At first glance, many people would consider the capital gains tax calculation on a guesthouse sale as reasonably straightforward. You need to consider the cost of the property, cost of finance, investment and the eventual sale price. However, there are many different issues you may wish to explore.
The two main scenarios are purchasing a guesthouse in your name and buying a guesthouse within a limited company. As they are both operated as commercial ventures, it is easy to assume that the best course of action would be ownership through a limited company. But is this true for everyone?
A couple decides to retire, sell their primary residence and acquire a guesthouse to run as a business. They will use proceeds from the sale of their home to fund the guesthouse purchase. Therefore no finance will be required. The gentleman has just retired from full-time employment, where he was paid £75,000 a year through the PAYE system. The guesthouse was purchased for £1 million, and they will live in the property.
Their long-term aim is to live off the guesthouse income, build their business in the future and sell the guesthouse in 10 years for a profit. There is no capital gains tax to pay on the sale of their home as this was their principal private residence and is therefore exempt.
Buying a guesthouse through a limited company
The first thing to remember with limited company ownership is that the company owns the property. Consequently, the array of personal tax allowances and offsets available to individuals and couples is not applicable. However, there are additional allowances and ways in which you can reduce any tax liability.
Corporation tax, not capital gains tax
Companies are not exposed to capital gains tax; instead, they pay corporation tax on any gains made within the company. In March 2021, the Chancellor of the Exchequer confirmed a proposed increase in corporation tax, from 19% up to 25%, had been delayed. The increased rate will come into effect on 1 April 2023.
As a side note, if you are looking to release net funds from the sale of a property to shareholders/directors, this would be done via salary or dividends. Each of these options would be liable for tax, dependent upon your higher rate of income tax. This is in addition to corporation tax paid by the company.
Lending funds to your company
In this scenario, the retired couple would look to lend £1 million to the company to fund the acquisition of the guest house. They can legitimately charge a commercial interest rate on the loan, which would be completed in the same manner as a commercial loan. The loan interest would be deducted from company profits. The interest received will be part of the couple's taxable income and reported to the authorities by the company each quarter using a CT61 form. This would reduce the company’s overall profit and corporation tax liability.
When acquiring a commercial property, such as a guesthouse, an element of the purchase price will typically cover the value of fixtures/integral features within the property. This might include:-
- Heating systems
- Electrical systems
- Kitchen equipment
It would not be uncommon for 20% of the purchase price of a guesthouse to be offset as a capital allowance. This capital allowance can be offset against future profits of the company, creating significant tax savings. The current corporation tax rate is 19%, although this will increase to 25% in the 2023/24 tax year.
Acquiring a guesthouse in your name
As the guesthouse is being run as a commercial business, many people automatically assume it should be held within a limited company. There will be situations where this is the best course of action but not always. We will now examine the pros and cons of acquiring a guesthouse in your name and the capital gains tax implications in the long term.
Capital gains tax
If you are self-employed and have assets registered in your name, you may be liable to tax on future capital gains. This is very different from limited companies with no capital gains tax element, where corporation tax is charged on annual profits.
Individuals also have a capital gains tax-free allowance, which is currently £12,300 per annum. As a couple, this equates to £24,600 per annum. Consequently, when crystallising a profit on the sale of an asset, the first £24,600 would not be liable to capital gains tax. Instead, the balance of any capital gain would be added to your income and charged at the appropriate rate.
In this scenario, the couple will live in the guesthouse. They can therefore offset their private accommodation against the value of the guesthouse. If they use 10% of the property for their private accommodation, then this would reduce the commercial element of the cost by £100,000. This would also shield 10% of the future sale value of the property against capital gains tax.
As the private accommodation element of the property is treated as the couple's primary residence, there will be no capital gains tax liability. If, for example, the guest house was sold for £1.2 million, the calculation will be as follows:-
Purchase price: £1 million
Private residence deduction: £100,000
Cost of Commercial Element: £900,000
Cost of Private Residency Element: £100,000
Property sale: £1.2 million
Commercial element: £1.08 million
Private residency element: £120,000
Capital gain on commercial element: £1.08 million - £900,000 = £180,000
Exempt gain on private element: £120,000 - £100,000 = £20,000
In this instance, only £180,000 of the capital gain (as opposed to £200,000) would be liable to capital gains tax. The current capital gains tax rate is 10% for basic rate taxpayers, rising to 20% for higher rate taxpayers. However, it is essential to note that a significant capital gain could take you from basic rate income tax into the higher bracket, prompting a higher capital gains tax rate.
Business asset disposal relief
When selling a business, you may be able to apply for business asset disposal relief. This means that you will only pay 10% tax on the capital gain instead of a higher rate, dependent on your income.
To qualify for business asset disposal relief, the following must apply at least two years before the date on which the business was sold:-
- You operated as a sole trader/business partner
- You have owned the business for a minimum of two years
The flat tax rate of 10%, against a possible rate of 20% for higher rate taxpayers, could equate to a significant reduction in your tax liability.
As with a company, when acquiring a commercial property, you can deduct the value of fixtures/integral features acquired as part of the deal. As we touched on above, this can include:-
- Heating systems
- Electrical systems
- Kitchen equipment
Ignoring all other deductions for the moment, using the same scenario as above, you would be able to claim £200,000 as a capital allowance against the purchase of the property. However, while companies can offset corporation tax against capital allowances, it is different for individuals.
In this scenario, the gentleman previously on £75,000 a year, paid through the PAYE system, will be able to reclaim income tax going back three years. This is where there is a significant benefit. While the corporation tax rate is only 19%, rising to 25%, this individual paid income tax at 45%. Therefore, he would reclaim a significantly higher element of tax than the company could offset against future profits.
HMRC will also pay interest on tax rebates going back three years!
While HMRC have tightened regulations regarding lettings relief, this is still a very useful offset for those looking to acquire a guesthouse. In the above example, the couple will be living in the guesthouse in a scenario described as “shared occupancy”. This means that landlords and tenants live in the same property at the same time - no part of the property is self-contained. In the above scenario, there are two landlords and therefore two lettings relief allowances.
Lettings relief specifically relates to:-
An individual's gain where private residence relief is available
Periods of “shared occupancy” where landlords and tenants share the same property
Part of the property has at some point been let as residential accommodation
There is a chargeable gain as a consequence of the letting
The amount of relief available is limited to the lower of:-
- The amount of private residence relief in respect of the letting
- The chargeable gain arising as a consequence of the letting
If we look at the following example:-
A couple lived in a property for ten years, five years as a private residence and five years with part of the property let as residential accommodation. On the sale of the property, they crystallised a £120,000 capital gain.
Lettings relief ensures that the property owners pay the tax due on the commercial element while still enjoying their principal residency tax exemption. When calculating the element of gain liable for capital gains tax, HMRC also allows you to treat the final 9 months (recently reduced from 18 months) of ownership as qualifying for letting relief. So the scenario is as follows:-
60 months of private residency plus 9 months of ownership before the sale
As a consequence, the calculation is as follows:-
69/120 = 57.50% of the capital gain is exempt from capital gains tax
51/120 = 42.50% of the capital gain is liable for capital gains tax
However, as the property is jointly owned the capital gain will be split 50/50 between each party. Consequently, the capital gains tax calculation for each party is as follows:-
Share of capital gain: £60,000
Principal residency tax exemption: 57.50% x £60,000 = £34,500
Gross capital gain: £25,500
Individual capital gains tax allowance 2021/22: £12,300
Net gain subject to capital gains tax: £13,200
So, on disposal, in the above scenario, each of the joint owners will pay the appropriate rate of capital gains tax on £13,200. Using the lettings relief, principal residency tax exemption and capital gains tax allowance, a gain of £120,000 has been reduced to a combined £26,400 for capital gains tax purposes.
There are many issues to consider when looking at capital gains and the purchase and sale of guesthouses. It is crucial to consider your broader picture when contemplating whether to use a limited company or operate as a sole trader. There will be a level at which it is more relevant to look at a limited company, but this will depend upon your specific situation. You must take advice as soon as possible so that the tax/business structure allows you to mitigate as much potential future tax as possible.