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A taxing conundrum: How to advise Harry

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Rebecca met an old friend for lunch and discovered he has a whole pile of potential tax problems. How should she advise him? Do you have any good ideas?

22nd Jun 2023
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Last week I met up with a friend I’m calling Harry, to explore the potential tax implications of selling his home and moving to the coast, but the reality was much worse than I feared.

Property issues

Harry lives in a large four-storey house, which is worth about £1m. He inherited the property from his parents on their deaths (different shares at the separate deaths) and bought out his sister at the time of the second death.

The property is now owned on a 50-50 basis by Harry and his wife Sally as tenants in common. This was done so separate shares in the property could be left by each spouse to the children on death.

Harry and Sally occupy only one-third of the property. The basement is let out as a self-contained flat. The upper floors are let as bedsits, which share a front entrance with Harry and Sally’s flat, so these tenants could possibly be considered as lodgers in the main home.

Harry manages the lettings, cleaning and maintenance of the property, which takes a considerable number of hours per week. He considers his business to be property management and declares the income and expenses relating to the let parts of the property on the self-employed pages of his tax return.

There is a small mortgage on the property, which is paid out of Sally’s bank account. Harry has never claimed a deduction for mortgage interest as part of his property management trade.

Harry has a secondary writing business which he declares as a separate trade on his tax returns.

The income from both Harry’s “trades” has generally been below the small profit threshold, so he hasn’t paid class 2 NIC for several years. However, recently he paid a lump sum as voluntary NIC (possibly class 3 NIC, he can’t recall) to make up the gaps in his NIC record and improve his state pension.   

Sally is employed through her own company and has never declared any rental income from the property on her tax return. Sally has an accountant who helps prepare her tax returns, unlike Harry, who completes his own tax returns with no professional assistance.

Capital gains

If Harry and Sally were to sell their property, there would be a significant capital gain based on the difference between the probate value(s) and the sales value. I had to explain to Harry that there is no longer any tax relief for the effect of inflation on capital assets.

Harry suggested turning the property back into one large family home before any potential sale so it would all be covered by the capital gains exemption for a main home, known as principal private residence relief (PPR).

Sadly that is not how PPR works, as the exemption is calculated as the proportion of the period of ownership during which the property has been occupied, or deemed to be occupied, as the taxpayer’s only or main home. Converting the whole property into one home would cost a lot and wouldn’t save much CGT.        

However, if the bedsits could be considered part of Harry and Sally’s home, perhaps PPR would be due on two-thirds of the property gain, not just the third they occupy alone.

Inheritance tax

Harry was concerned about a potential inheritance tax (IHT) bill landing on his death. I was able to reassure him that both he and Sally would benefit from the nil rate band (NRB) of £325,000, and the residence nil rate band (RNRB) of £175,000 if their home was passed to their direct descendants.

Should Harry die before Sally and leave her his entire estate, she would also inherit his unused NRB and RNRB, leaving her with around £1m of IHT exemption. This does raise the question of whether the RNRB would cover the parts of the property which are let out on his death.   

Income tax

Harry has been declaring his property income as a trade for around 25 years. He has not deducted loan interest or paid class 2 NIC on the small profits, so he has probably paid the right amount of tax, but possibly under the wrong heading. Will HMRC be happy with this?

What is more worrying is that Sally has not declared any of the property income. This is not uncommon for properties held by a married couple. They can’t recall making a declaration on form 17 to inform HMRC of the different splits of the beneficial interest for tax purposes.

What would you advise?

Is it best to let old tax dogs lie and carry on declaring the property income as a trade on Harry’s return?

Should any corrections be made to earlier tax returns?

What about Sally’s tax position?

Should the couple be advised to sell up and move before CGT rates get aligned with income tax?

What should be done with a view to IHT planning?

Your views on this taxing conundrum are welcome below the line.     

Replies (23)

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By Justin Bryant
22nd Jun 2023 12:27

DN would simply recommend that they pay the highest tax bill (and penalties) possible (especially IHT), being the greedy, grasping capitalists that they are.

He's likely to report any tax mitigation suggestions here to the PBs of the relevant individuals and recommend to HMRC £1m DoTAS fines etc., not to mention inflicting highly sexed-up public shaming of all concerned.

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Replying to Justin Bryant:
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By Justin Bryant
22nd Jun 2023 15:33

They can just wait for one of them to become terminally ill and do this neat trick (that would no doubt much annoy DN): https://www.accountingweb.co.uk/any-answers/iht-death-bed-planning-and-e...

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Replying to Justin Bryant:
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By Justin Bryant
18th Aug 2023 10:43

I note that my above solution has been approved here: https://www.taxinsider.co.uk/a-family-affair-passing-down-the-property-p...

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Replying to Justin Bryant:
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By farrcorfe
23rd Jun 2023 12:22

Maybe they should quickly liquidate all assets and do a runner abroad for quite a long time!

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By CJaneH
22nd Jun 2023 13:13

This is an example of why tax payers should use an accountant even though HMRC use the terms Self Assessment & Customer, and in their guidance notes do not like to suggest that 'tax payers might be advised to employ advisers.

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By RobbieT
22nd Jun 2023 15:21

I would advise that Sally & Harry engage a tax adviser who can offer advice under the protection of an engagement letter and Professional Indemnity Insurance rather than anyone risk a professional negligence claim for offering financial advice without that protection.

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By ireallyshouldknowthisbut
22nd Jun 2023 15:53

Id find myself quite busy if this guy called me for advice.

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By Hugo Fair
22nd Jun 2023 16:06

It's not 1st April so I can't work out your intention, Rebecca, in raising all these questions?

The scenario covers little that will be untypical of what passes across the desk of most members on here on an all too regular basis - thereby 'proving':
* how ill-equipped (as well as unprepared) is the average unrepresented taxpayer;
* how the 'complexity' of overlapping taxes means that only the represented are likely to get things right - and, more importantly, be in a position to make good decisions before it's too late.

Is this a test of Aweb's policy?
Given that the rules (and lack of LoE / PII cover) prevent us from giving specific advice on which an individual may act ... the article is a fun read but a bit of a 'tease'.

Thanks (4)
Replying to Hugo Fair:
By ireallyshouldknowthisbut
22nd Jun 2023 16:13

@hugo, tell you don't work in practice. This sort of thing arrives all too regularly, albeit it would probably start with a random seemingly sensible question and slowly implodes as more data arises whilst you slowly regret having ever taken this on as you thought it was an hours work to file a cancelled call, and suddenly its an epic 3 month slog for which you end up sending a bill for about half the time, and even then the client is shocked how high it is as they cant comprehend the level of mess they have inadvertently created.

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Replying to ireallyshouldknowthisbut:
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By Hugo Fair
23rd Jun 2023 20:12

Been out for the day ... and puzzled by your response.

I don't disagree with anything in your lengthy 2nd sentence ... so were you confused by the double-negative in my original comment:
"The scenario covers little that will be untypical of what passes across the desk of most members on here on an all too regular basis"
... surely this says the same as your "This sort of thing arrives all too regularly"?

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Replying to Hugo Fair:
Head of woman
By Rebecca Cave
23rd Jun 2023 07:36

This article was intended to prompt discussion of the real underlying tax problems, which have several alternative solutions.
I agree with your very valid points about the complexity of overlapping taxes and how unprepared taxpayers are to deal with such issues.

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By rockallj
22nd Jun 2023 17:33

Imagine reporting that lot under MTD. These are queries we accountants deal with regularly.

But reporting this lot to HMRC?
Their systems would implode.

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By johnthegood
22nd Jun 2023 17:50

first question has to be, who paid for lunch?

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By BV
23rd Jun 2023 10:18

I had a similar situation a few years ago, when I found that a new client was not registered for VAT, he was not putting staff wages through a PAYE scheme, he thought he was running a limited company but everything was in his sole name, he had not registered for self-employment, nor paid class 2.

I said I would take him on, but only if we put everything right, which he agreed, so we registered late for self-employment, late for VAT, and late for PAYE, and submitted all the missing returns.

Because there were so many issues, I advised we make an appointment to see HMRC and plead for forgiveness. We and sat for an hour going through the issues, which I had covered in a letter I took with me. They did not want the letter, instead the officer asked me to talk through it and she input as we went along, the next day I set my letter just in case she had missed anything.

While the HMRC officer was inputting, she said 'no-one is going to want to touch this with all the problems' and she was correct, we never heard back!

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Replying to BV:
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By Justin Bryant
23rd Jun 2023 10:33

I'm sure if they were employing and paying their children a salary, all hell would have broken loose with HMRC there - at least according to some people here.

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By indomitable
23rd Jun 2023 11:13

He needs a tax advisor!!

It is unwise for anyone to provide advice here unless the have signed a letter of engagement and are a client and covered under PI insurance

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By Taxedtothemax
23rd Jun 2023 12:02

I would advise him to appoint a competent tax advisor. Potentially an IFA as well depending on his plans for the funds from sale. This isn't the kind of situation I would advise anyone on over a coffee. Do members really have time for discussing hypothetical scenarios when there is actual work to be done? May come back and answer the last six questions, at the end of the article, if my Friday evening doesn't hold more exciting prospects. :')

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By ireallyshouldknowthisbut
23rd Jun 2023 12:34

In terms of approaching this as no-one else seems to be playing ball.

I think I would go along the lines of "getting it right ongoing" as opposed to fixing the past (albeit advising the client of what they *should* have done). Generally HMRC seem less interested if its "right now".

Regarding the rental incomes there seem to be a variety of approaches here.

The rent for the GF flat is seemingly joint BTL income. Ongoing it sounds like the route would be to split the income loading to Harry under the assumption Mrs H is a HR tax payer given her ltd co. I would probably add the rent to the 22/23 return for them both, and for 23/24 split such that Mrs H get about £1k income so covered by the allowance.

However the rent for the bedsits might just fall under the definitions of a trade and/or rent a room. This seems to be generally beneficial from a CGT point of view, and also means if its a partnership, then Harry can claim, and potentially pay class 2 NI so get some 'cheap' qualifying years for state if not available else where.

As for the past................might revisit later. My 12.30 is calling.....

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7om
By Tom 7000
23rd Jun 2023 12:42

Is it best to let old tax dogs lie and carry on declaring the property income as a trade on Harry’s return? ##No

Should any corrections be made to earlier tax returns? ## yes 4 or 6 years depending

What about Sally’s tax position? ##fix it

Should the couple be advised to sell up and move before CGT rates get aligned with income tax? ## speculation - no

What should be done with a view to IHT planning?## do some

Thanks (1)
7om
By Tom 7000
23rd Jun 2023 12:42

Is it best to let old tax dogs lie and carry on declaring the property income as a trade on Harry’s return? ##No

Should any corrections be made to earlier tax returns? ## yes 4 or 6 years depending

What about Sally’s tax position? ##fix it

Should the couple be advised to sell up and move before CGT rates get aligned with income tax? ## speculation - no

What should be done with a view to IHT planning?## do some

Thanks (0)
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By listerramjet
23rd Jun 2023 14:04

There are some interesting questions (if you are a tax anorak) within this "fictional" situation, and your friend may have some interesting challenges to solve in the future, but surely the first point to make is that you should not advise your friend in any formal capacity. Always a recipe for disaster. And more so since there are other interested parties in the property, including another owner and people with varying forms of tenancy statuses. And actually, so far you have limited information on which to base an opinion, and in all honesty some of that information sounds more like professional supposition!
As I am not a tax anorak I would be more interested in the commercial position, and whether it would make more sense to sell the property as a family type home or as a business proposition. Or possibly for its development potential. On the face of it there may be some historical technical tax questions, but you seem to accept there is unlikely to be any underpaid tax. The more interesting question is what scope there is for minimising any potential capital gains tax on a disposal - a question which may have different answers for each of the parties.
Which in summary means keep your friend and suggest as a friend that he and his wife each seek independent advice, on a professional basis.

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paddle steamer
By DJKL
26th Jun 2023 14:15

Surely the main question is what did Sally have for lunch and can others have the same?

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