Tax on buildings insurance claim for damage or destruction

Published: 26 Aug 2020

Updated: 04 Oct 2020

Written by Ray Coman

Buildings insurance pay-outs and compensation for property damage can give rise to capital gains tax.  A home is exempt from capital gains tax and therefore any payment for damage to a person’s home will have no immediate tax consequences.  However, where the property is not being lived in by the owner there is exposure tax resulting from flood, fire, or other damage to land and buildings.  The discussion below uses residential property for illustration purposes but can apply to any asset with an expected life of over 50 years, such as a high value antique.  The caluclations can be complex, however basically compensation is treated as subject to capital gains tax.  Rebuild or restoration costs can be used to reduce tax liability and in many cases there will be no tax to pay.

Capital gains on compensation for loss or damage to property

Allowable loss on destruction of loss of uninsured assets

Property loss. Roll over relief

Property damage. Part disposal formula

Property damage. Roll-over relief

Tax planning

Capital gains on compensation for loss or damage to property

Under TCGA s.22 compensation received from damage to property is capital sum derived from the asset.  The pay-out is therefore regarded as proceeds subject to capital gains tax.  The date of receipt determines the tax year in which the disposal occurs.  The date of loss, damage or destruction to the asset is ignored.

In theory, it is the right to take action that has value, as established in the case of Zim Properties Ltd v Proctor 1985.  However, in practice, attaching this right to the underlying assets means that a part of the underlying asset can be deducted from the compensation in calculating the taxable gain (or allowable loss.)

Allowable loss on destruction of loss of uninsured assets

For tax purposes a loss occurs on the date of loss or destruction of an uninsured asset.  The general rule is that if an asset is chargeable to tax, the loss is allowable, otherwise the loss is not allowable.  An allowable loss can reduce other gains in the same tax year or is carried forward and set against any gains of a future tax year.  Any scrap value represents proceeds in reducing the amount of loss.  Certain assets are exempt from capital gains tax, such as motor cars, and a person’s home.  Therefore, an allowable loss would not arise on these two most common possessions.  This means that damage to the main home and motor cars do not create a loss that can be used for capital gains tax purposes or any other form of tax relief.

In some cases, a negligible value claim can be made.  This will treat the assets as being disposed of for nil proceeds even though it continues to exist in some scrap form.  It is practical in expediting tax relief in situations where formalities, for instance around insurance or liquidation procedures, need to be observed.

Property loss. Roll over relief

Provided a replacement asset is purchased within twelve months, the insured party can claim roll over relief (under section 23(4) of TCGA 92) so that there is no tax on receipt of insurance money.

For capital gains tax purposes, the base cost of the replacement assets is reduced by any scrap value of the old asset and any ‘excess’ insurance proceeds.  Excess being the extent to which insurance compensation is greater than the original cost of the old asset

In an example, a buy-to-let flat is bought for £200,000.  Shortly after, say in May, the flat upstairs floods and leaves the property almost entirely destroyed.  The second-hand value of bricks and floorboards is about £2,000.

The owner receives £220,000 in compensation and buys a new investment property for £250,000.

The insured does not claim roll-over relief.  Therefore, capital gains is:

In a different scenario, the facts are the same except roll-over relief is not claimed so that the £22,000 gain is not taxed on receipt of the insurance pay-out.  The following April the replacement property is sold for £270,000.

In the above example, all the insurance pay-out has been spent on a replacement asset.

However, any proceeds not reinvested are immediately subject to CGT.  The base cost of the replacement assets is not reduced by that amount ‘already taxed.’

Let us say that the facts are the same except that the replacement property is bought for £210,000 and sold for £270,000.

The immediate charge to capital gains tax is £10,000 as illustrated below:

The gain on disposal of replacement property is best summarised in the follwing table:

Capital gains tax regime for compulsory purchase of property is similar that just outlined for property destruction.

Property damage. Part disposal formula

Capital gains on part disposals are calculated by reference to the A/A+B formula set out in section 42(2) TCGA 1992.  In the case of compensation, the allowable cost is:

Original cost x A/A+B, where:

A is consideration and B is the value of the remaining part of the property.

Let us say a buy-to-let flat is bought for £200,000.  Shortly after, say in May, the flat upstairs floods and leaves the property severely damaged.  The damaged property is valued at £140,000.  The owner receives £85,000 in compensation.  Said owner has trouble selling due to its state but eventually is helped by a rising property market.  The following April, the property is sold for £160,000.

Capital gains is calculated as follows

The original cost - less the amount attributed to part disposal - is available to reduce capital gains on disposal of the remaining part.  Thus, capital gains tax on the eventual sale is calculated as follows:

Proceeds of £160,000 less the remaining cost (i.e. £200,000 – £85,000 + £9,444.)  The gain taxed on final sale is therefore £35,556.

An alternative way of expressing the above is that the landlord received £160,000 + £85,000, or £245,000, in total for the property.  He paid £200,000 for the property and therefore made an overall gain of £45,000. Of the £45,000 gain, £9,444 is taxed on receipt of compensation and the remaining £35,556 is taxed on eventual sale.

In the above example the compensation is received in May and the proceeds are received the following April.  Since the disposal occurred in two different tax years, the capital gains tax annual exemption will be available to reduce gains on compensation and again to reduce gains on sale.  Costs directly attributable to one or other part are deducted accordingly.  Therefore, estate agent fees on disposal of the damaged property reduce the £35,556 gain only.

Property damage. Roll-over relief

Where compensation is used to restore an asset, it is possible to defer or ‘roll over’ the gain (under section 23 TCGA 92.)  “Roll over” means that instead of the compensation being taxed in the tax year of receipt, it is reduced from the value of the property subject to capital gains tax on eventual disposal.

Deferring a gain is preferable because of the cash flow benefit and because, in general, the capital gains tax allowance tends to increase over time to adjust for inflation.

However, the relief is made by election.  Therefore, the taxpayer can choose to be immediately chargeable.  This could be beneficial, for instance, where annual exemption reduces taxable gain in the year of compensation.  This is because the base cost of the asset is not reduced for future disposals.

The facts at the same as in the example above, except this time the owner spends £85,000 compensation in restoring the asset.  The restored value is £300,000 and it is eventually sold for £350,000.

If a section 23 (1)(a) claim for roll over relief is made, there is no gain on receipt of the compensation money.  This is because it is fully reinvested.  The gain is calculated as follows:

If a section 23 claim is not made, there is a part disposal on receipt of compensation money which is calculated as follows:

Note that the unrestored value is used in the calculation of gain on insurance proceeds, even though the proceeds were invested in the property.  In practice there will likely be a lag between receipt of insurance monies and commencement of remedial work.

Any part of the compensation not used in the restoration is taxable.  If the unused part is “small” the whole amount can also be rolled over.  If the unused part is not small, only the compensation used in the restoration can be rolled over.  It follows therefore that if all the compensation is used for restoration, the entire amount can be roll over.  More specifically, to ‘roll over’ the unused part (under section 23 (1)(b)), either:

• The unused part of the compensation is 'small' compared with the total compensation, or
• 'Small' compared with the value of your property.

'Small' means the higher of 5% of the capital sum received, or £3,000 (s.23 TCGA 92.)

The facts are the same as in the example above, except that only £81,000 is used in the restoration.  The unused part of £4,000 is less than 5% of £85,000 and therefore small.

In this example, it is better not to claim section 23 (1)(b) roll over relief.

Where the compensation is partly used to repair the asset but the unused part is not small, the taxpayer can claim to roll over the amount used to repair the asset.  The unused part of the compensation is taxed as follows:

Capital sum not used in restoration

Less: Original cost × (compensation not used in restored/ not used in restoration + restored value)

Less: Restoration cost × (compensation not used in restored/ not used in restoration + restored value.)

The amount derived from the calculation above is a capital gain of year in which the compensation is received.  Any gain can be reduced by the annual capital gains tax allowance.

On eventual sale of your property, the base cost of the original and restored value is reduced by the amount “already taxed.”

The facts are the same as before except in this example restoration costs are only £75,000.

The following is taxable gain on receipt of compensation:

The following is taxable gain on eventual disposal:

Tax planning

Roll over relief is available for part disposals of land, even the land has not been damaged or destroyed.  Compulsory purchase of land is treated in a similar way.

Reasons not to roll over

To make use of annual exemption. The exemption would reduce or eliminate any gain arising on insurance proceeds from a damaged, lost or destroyed asset.  Not using roll-over relief could be a useful method for ‘mopping up’ any losses brought forward.  Losses could have arisen for instance on the disposal of investment property or shares in a preceding tax year.

Consider disposing of an asset that stands at a loss before the end of the tax year in which insurance proceeds are obtained.  Proceeds from sale of the loss-making asset could be used towards a replacement asset.  This could work out more tax efficient because there would be less tax in the year of insurance receipt and a lower base cost on the replacement asset.

Reasons to use rollover

A 'dry' gain occurs where there is a charge to tax but no cash proceeds from which to pay the tax.  Using insurance proceeds to pay for restoration could cause a dry gain.  Given that roll-over is an 'all or nothing' claim, a considerable liability could result from an immediate charge to tax.

If the annual exemption has already been used in the tax year on other gains, the remaining consideration could be the timing of tax.  Discounting speculation about future tax rates, any tax deferral confers a cash flow benefit.

Any inflation between receipt of compensation and sale of replacement asset will help to lower tax burden on eventual sale in real terms.

This is especially the case if capital gains tax allowances have increased to keep pace with inflation.

Death creates a capital gains tax free uplift in value, and therefore roll over relief will be especially valuable it is not the intention of the owner to dispose of the underlying property.  In tax jargon the gain is said to be “washed out”.  Probate value establishes base cost for capital gains tax purposes, and this occurs even if the spousal exemption removes any inheritance tax liability.

There will inevitable degree of interpretation in assessing the extent to which works are restoration and not improvement.  Therefore the improvement element could be regarded as 'unused.'  This interpretation could result in tax saving.  However, it should be noted that any relief could be denied where tax avoidance is identified as the sole or main purpose.