Capital Gains Tax

A holiday home can cost you in tax

We get lots of questions from viewers about Capital Gains Tax (CGT). Hardly surprising as it's so complicated.

We've taken some of the most common queries and tried to explain things. But this is just a guide - get proper advice if you're unsure about your own situation.

What is a capital gain?

To put it simply you get a capital gain when you buy something as an investment and its value increases.

This increase only matters, or - in tax terminology - is realised, when you sell the asset. The difference between the price you paid and the price you sold at, is considered to be your capital gain.

Most of the questions we get at Working Lunch are about shares, but other investments which can be subject to CGT include land, property and business assets.

How is it calculated?

A simple question - if only the answer could be as short!

Like most taxes you're allowed an annual exemption before you have to start paying the tax. For tax year 2005/06) you can have an annual gain of up to £8,500 before you start paying CGT.

The rate you pay depends on your marginal income tax rate. So if you're a higher rate taxpayer (40%) then you pay CGT at 40%. If you're a basic rate taxpayer (22%) you pay tax at a lower rate - not, however, at 22% but at 20%.

Already you're beginning to discover the joys of CGT and why it's such a complex tax to calculate.

Finally, if you're a 10% taxpayer you pay at that rate. But of course, if you do make a big gain it could easily put you into the 40% tax bracket - so you pay some CGT at 10% some at 20% and some at 40%.

If your head is already spinning, let's try and work through an easy example, based on a question that John, a Working Lunch viewer, sent to us.

John says, "If I should hypothetically buy £10,000 worth of shares today, and sell them for £20,000 a year down the line, what would I pay tax on? Is it the £20,000 value less the CGT allowance for the year, or the £10,000 profit on the deal less the CGT allowance?"

To calculate the capital gain you need to deduct the original cost of the shares (£10,000) from the amount received when the shares were sold (£20,000).

Capital gain = £20,000 - £10,000 = £10,000

But you don't have to pay tax on the whole £10,000.

To work out the taxable gain we need to deduct the annual allowance of £8,500.

Taxable gain = £10,000 - £8,500 = £1,500

This taxable gain of £1,500 is the figure CGT would apply to. So the amount John would have to pay would be:

Higher rate taxpayer: £600 (40% of £1,500)

Standard rate taxpayer: £300 (20% of £1,500)

Of course that's a highly simplified example of a CGT calculation. There are normally many more complications you need to take into account when working out CGT.

As one small point, you can deduct the costs of buying and selling the asset when working out the gain.

Am I allowed to include losses when working out my CGT liability?

Yes, you are. Let's consider the above example again. If, in the same tax year, John had sold another set of shares but this time made a loss of £3,000 he could set this loss against the gain he'd made on the other deal.
Now his taxable gain is £10,000 (the profit on the first deal) less £3,000 (the loss on the second deal) which equals £7,000.

As £7,000 is within the CGT allowance of £8,500, John now doesn't have to pay CGT.

Does my CGT liability reduce the longer I hold on to an asset?

The short answer to this question is yes.

The long answer comes when you try to explain it!

Basically, until April 1998 you were allowed to make an adjustment for inflation (called an indexation allowance) calculated by the rise in the Retail Price Index over the time you've held the asset.

This means that if you held an asset for a number of years you could offset the effects of inflation on the asset's price.

However, in April 1998 the system changed to something called 'taper relief'.

What this means is the longer you hold an asset, the less CGT you pay. And if it's a business asset you hold, CGT reduces even faster.

If you've held an asset since 1990, you'd still get the indexation allowance for the period 1990-98, but then taper relief kicks in.

Fun, isn't it?

Can I transfer shares or assets to my spouse without being liable for CGT?

Yes you can, which can be quite useful if one half of a couple has already used up their CGT exemption for the tax year.

By transferring ownership of shares (or other assets) to a spouse, couples can make use of both their annual CGT exemptions. This is because such a transfer is treated for tax purposes as being made at cost.

But this treatment only applies to married couples - it doesn't apply to live-in partners or other friends or relatives.

How do I calculate my CGT liability on my windfall shares?

For CGT purposes if you received these shares free and you then sell them, the entire amount you receive is counted as a capital gain.

It's not the same if you bought shares in one of the privatised companies. Here the capital gain is the amount you receive when you sell the shares, less the amount you paid for them originally.

If I've bought more than one block of shares in a company and I then decide to sell some of them, which shares am I deemed to have sold?

Basically the rule here is "last in first out" (LIFO).

So the shares you most recently bought are the ones first sold. Let's consider an example.

In year 1 John buys 1,000 shares which cost £1 each.

In year 2 he buys another block of 1000 shares in the same company, except now the share price has risen to £2.

In year 3 he decides to sell 500 shares, and by now the share price has risen to £3.

John's proceeds from the sale will be 500 x £3 = £1,500.

Using the LIFO rule the shares he sold will be from the batch he bought at £2, so these will have cost him 50 x £2 =£1,000. So the gain relevant for CGT purposes here will be £1,500 - £1,000 = £500.

But not everything is quite so simple. Shares bought before 1998 are all aggregated in a pool - unless they were bought before 1982 in which case they're in another pool!

Do I have to pay CGT on my PEP or ISA?

At last! A question with a simple answer! And the answer is - no.

Any gains made on assets held within a personal equity plan (Pep) or individual savings account (Isa) are free from capital gains tax.

Do I have to pay CGT when I sell my house?

In most cases you don't, as long as the house you're selling has been your only home or main residence.

But if you own further properties - like a holiday home, or a flat you've bought to let out - CGT does apply when you sell them.

What is bed and breakfasting?

The phrase conjures up rather surreal images of people sending their share certificates off to the seaside for a well-earned break.

As you might expect the truth is rather more mundane.

Bed and breakfasting refers to a practice which usually took place towards the end of every tax year.

Shareowners would sell their shares late in the tax year and buy them back the next morning, often for only a small charge from their broker.

Why go to this trouble? Well, by doing this shareholders could "lock-in" any gains their shares had made over the previous 12 months and set it against their annual CGT allowance.
Unfortunately the Inland Revenue has now put a stop to this by changing the calculation rules.

Now if you do a bed and breakfast (or sell and buy-back shares within 30 days) the taxman will put the two halves of the deal together to calculate any gain or loss, rather than referring the sale of the shares back to the original purchase.

Head still spinning? Let's explain that.

John buys 100 shares worth £5,000. One year later, he sells the shares for £10,000. The next day he buys 100 shares back again and they cost him £10,100 (assuming a small movement in the share price).

Under the new CGT rules the taxable gain is worked out by comparing the two sides of the B&B deal.

So the gain for CGT purposes is £10,000 less £10,100 - so John's made a loss of £100.

If one year later John then sells the shares for £15,000 the taxable gain is £15,000 less £5,000 (i.e. the original cost of the shares) which is £10,000.

Obviously as this is above the annual allowance of £8,500 John will incur a CGT bill.

We warned you it was a complex subject.

These answers are just a guide - if you want to know more you should contact the Inland Revenue (who publish some helpful guides) or take professional advice from a tax adviser (now you know why they get paid so much!).