Incorporation relief and latent gains explained

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A common question asked by landlords who are considering the transfer of their rental property business into a Limited Company is this; how does incorporation relief work and what does washing out Capital Gains Tax (CGT) on incorporation actually mean?

I will explain this first using an analogy, which will make a lot more sense when I then relate it back to the question.

Imagine you have just cleaned a muddy floor with a white towel. The towel isn’t white any more is it? This is because the mud has been transferred from the floor onto the towel. The floor might well be clear of mud but the towel isn’t is it? The mud still exists, it has merely been transferred.

There is no less mud after the transition than there was before. You have simply moved the unwanted mud from an inconvenient position to a more convenient position for you.

In this analogy the mud represents the capital gains on which CGT is ordinarily payable and the towel represents shares in your new company.

When a property rental business is transferred into a company it is treated as a sale, which crystallises capital gains. However, a piece of legislation called TCGA92/S162 enables business owners to exchange equity in their business for shares and to offset the value of the shares created (the value of the equity in the business) against the capital gain resulting from the sale of the business, to reduce or even eliminate the payment of CGT at this point by deferring it. Effectively, the capital gains have been transferred from the properties into the shares in the company, much like the mud being transferred from the floor to the towel.

Imagine a scenario where a property was originally purchased for £100,000 but transferred to a company for £200,000. If that property was sold for £200,000 the following day, the company would have made no profit, hence there would be no tax dues. This is because the £100,000 of capital gain has been washed out of the property and into the company shares. The CGT is deferred until the shares (not the properties) are disposed of.

However, there is a scenario where CGT would not fall due on disposal of the company shares, i.e. if the owner of the shares dies before they are transferred – rather an extreme way to avoid paying tax though!

The above often leads to another question; “what are latent gains?”

Latent gains occur when equity in your business is less than your capital gains. Capital gains are current value minus acquisition costs. Equity is current value minus liabilities. If a latent gain exists, it is because you have insufficient equity to convert into shares in order to offset all of your capital gains at the point of incorporation. Accordingly, CGT remains payable on the element of latent gains. There are only a few ways to avoid this problem. The first is to move abroad and become non-resident, in which case your acquisition costs are deemed to be the value of your properties as of April 2015, or the date you purchased them if they were acquired after April 2015. The others are to reduce your debt, or to add assets to the business, so that your equity is the same level as your capital gains.

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