As the sun begins to peak its way through the clouds, dreamers begin to consider the potential of investing in a holiday home. Investing in a holiday home can be a rewarding venture, offering both personal enjoyment and potential financial gain. However, amidst the excitement of acquiring a second property, forward planning is crucial, especially when considering tax implications for future disposal of the asset.
Inheritance Tax
It is important to understand the tax implications when purchasing a second property, as it is likely to impact to the Inheritance Tax liability for your Estate. Inheritance Tax is levied on the value of your Estate upon death, including property, and will be charged on the part of your Estate which does not benefit from the various exemptions or reliefs.
- The Nil Rate Bands: Every individual has a Nil Rate Band of £325,000 which is the amount of your Estate that passes tax-free (subject to any reductions by gifts made in the seven years before death). Each individual also has a Residence Nil Rate Band of £175,000 which is conditional upon you leaving a property to your lineal descendants (i.e., children and grandchildren) when you die.
- Spouse exemption: There is benefit for those who are married or civil partners, as the Inheritance Tax spouse exemption will apply on the first death, meaning that all assets, including property, that pass to the survivor will be free of Inheritance Tax.
- The 'transferable allowances': On the second death, spouses can also benefit from the 'transferrable' Nil Rate Band and Residence Nil Rate Band of their predeceased spouse if unused on the first death. This means that there could be up to £1m of tax-free allowance to use on the second death.
These exemptions and reliefs will be relevant when considering the purchase of a second property as it is likely to increase the size of your Estate for Inheritance Tax purposes. Whilst up to £1 million of your Estate could pass tax-free, sizeable assets such as properties could use up the tax-free allowances and leave your other assets liable to Inheritance Tax at 40%.
One way of mitigating Inheritance Tax is making lifetime gifts. Any gift, whether money, property or otherwise, is considered a Potentially Exempt Transfer (PET). During your lifetime, you can make as many PETs as you wish of an unlimited value. However, there are important tax considerations to be had when making lifetime gifts:
- If you make gifts over your annual allowance (£3,000) and die within seven years of making that gift, the gift becomes a PET and starts to utilise your Nil Rate Band. Therefore, if you made a gift worth more than £325,000 and did not survive seven years from making that gift, the amount in excess of £325,000 would be subject to Inheritance at 40%. If the intention is to buy a second property, but to gift it to children to reduce the value of the Estate on death, you should be aware of the seven-year rule and the Inheritance Tax implications should you not survive seven years.
- When making lifetime gifts, the individual must also be aware of HMRC's 'gift with reservation of benefit' rules. This captures a situation where a person still retains the benefit of an asset they have gifted. The 'gift with reservation of benefit' rules mean that HMRC may seek to bring the value of that gifted asset back into your Estate for Inheritance Tax purposes. If the intention is to buy a second property and to gift it to children but you still use it yourself or as your holiday home, there is a risk that HMRC will not treat it as a gift at all and there could still be an Inheritance Tax charge on your Estate for this gift, despite surviving years.
Utilising tools like trusts, lifetime gifts, or life insurance can help mitigate Inheritance Tax burdens. It is worth seeking advice from estate planning professionals who can provide insights into optimising tax efficiency and implementing strategies to minimise the impact of Inheritance Tax when acquiring a second property.
Capital Gains Tax
Capital Gains Tax (CGT) is levied on the profit made from selling an asset, including property. Therefore, if there is an increase in the value of an asset from the date of purchase, this could trigger a CGT liability and HMRC reporting requirement. The extent of any CGT liability will be dependent on multiple factors, including the use of the property.
- Principle Private Residence relief (PPR): You do not pay CGT when you sell your home if you have lived in it as your main home for all the time you have owned it. When you own two properties, the PPR relief will not apply to both properties. There are complex rules regarding PPR when you own a second home and advice should be sought on the election of PPR in these circumstances.
- CGT allowance: Every individual has a CGT annual allowance, which until recently stood at £6,000. However, the Government announced in the Spring Budget that this allowance would be halved to £3,000. Across the period of ownership of the property, its value is likely to increase, and the sale of a second property is therefore likely to trigger a CGT liability. A basic rate taxpayer will pay CGT on any gain at 18% and a higher rate taxpayer will pay CGT on a gain at 28%, although this has just been reduced to 24% in the Spring Budget. The individual must also file a CGT Property Disposal Return with HMRC and pay the CGT within 60 days of selling the property otherwise penalties will be issued by HMRC.
- In instances where the second property is being rented or let out, there is a potential to claim Business Asset Disposal Relief. There are specific criteria to claim this relief, but if successful the CGT will be reduced to 10%.
Disposing of a second home has complex tax implications and reporting requirements and advice should be sought not only at the stage of selling an asset, but also when it is bought to ensure that the necessary tax planning has been put in place as early as possible to mitigate potential CGT charges
So what next?
Prospective holiday home buyers should always seek advice when purchasing second homes to plan ahead for Inheritance Tax and CGT.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.