get around the CGT implications by using a discretionary trust.
In simple terms a trust is set up and the property is transferred into it. The trustees have the discretion to decide on various matters relating to the trust, the property held within in, and the entitlement to income etc. paid to the beneficiaries. Once the trust is set up, the person to whom the transferor wishes to give the property becomes a beneficiary of the trust.
There would normally be a CGT charge at this stage, but it is possible to postpone this by making an election (under Taxation Charge Gains Act 1992, section 260). Broadly, this election transfers the profit on the property already made to the date of transfer into the discretionary trust. When the trustees eventually sell the property they will pay tax on the increase in value of the property from the date it was originally acquired. Note that the person transferring the property cannot be a beneficiary of the trust for these purposes, as the CGT relief is not available in those circumstances. The same applies to spouses, civil partners and minor children.
The gift of a property into a discretionary trust is subject to an immediate inheritance tax (IHT) charge calculated at a lifetime rate of 20% on the value of the property in excess of £325,000. So if the property is worth less than £325,000 and no other assets have been gifted into a discretionary trust within the last seven years, IHT is charged at 0%, and no tax is actually paid.
Stamp Duty Land Tax
Stamp duty land tax is not charged on the value of inter-spouse/civil partner gifts as long as the property is not mortgaged.
It is recommended that proper proof of gifts between spouses and civil partners is retained, and where the transfer involves property or shares, the proper legal formalities must be complied with. It may also be helpful to write a letter to accompany the gift.
By Sarah Laing
This article was first printed in Property Tax Insider in June 2011.