The ‘Capital Gains Trap’ can be a problem for property investors. Having built up a portfolio of properties, and having seen that portfolio increase in value (though not, unfortunately, in the last couple of years!), they may find themselves faced with a significant capital gains tax (CGT )bill if they sell those properties.
The rate of CGT is 28% for disposals of let property. There is some tinkering at the edges that can be done, such as transferring an interest in the property to a spouse with little or no income (CGT is charged at 18% until you cross the threshold for higher rate tax, with income and gains above about £42,500), and of course losses on one property can be set off against gains on another – but only if the loss is in the same or an earlier tax year.
Enterprise Investment Scheme (EIS)
It is here that the Enterprise Investment Scheme (EIS) can come to the rescue, providing several important tax reliefs for those who invest in newly issued shares in a ‘qualifying company’:
• An income tax repayment of 30% of the sum invested (capped at the amount of income tax actually paid in the tax year of the investment or the previous year).
• A deferral of any capital gains in the three years before (and one year after) the date of the EIS investment equal to the sum invested, until the EIS shares are disposed of.
• Exemption from CGT on any gains arising on the EIS shares themselves, but loss relief against either capital gains or against income if the EIS shares make a loss.
Up to £500,000 can be invested in EIS shares in 2011/12, and the plan is to increase this limit to £1million from 6 April 2012.
A ‘qualifying company’ is, broadly, a trading company which is not asset-backed (so hotels, for example, do not qualify). In the past this has meant that EIS investments tended to be somewhat risky, but in the last few years specialist promoters have developed strategies for setting up EIS companies that, while providing quite low rates of return on investment, are nevertheless most unlikely to lose money. I am not allowed to name specific companies, but a good IFA will be able to point you in the right direction.
Even if your EIS investment provides no income at all, when you consider the 30% tax relief, it still produces a respectable return. The investment must be held for three years to avoid having the tax relief clawed back, and once the formalities at each end are taken into account you are looking at more like four years. If you invested £100,000 for four years in a conventional share portfolio, in order to produce a £30,000 return after tax it would have to provide income of £40,000 over the period if you were a 40% taxpayer – can you think of any investment that can do that?
Once the ‘quarantine’ period is over, you can cash in your EIS shares, but this will revive any capital gains you have deferred when you invested. Of course, the 30% tax relief would be more than enough to pay the 28% CGT on the gain, but you will no doubt have spent it in the four years. You can however reinvest the funds in another EIS company, and defer the gain again, whilst picking up another 30% in tax relief.
Another useful feature of the EIS is the way it can help with the timing of gains and losses. It is all very well to say that you must realise losses in the same or an earlier tax year to the gains you wish to set them against, but in the real world of property investment that is not always easy to do – the loss bearing properties may be harder to shift than the ones with gains. By investing the gains in an EIS company, you give yourself a minimum of four years to realise those losses before the gains come back again when the EIS shares are disposed of.
This is a sample article from the monthly Property Tax Insider magazine. Go here to get your first free issue of Property Tax Insider.