How to Bank Your Indexation Allowance
Newsletter issue - March 08.
Several important capital gains tax reliefs are being withdrawn at the end of this tax year on 5 April 2008, including indexation allowance which compensates for the effect of inflation on the value of your assets. In return for this simplification, capital gains made from 6 April 2008 will be taxed at a flat rate of 18% instead of your marginal tax rate of 20% or 40%. In spite of this tax rate reduction those who have held assets for ten years or more could pay more tax on a disposal after 6 April 2008, but it does depend on how much the asset originally cost.
Example:
You are about to sell some land you've held since April 1982. It has not been used for a business purpose, so the taper relief is 40% for a non-business asset. You also get indexation allowance to compensate for the effect of inflation from April 1982 to April 1998. We assume you have already used your annual exemption for 2007/08, so all the gain you make is taxed at your highest margin rate.
| Sale Agreed: | Before 6 April 2008 | After 5 April 2008 |
| £ | £ | |
| Proceeds of sale | 1,200,000 | 1,200,000 |
|---|---|---|
| Less cost in April 1982 | (200,000) | (200,000) |
| Indexation allowance at 1.006 | (201,200) | - |
| Gain before taper relief | 798,800 | 1,000,000 |
| Taper relief at 40% | (319,520) | - |
| Gain after taper relief | 479,280 | 1,000,000 |
| Capital gains tax at 40% or 18% | 191,712 | 180,000 |
By delaying the sale you save tax of £11,712 (£191,712 - £180,000), but you lose the benefit of both the indexation allowance and the taper relief.
You can bank the indexation allowance by transferring the land to your spouse before 6 April 2008, who then sells it in the new tax year to take advantage of the lower tax rate. A transfer to a spouse or civil partner is treated as a no gain/ no loss transaction for capital gains tax purposes, so no tax is due on the inter-spouse transaction. The deemed cost of the land for your spouse includes the indexation allowance.
Example:
| Transfer to spouse in 2007/08 | Sale by spouse in 2008/09 | |
| £ | £ | |
| Deemed and actual proceeds of sale | 401,200 | 1,200,000 |
|---|---|---|
| Less cost | (200,000) | (401,200) |
| Indexation allowance at 1.006 | (201,200) | - |
| Taxable gain: | NIL | 798,800 |
| Cost of land for spouse: | 401,200 | - |
| CGT payable at 40% or 18% | NIL | 143,784 |
By making the inter-spouse transfer and selling in the later tax year you and your spouse pay tax of £143,784 on the gain rather than £180,000, a further saving of £36,216.
Points to note:
- This indexation saving trick only works when transferring the asset to a spouse or civil partner, a transfer to a sibling or unmarried partner will not work.
- The spousal transfer must be legal and complete. Land must be transferred by a deed, and shares must be recorded against the new owner's name on the company's share register.
- Complete the transfer to your spouse well before the asset is advertised for sale. If the sale negotiations start before the spousal transfer is done, the Taxman will say the transfer is an inserted step to reduce the tax payable, and will ignore the spouse transfer for tax purposes.
- Check whether the final tax saving is worthwhile before making the transfer. An asset with a low cost, or low base value in March 1982, will not attract much indexation.