You can recover VAT and avoid Capital Gains Tax

I will deal with house B first, as this is the simpler of the two. If you occupy house B as your main private residence for a reasonable period of time (say a year or more), you will be entitled to a partial exemption on the capital gain arising on its sale. The exemption, known as ‘principal private residence relief’ will apply to the last three years of your ownership plus any earlier periods of occupation as your main residence. In addition, you will also be entitled to private letting relief which will provide a further exemption equal to the lower of the exemption already given by principal private residence relief, or £40,000. The £40,000 limit applies on a ‘per person’ basis, so, if two of you own the property jointly, your total private letting relief may be up to £80,000.

Let’s say you bought the property in March 2001 for £200,000, let it out and then occupied it as your main residence from March 2010 to March 2011 before selling it for £400,000 after ten years of ownership. You would then have a capital gain of £200,000. As you occupied the property as your main residence for a year between 2010 and 2011, you will be exempt on the gain arising in the last three years of ownership. This is calculated on a simple timeapportionment basis, giving you principal private residence relief of £60,000 (£200,000 x 3/10 years).

You will then also be entitled to private letting relief of either £40,000 if one individual owns the property, or £60,000 if you own it jointly. In addition, if you do not have any other capital gains in the same tax year, you will have an annual Capital Gains Tax exemption. This is currently £10,100 per person.

Overall, if two of you own the property jointly, you could have a taxable capital gain of as little as £59,800, giving rise to a Capital Gains Tax bill (at the current rate of 18%) of just £10,764.

Let’s now turn to house A. Demolishing the existing house and constructing the new terraced houses would amount to a trading activity of property development unless you hold the new houses as long-term investments (either for private use or for rental). If, however, you and your children occupy all of the new houses as your own private homes for a reasonable period after construction (I recommend at least three years), then these will indeed be long-term investments and you will not be taxed as a property developer.

Your own occupation of one house as your main private residence will ensure that it is exempt from Capital Gains Tax on any future sale. For the other two houses to be exempt from future Capital Gains Tax, they will either need to be owned by the adult children who occupy them as their main private residence, or possibly held through a trust. In the latter case, the adult children occupying the properties would need to be the beneficiaries of the trust. It is also important that you and your partner are excluded from being able to benefit from the trust. Either way, the problem you will face is that you will need to transfer the properties at some point. For Capital Gains Tax purposes, the transfer would be treated as if it were a sale at market value.

Assuming that you have occupied house A as your main private residence throughout your ownership, the best way to avoid Capital Gains Tax on this transfer would be to put the existing house into joint ownership with your children, or a trust. The best time to do this would be after you cease to occupy the property but before it is demolished. The new ownership structure should mirror the eventual intended occupation of the new houses after construction: i.e. one third to you and either one third to each adult child who will later occupy one of the new houses, or two thirds to the trust.

Following the demolition of house A, the legal ownership of the land can be rearranged so that you (and your spouse if you wish) own one of the new properties outright and the other two properties are either owned directly by the adult children who will occupy them or by the trust described above.

The new owners would then develop the new properties together. Under this structure, it should be possible to use the ‘VAT Refund Scheme’ as ‘DIY Housebuilders’ (VAT431NB) and thus recover most of the VAT incurred during construction.

If you have transferred partial joint ownership of the property directly to your adult children, then they will retain the eventual sale proceeds of their respective properties. If, however, you use a trust to own the properties occupied by your adult children, you will be able to wind up the trust after selling the properties and, if you wish, could then distribute the sale proceeds back. Although you cannot benefit from the trust whilst it is in existence, it is possible for you (and your spouse if you wish) to have a ‘reversionary interest’ which means that the trust’s assets eventually revert back to you. The mechanism is fairly complex and there are a number of other issues which need to be considered, including some potential restrictions under the ‘VAT Refund Scheme’, as well as Stamp Duty Land Tax and Inheritance Tax, so I would strongly recommend that you take professional advice before embarking on the project.

Nevertheless, if carried out correctly, this strategy could enable you and your family to recover most of the VAT incurred during construction and to eventually sell all of the new properties free from Capital Gains Tax.

Carl Bayley is author of the best-selling guide How to Avoid Property Tax (available from www.taxcafe.co.uk).