Cash Clinic: Reducing liability to capital gains tax on a buy-to-let investment

As we approach retirement, we intend to sell the flat in a few years time but want to minimise our exposure to capital gains tax (CGT) on any increase in the flat's value. Could any outstanding debt be offset against the capital gain? For example, if, when sold, the flat had gained 50,000 in value but we had 50,000 outstanding debt on the property, would our CGT exposure be zero? Also, we both pay income tax at the basic 20 per cent level. Given a 50,000 gain (25,000 each), can we each apply our tax-free allowance to reduce the exposure to 40 per cent? If so, in the tax year of sale, could we reduce the burden by paying all of our salaries into pension schemes and live off the proceeds of the sale?

This would reduce our taxable income to zero, perhaps freeing all allowances to reduce the capital-gain exposure. In uncertain times, we might not know when the flat would sell, so we might have to put our salaries into pension schemes using one-off payments after the fact but in the same tax year. Any advice would be most welcome.

JM Glasgow

A The rate of CGT remains at 18 per cent for basic rate taxpayers and rises 28 per cent for higher earners (those with total income and gains of over 37,400). Currently there is no 40 per cent rate of CGT payable. A buy-to-let flat is regarded by HM Revenue & Customs as an investment rather than a business asset so the Entrepreneurs Relief (ER), which brings the tax payable to an effective rate of 10 per cent, does not apply.

To calculate the taxable gain arising from the sale of your buy-to-let flat, you deduct the original cost of the purchase (adding to this the cost of lawyers fees) from the proceeds received (again deducting from this your lawyers fees and any estate agency costs).

The cost of any capital improvements to the property throughout your period of ownership (for example an upgraded kitchen/bathroom) is also factored in. Unfortunately there is no relief available for any outstanding debt against the value of the property.

Each of you has an annual CGT exemption, currently 10,100, to set against your share of the gain and this is unaffected by any other income that you may receive in the year. Conversely, should you not fully utilise your annual personal allowances available to set off against your income for the year, these may not be used against any capital gain that has arisen.

The level of your income in the year the flat is sold will determine the rate at which you pay CGT. You have stated that you both currently pay tax at the basic rate, but should the amount of the gain attributable to each of you, when added on to your taxable income (i.e pension and salary minus your personal allowance), exceed 37,400 CGT will be payable at higher rates over this amount.

Payments from your salary into a pension scheme attract tax relief by extending the amount of your income that is taxed at the basic rate, so it may be that a payment of part of your salary into your pension would ensure that any CGT would be payable at the lower rate. However, I would strongly advise that you take independent financial advice on this type of investment - investment decisions should never be taken purely to obtain a tax advantage, and should always be considered carefully looking at your complete financial position.

• Glen Gilson is partner and head of private client and financial services at HBJ Gateley Wareing.

• If you have a question you need answered, write to Jeff Salway, The Scotsman, 108 Holyrood Road, Edinburgh EH8 8AS or e-mail: [email protected].

This above is for general purposes only and is not tailored for individual use. It does not constitute legal, financial or investment advice on any particular matter and must not be treated as a substitute for specific advice. No action should be taken in reliance of the information given. The Scotsman Publications Ltd and HBJ Gateley Wareing accept no liability on the basis of this article.