Tax Traps for Tenants: Insights from a Chartered Surveyor in Wimbledon, London
As chartered surveyors based in Wimbledon, London, we’ve often observed that purchasing the freehold of a property in SW19, particularly in a shared flat management context, can present significant financial and legal complications, writes Clive Scrivener, Founding Partner of Scrivener Tibbatts. One common issue arises when tenants, having successfully bought the freehold through a tenant-owned flat management company, delay extending their leases. This seemingly minor decision can have long-lasting financial repercussions.
The Initial Success: Purchasing the Freehold
Imagine a group of tenants in Wimbledon successfully negotiating with their landlord to acquire the freehold of their Georgian townhouse, which has been converted into multiple flats. They form a management company and collectively purchase the freehold. This is a great achievement, and it often leads to celebrations among the tenants. However, extending their leases tends to be seen as a task for another day, as they now “own” their flats in their entirety. Unfortunately, this mindset can be problematic.
The Hidden Danger: Short Leases
Over time, the danger of ignoring lease extensions becomes more apparent, especially when lease terms fall below 80 years. At this point, the freeholder (now the management company) becomes entitled to a portion of the “marriage value” of the lease. This makes extending leases progressively more expensive. In addition, banks are generally reluctant to offer mortgages for properties with short leases – typically less than 60 to 80 years – since their value diminishes with time. As a result, a tenant looking to sell their flat could suddenly find themselves facing an expensive and time-sensitive lease extension, especially if their buyer’s mortgage lender demands it.
Purchasing the Freehold: Key Options
When a group of tenants in Wimbledon buys the freehold, there are two primary ways to structure the ownership:
- Nominee Ownership:
In this scenario, the management company holds the freehold in trust for the tenants. Here, each tenant effectively owns part of the freehold along with their leasehold interest in their flat. When they sell, they sell both the lease and their share in the freehold. If the property is their main residence, they are eligible for Private Residence Relief (PRR) from Capital Gains Tax (CGT).
This method of ownership is often chosen when acquiring a freehold through statutory leasehold enfranchisement.
- Immediate Lease Extensions:
Alternatively, tenants can immediately extend their leases to 999 years upon purchasing the freehold. This effectively nullifies the reversionary value of the property, meaning that no one is sitting on a valuable freehold that grows more expensive over time. The tenants essentially loan money to the management company to buy the freehold, which is then repaid through the premium paid for lease extensions.
Where Things Go Wrong
Problems start when tenants fail to extend their leases immediately. Over time, as property prices rise and lease terms shrink, the value of the freehold (which the management company owns) increases. For instance, let’s consider the case of a tenant in Wimbledon who bought into the management company in 1987, when their flat’s lease had 90 years remaining, and the flat was worth £50,000. Fast forward to 2017, and the flat is now worth £500,000, but only 60 years remain on the lease. The tenant may assume their flat is still worth £500,000. However, the reality is that £60,000 of that value now belongs to the freehold, reducing the flat’s leasehold value to £440,000.
At this point, the tenant wishing to sell the flat will likely need to extend the lease, especially if their buyer’s mortgage lender demands it. If the other tenants are in agreement, the lease extension can proceed smoothly. But problems arise if the freehold is held by the management company without any nominee arrangement.
Capital Gains Issues
If the freehold is not held in trust for the tenants, extending the lease will trigger a capital gains event. The management company will have acquired the lease at a market value (in our example, £440,000) and, by extending it, will effectively dispose of a reversionary interest in the flat, leading to a capital gain. This can result in significant tax liabilities for the management company, which could total tens of thousands of pounds, depending on the rise in the flat’s value. These unexpected costs can catch tenants off guard, as they may not have anticipated paying for what they see as an “internal” lease extension.
Additional Tax Complications
Tenants extending their leases might also face complications with Capital Gains Tax (CGT) and SDLT (Stamp Duty Land Tax). For those who do not occupy the flat as their principal residence, or who have other properties, there’s a risk of CGT on the lease extension. Although Extra-Statutory Concession D39 can offer some relief from this, it requires the transaction to resemble an arm’s-length deal—meaning the tenant would have to pay full market value for the extension, potentially £60,000 in our example.
Distributions and Dividends
Another complication arises with how any surplus funds in the management company, resulting from lease extension premiums, are treated. If the funds are distributed back to shareholders (the tenants), these payments may be classified as dividends, leading to further tax liabilities. Even distributing the surplus to cover corporation tax on the capital gains could trigger dividend tax.
Avoiding Tax Traps
As a chartered surveyor, I strongly advise clients in Wimbledon and beyond to address lease extensions as soon as they purchase their freehold. Failing to do so can lead to significant and often unforeseen financial complications, particularly as property values rise and lease terms shorten. Early action can prevent tenants from facing unexpected tax liabilities and ensure that their flats remain attractive to potential buyers.
If you would like to discuss something related to a property valuation please contact Clive Scrivener direct via email at Clive@scrivenertibbatts.co.uk or call 020 8971 2983.
