Is This REALLY the Way to Avoid Property Taxes?

Over recent months it has come to our attention that a tax strategy referred to by us as ‘never sell a property means no taxes’ has started to get mentioned on various discussion forums, with people saying that this is the solution to all the investor’s property tax problems.

In this article, Arthur and I will discuss the merits and potential pitfalls of this strategy and why it really needs some careful thought before one decides to adopt it.

How Does the Strategy Work?

Quite simply, the strategy involves growing a portfolio without ever selling a single property. As the property prices continue to increase, the owner would then release equity from the property, using it to:

a)    Provide a means of living

b)    Acquire more property

c)     Both of the above

The Benefits of the Strategy.

The main tax benefits can be summarised as follows:

1.     Zero tax on the equity release.
This is probably the ‘biggest tax’ selling point of this strategy. Whenever equity is released from a property, no tax is due.

So, let’s consider an example where John buys a property for £15,000. The property price increases to £200,000. John withdraws £20,000 equity from the property. There is no tax due on this equity release.

2.     Zero capital gains tax (CGT).
Capital gains tax can be avoided purely because the property is never sold. When the owner dies, there is no cgt to pay, because there is never any cgt on death.

3.     Zero (or minimal) inheritance tax.
Inheritance tax is only due on the net value of assets (i.e. the total assets owned, minus the total debts owed) for the inheritors of the estate. Because equity has continuously been released on the property then the amount of debt on the property is likely to be high, perhaps between 75% to 85%.

Because the current IHT threshold level is £300,000 there will need to be a sizeable portfolio before the net assets exceed the IHT threshold limit.

It sounds like the perfect property tax strategy, doesn’t it?

By never selling a property you can take tax-free lump sums from your property, will never pay any capital gain taxes and your loved ones may be able to avoid inheritance taxes.

Before you surge ahead and decide that this strategy is for you then you should also consider the following potential pitfalls.

The Drawbacks of the Strategy.

If you have a 100% loan on the property, and the market value of the property has risen since you acquired it, and therefore you want to release further equity from it, then the following three points need to borne in mind:

1.     Greater income taxes.
It is important to understand that by releasing equity you will not pay any less in annual rental income taxes. If the equity release is used to provide a living, or supplement a lifestyle, then considerably more tax may be due on the rental income profits.

2.     Strategy depends on increasing property prices.
For the strategy to work, property prices must increase. If property prices don’t increase then there simply won’t be any equity available for release.

We all know that property prices have increased significantly over the past few years, but we are now going through a period where property prices have stalled or are even dropping in some areas.

This, of course, means that you may not be able to release equity for several years!

3.     What if rental yield does not increase?
This strategy is also dependant on rental yields increasing. Rental yields must typically also increase before any further equity can be released.

If you have invested in apartment blocks where there are a huge number of existing investors, then you may need to wait a very long time before any of the rental yields increase and further equity can be released.

4.     What if you want to sell up?
Let’s face it, being a landlord may sound like a good idea now but what if, in the future, you want to sell your entire portfolio and rid yourself of the challenges facing landlords.

You may not be able to sell a single property if your debt ratio is so high that the sales proceeds do not even cover the tax liability.

Even with capital gains tax due to be reduced to 18% on 6^th April 2008, you may still not be able to avoid the ‘capital gains’ tax trap.

5.     Minimal inheritance tax
If you plan to pass down a sizeable estate to your loved ones, then this strategy is unlikely to provide any significant tax free lump sums.

Summary

Blindly adopting this strategy can create big problems, such as bankruptcy, as well as tax issues! However, it can work if your ‘investment’ strategy is discussed with a tax advisor and you fully understand the tax, and the non-tax, implications.

Arthur Weller & Amer Siddiq

About Arthur Weller