Take advantage of this CGT loophole

Audible murmurs of relief were expressed in some quarters when capital gains tax was increased to only 28% in the emergency Budget, given that there had been an assumption it would rise to 40 or 50%.

There is evidence that higher earners will take all possible measures to convert income into capital when the CGT rate is far lower than the top rate of income tax.

Looking back only a few years, CGT was taxed at the individual's marginal income tax rate, so there was no reason to try and convert income into capital for tax reasons.

Chancellor George Osborne clearly listened to those who argued that it would be unfair to introduce an even higher rate, as there is no longer any allowance under CGT for the effects of inflation.

As such, an asset held for 10 years, and taxed on a sale at 40%, would effectively be taxed at a much higher rate because some of the gain would purely be as a result of the general increase in prices. So it could be argued that 28% is still quite a high rate.

Nevertheless, the 28% rate only applies to higher-rate income taxpayers. Basic-rate taxpayers and non-taxpayers continue to pay 18%, which is probably something the Lib Dems pushed for in an effort to make the tax more progressive.

One other mooted change (favoured by the Lib Dems) that did not take place was a reduction in the annual CGT exemption, which is currently £10,100.

The view prevailed that taxing relatively modest annual gains would raise a disproportionately small amount of tax for the effort involved, and it would bring many more people into the tax-reporting net.

There were some unusual aspects to the tax rise. First, the rate went into effect from midnight on Budget day (23 June 2010) part way through the year. This means that gains realised up to 22 June are taxed at 18%; those after that date are taxed at either 18% or 28%.

This inevitably brings complications. The year must be split in two and gains in each part must be calculated separately.

You might ask why Osborne did not make the change from the start of this tax year or the next tax year. But Backdating the change would be unfair because people would have made decisions about selling (or not selling) based on an assumed tax rate of 18%.

An announcement about making the change from next year would have started a stampede to sell prior to 6 April 2011, which could distort or destabilise the share and housing markets. Hence the rather messy tax position for this year.

When a disposal actually takes place the critical moment is the date of the contract. In the case of a property, for example, it is when contracts are exchanged, not completed.

If contracts are exchanged on 20 June, but completed on 20 July, the disposal is before the change in the rate of CGT, so the rate that applies will be 18%.

How do these new rates work in practice?

Take Steve, who made a capital gain of £20,000 in May 2010, and another gain of £35,000 in August 2010. He has a total income for the year of £30,000.

The personal allowance for 2010-11 is £6,475, and the higher-rate tax threshold is £37,400. Adding these together gives you the total taxable income limit above which the 28% CGT rate would kick in: a level of £43,875.

The pre-23 June gain is taxed at the flat rate of 18%. To calculate the post-22 June gain, Steve needs to compare his income with the higher-rate income tax threshold after taking into account the personal allowance.

As his taxable income is £30,000, after deducting the personal allowance his income is £23,525, which is lower than the higher-rate tax threshold by £13,875.

As a result, this amount of the taxable gain is taxed at 18%, with the rest at 28%. However, before calculating this tax Steve can choose which gains to absorb his annual CGT exemption of £10,100.

As he can't avoid CGT at the higher rate of 28% for the post-22 June gain, he should set the annual exemption against this gain, which brings the taxable post-22 June gain down to £24,900 (£35,000 less £10,100).

The first £13,875 is taxed at 18% as this uses up his basic-rate tax band, and the remaining gain of £11,025 is taxed at the higher rate.

If Steve had any losses in the year he would offset these - like the annual exemption - in the way that minimises his CGT, so in-year losses, whether realised before or after 23 June, and losses brought forward from earlier years would be offset against the post-22 June gains to minimise the gains taxed at 28%.

Note one other point. The gains pre-23 June are ignored when comparing post-22 June gains with the level of income for the year.

This split-year complication will not recur in future years. The annual exemption will be deducted from total gains, and the resultant taxable gain will be taxed at either 18%, 28%, or a bit of each depending on the level of income for the individual.

Entrepreneurs get a higher threshold

Entrepreneurial CGT relief, under which CGT is charged at only 10%, is retained and boosted by a higher lifetime limit of £5 million. Again, the interaction with the split-year CGT rate has some interesting effects.

If an entrepreneur made a gain before Budget day, and another one after that date, the lifetime limit rule may affect the tax paid.

However, in determining what rate of CGT is charged on any gains not qualifying for the entrepreneur's relief, the gains qualifying for entrepreneur's relief are set against any unused basic-rate band before non-qualifying gains.

Take Lisa, for example, a serial entrepreneur who has, in the past, made gains of £1 million. She sells one business on 1 June 2010, making a gain of £2 million, and another one in February 2011 for £4 million. Her income after deducting her personal allowance is £25,000.

The first gain of £2 million is compared with the existing lifetime limit of £2 million. She had previously made gains of £1 million, so only £1 million of the June disposal qualifies for the entrepreneur's rate of 10%; the other £1 million is taxed at the normal CGT rate of 18%.

For the disposal in February 2011, the lifetime limit has now risen to £5 million, of which she has used up £2 million, so a further £3 million is available at the entrepreneur's rate. Of the rest, £1 million is taxed at the same rate as applies to everyone else: either 18%, 28%, or a mixture.

However, the £3 million of the gain taxed at 10% is taken into account in priority to the other gains that fall outside the entrepreneur's relief in determining whether total income and gains exceed the basic-rate tax band.

As a result, none of the basic-rate band remains, so all of the remaining £1 million gain is taxed at 28% (after deducting the annual exemption).

This article was originally published in Money Observer - Moneywise's sister publication - in August 2010