Determining the tax treatment of a lease transaction, including worked examples
A property lease is basically a right to use an asset. A lease is a contract by which one party (lessor) gives the use and possession of land and building to another party (lessee) for a specific period of time, usually in return for a specific rent.
This contrasts with a licence, which entitles a person (licensee) to the use of the property, but which is subject to termination at the will of the owner of the property (licensor).
Leases usually run for many years, while licences cover a relatively short period of time (up to two years).
The key point in determining the tax treatment of a lease transaction is to establish whether there is an assignment of a lease or a grant of a lease. An assignment of a lease is the legal term used for the sale of a lease. On assignment, the owner relinquishes rights over the property.
A grant of a lease is the creation of a new asset. The person who owns the property grants a lease to a tenant for a specific period of time; however, the rights in the property will eventually revert back to the freehold landlord.
The tax treatment on the assignment of a lease depends on whether the taxpayer is selling a long or short lease.
A long lease is a lease that has more than 50 years to run at the date it was sold; a lease with less than 50 years to run is a short lease.
The capital gains tax (CGT) computation on the assignment of a long lease is quite straightforward; the original cost is deducted from the proceeds and the resulting gain is then subject to CGT (after the annual exemption).
The CGT computation on the assignment of a short lease is slightly more complex.
A lease with a useful life of less than 50 years is called a ‘wasting asset’. As wasting assets depreciate over time, the allowable base cost for CGT purposes is calculated using the lease depreciation tables (Schedule 8 Paragraph 1, TCGA 1992).
The allowable base cost is the original acquisition cost multiplied by the fraction S/P, where:
Example 1
Sarah purchased a 42-year lease for £100,000 in January 2000. In January 2012, she sells the lease for £150,000.
As 12 years have passed since original acquisition, Sarah is selling a lease with 30 years left to run.
From the proceeds of £150,000, we deduct the allowable base cost (which is the original acquisition cost multiplied by the fraction S/P).
From the lease depreciation table, the relevant percentage for a 42-year lease is 96.593 and for a 30-year lease the relevant percentage is 87.33.
The capital gain is therefore:
Proceeds: £150,000
Allowable cost: 100,000 x 87.33/96.593 (90,410)
Gain: £59,590
A long lease will become a short lease once less than 50 years are remaining.
Example 2
Louise bought a 60-year lease on 1 January 1990 for £90,000. She sells the lease on 1 January 2010 for £120,000.
As 20 years have passed since original acquisition, Louise is selling a lease with 40 years left to run.
Accordingly, Louise is selling a short lease and we need to refer to the lease depreciation tables.
The percentage for 50 years or more is always 100, and the percentage for a 40-year lease is 95.457.
The capital gain is therefore:
Proceeds: £120,000
Allowable cost:
90,000 x 95.457/100 (85,911)
Gain: £34,089
As with the assignment of a lease the tax implication on the grant of a lease depends on the length of the lease granted.
Where a freeholder grants a long lease to a tenant, CGT is calculated by using the part-disposal formula:
The allowable cost is the acquisition cost multiplied by the fraction A/(A+B), where:
Example 3
Rose grants a 55-year lease on a freehold property which she purchased in 2000 for £100,000.
She receives a premium of £150,000 from the leaseholder. The value of the freehold reversion is £200,000.
The capital gain is therefore:
Premium: £150,000
Allowable cost:
100,000 x 150,000/(150,000+200,000) (42,857)
Gain: £107,143
The premium received from the grant of a short lease must be split between the amount chargeable to income tax (under property income rule ITTOIA 2005 S 277 (4)) and the amount chargeable to CGT.
The capital element chargeable to CGT is 2 per cent x (N-1) x P, where:
The grant of a lease out of a freehold is treated as a part-disposal; accordingly, allowable cost is calculated as the acquisition cost multiplied by the fraction a/(A+B), where:
Example 4
Elizabeth bought a freehold property 20 years ago for £50,000. In 2010, she granted a 40-year lease for a premium of £100,000, the reversionary interest being £200,000.
We first need to split the premium of £100,000 into the amount subject to income tax and the amount subject to CGT:
The capital element is 2% x (40-1) x £100,000 = £78,000.
The amount chargeable to income tax (as property income) is the difference between the premium received and the amount charged to CGT (£100,000-£78,000 = £22,000).
The capital gain is as follows:
Capital element of the premium: £78,000
Less allowable cost:
50,000 x 78,000/(100,000+200,000) (13,000)
Gain: £65,000
The above only looks at tax implications on assigning or granting of a lease; however, there might be legal implications if the taxpayer wishes to get out of a lease agreement before the end of the term.