In his second article in the series, Lee Sharpe compares two aspiring property developers in case studies.
The next case study continues the saga of Bill and Benita. It considers the implications of developing a dwelling for re-sale, and what happens if you change your mind part-way through.
The story so far…
To recap, Bill was developing an investment property for letting, and Benita was about to develop a new property in the reasonably ample grounds of her main residence, for onward sale (having first registered for VAT so that she could recover the bulk of her VAT costs).
Case Study 2: Benita the one-off developer (continued)
Let’s say that the numbers work out as follows:
Note that most of the figures are similar to those for Bill in Case Study 1. The differences are:
- Bill has not actually done anything yet to trigger a gain or development profit; he has developed an investment property to let out. Benita is taxable much sooner (see also below).
- Bill’s finance costs are charged against his property business profits (and his finance costs may take longer to pay off, assuming he has to pay them out of rental income).
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For the purposes of this comparison, we are saying that Benita sought planning permission after having commenced to trade. The value of the property when ‘appropriated for the development business’ is therefore lower – in this case, just £100,000.
There are several consequences:
- Benita’s combined trading profit and overall gains are slightly less than the capital gain Bill would make if he were to sell both the ‘old’ and the new property at the same time. The difference for Benita versus Bill is: (Profit £230,000 + potential gain £355,556 + actual gain £44,444) = £630,000 vs £650,000 = £20,000 - that difference being the interest cost (although, as noted, Bill can claim his loan interest against his rental income).
- When compared to Bill, Benita has effectively turned much of the amount of residential capital gain, taxable at no more than 28%, into a self-employed profit taxable at up to 45% - and potentially self-employed National insurance contributions (NICs) as well. Bill’s ‘pure gain’ of £650,000 would cost around £180,000, whereas Benita’s combined income and gains of £630,000 could cost around £220,000 in income tax, CGT and NICs – approximately £40,000 more tax overall, on significantly less income and gains, if we set aside the main residence relief she gets only because she’s building in her own garden.
- It is made worse because Benita’s capital gain on the development plot would have been higher if it had achieved planning permission comfortably before the development trade commenced. As this didn’t happen, the uplift following commencement is larger than it could have been, so more is being taxed at 45% plus NICs, instead of just 28%.
- It is even worse than that in this particular case, because Benita’s capital gain on carving out part of the garden of her main residence is exempt, so the increase in market value on achieving planning permission is being taxed at 45% plus NICs vs 0%, not the usual 45% plus NICs vs 28%.
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Further challenges often follow; see next.
Beware changing your mind
Starting with Bill as the simplest example, let’s assume he changes his mind part way through the development of his rental property, and decides to sell the new property once complete. HMRC is likely to argue that, like Benita, he has moved onto a trading footing, and the property has changed from a rental business fixed asset to a current asset, held for profit.
The legislation therefore deems Bill to have made a capital disposal, subject to CGT, even though he has not actually sold anything yet. This is something that often catches out property investors who decide to start developing their investments for profit. The calculation works basically the same as for Benita above, with deemed ‘proceeds’ based on the market value at the date on which the property is taken for development (this now-taxed value then becomes part of the base cost for the trading part of the calculation, as indicated by the arrows in Benita’s calculation above).
Bill is then required to pay CGT on the gain made to date, despite having received no real money. Under traditional self-assessment rules, Bill would not have to pay the CGT until 31 January following the year of the gain, but under the regime as applied for disposals from 6 April 2020, Bill will have to make a CGT return, and payment on account, within 30 days of the ‘disposal’ to his own trading business.
Bill could instead elect to roll the capital gain into the trading profit ultimately made on the sale of the developed property. This may seem attractive, as it postpones the tax until real proceeds are received. But if the postponed gain is significant the election will prove expensive, as it swaps CGT at no more than 28%, for income tax at 45%, and potentially NICs.
When Benita took part of her large garden to develop a new property for sale, she would also potentially have been exposed to this 30-day CGT bill, except that the £44,444 gain at that point was exempt because it is in the qualifying grounds of her main residence.
Bill could argue that he did not really intend to sell the property as a trading developer, but may have received an offer he could not refuse, or a change in circumstances may have forced a sale, rather than deliberate intention. This will depend on the facts of the case but broadly, the longer the interval between development and subsequent sale, the stronger is Bill’s argument that CGT should be applied to the sale instead of income tax (and NICs).
Does it all end up the same?
Turning back to Benita, let’s consider what happens if she completes her development property, but then decides to keep it as an investment and add it to her rental portfolio. Her finishing position is quite similar to Bill’s in the first case study, so does this mean that she has no tax to pay, because she has not actually sold a property yet?
Unfortunately, probably not. Benita will still be treated as having made a capital gain when appropriating the land for development for resale, and will then be deemed to make a sale at open market value (i.e. to herself) when she decides she wants to retain the new property. In this case, the initial gain is exempt because the land comes from her main residence, but the later profit is taxable nonetheless. And at no stage does Benita actually receive any money!
Note that if Benita were developing a garden plot from one of her other properties, (i.e. not her home), the fact that she might then have to notify HMRC and pay CGT on that in-year disposal, potentially warns HMRC that self-employed development profits should soon follow.
Conclusion: Be more like Bill!
Where the facts and history support it, it is not uncommon or unreasonable to argue that the self-employed development activity commenced after planning permission was achieved, in which case the planning gain uplift in value will be subject to the lower rates of residential CGT, rather than income tax and potentially NICs. Benita would have done well to take a leaf out of Bill’s book.
It could be argued that the development of a long-standing capital asset prior to sale should not be taxed as a trade but merely as if the underlying asset had been enhanced; in other words, ‘CGT all the way’ like Bill. This is likely to be much cheaper. In fact, Benita would have a stronger case than most, because she is developing part of the grounds of her main residence, which certainly started life as a capital asset, and she is retaining the remainder (at least for now) as her main residence. HMRC usually has the ‘nuclear option’, being the ‘Transactions in land’ tax regime (as upgraded by FA 2016). This makes almost all gains (on developing land for profit) taxable as income. But it does not attract self-employed NICs, and it cannot be applied to gains derived from one’s main residence, as defined.
The rules that deem a taxable gain to arise when an investment property is appropriated to trading stock can catch out many landlord investors, and even advisers. When combined with the ‘brand new’ requirement to notify and pay CGT on account within 30 days of a chargeable gain, there is now little time to spot or remedy any misunderstandings. And subsequently changing one’s mind could prove awfully expensive.
The key points are to take advice before making any substantive decisions on what to do with property, and to document them carefully so that they can be used as evidence, as and when needed.
