Lee Sharpe looks at the tax position on the removal of a property from the property business.
Over the last few case studies, I have looked at introducing property into the property business and the implications of updating, repairing and adapting property for its intended use.
This article considers the tax position where a landlord or landlady is about to remove a property from their continuing property business.
Enough is enough
Sean (whom some readers may remember from the previous case study) has now been letting a substantial Edwardian townhouse as a house in multiple occupation (HMO) for a few years. But he is finding that running an HMO for students is particularly demanding of his time and attention.
As the summer break heaves into view, Sean finds that the property will need substantial repairs to the bedrooms and kitchen to make good on the year’s occupation. He resolves that this will be the last year that he spends his summer holidays cleaning up after the nation’s future elite.
Sean could:
- try to sell the property as it stands, as an HMO – ideally with tenants in occupation;
- convert it back into an ‘ordinary’ residential letting (i.e., more like the original property) and trust that looking after a single tenant or family will be less demanding (like with his other properties); or
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convert the property back into an ‘ordinary’ residence and try to sell it on.
Option 1: Sell as an HMO
This clearly involves the minimum amount of effort on Sean’s part. It will effectively remain part of his rental portfolio until the property is sold for a capital gain.
This will mean that:
- there are no further costs of conversion;
- while it remains part of the property letting business, the usual expenses such as repairs, mortgage interest, etc., will be allowable for offset against his income from letting the property (practically, against aggregate property income); and
- the capital costs incurred to date, such as in adapting the property for use as an HMO (extension, loft conversion, shower room and general structural works; see case study 5) will be allowable against any gain on disposal – alongside valuation, advertising, and legal and some other professional fees as incidental costs of the capital disposal itself.
However, Sean finds that the market for HMOs has taken a dip of late, as people are moving away from built-up areas to more remote and less cramped properties. Fewer landlords want to take on the risk, and he concludes that the property will have to be converted back into its original single-dwelling format in order to ensure a reasonably quick and easy sale.
Option 2: Convert but keep for ordinary rental
While the extended kitchen and the shower room will be kept (alongside the loft conversion) a lot of the other structural work incurred in order to turn the original dwelling into an HMO will effectively have to be reversed; essentially, knocking an array of partitioned rooms back into larger rooms, suitable for occupation by a larger family.
Sean faces a mixture of structural and repair work. For example, fixing and replacing damaged kitchen units (to the same standard) will count towards repairs, as will patchwork to repair plaster, re-carpeting and re-decorating generally; likewise, any other work to make good on general wear and tear from tenants.
But re-sizing rooms and similar will constitute long-term changes to the fabric of the property, so it will be capital in nature.
As Sean intends to retain the property in his letting business, he will continue to be able to deduct his repair and ongoing mortgage and re-letting costs against his overall property business income.
Note that Sean will again be changing the number of dwellings in the overall property envelope (from a VAT perspective, at least), just as he did when converting the original residence into a multi-occupancy HMO in case study 5. This, in turn, means that he may be able to save VAT on the cost of supplies of construction services (and associated materials costs) in relation to the ‘conversion’. Again, this is a potential ‘real’ saving in Sean’s hands.
The bad news
So far, so good. But Sean also needs to bear in mind that the improvements he made in case study 5 when converting the original property into an HMO in the first place have in part been reversed. This means that some of the improvements made at that point will no longer be reflected in the property when it is ultimately sold, post ‘re-conversion’.
Sean will therefore be unable to claim some of the capital costs incurred by him over his entire period of ownership (see TCGA 1992, s 38(1)(b)). This may come as a surprise. But consider if Sean had spent £15,000 to build a conservatory for the property and then knocked it down five years later, having decided it was not in keeping with the property. That cost would have effectively been for nothing, and it would therefore be logical that Sean got no relief for the £15,000.
Option 3: Convert to sell
Sean needs to be very careful here, as developing the property with the intention of a prompt onward sale at a profit will usually trigger the anti-avoidance ‘transactions in land’ regime.
This has been covered already in case study 2 (Bill and Belinda), and readers will recall that this regime is a minefield for unwitting landlords. Essentially, the regime turns the net gain made during the development phase into a profit that is calculated and assessed on income tax rules; and there are immediate consequences:
- Sean will be deemed to make a disposal of the property for CGT purposes, at the point where he develops the firm intention to convert the property for onward sale. Sean effectively sells the property to himself at market value, even though he has made no proceeds.
- Sean will also trigger the 30-day period for notifying HMRC that he has made a disposal of UK residential property at that point and will likewise need to make a payment of CGT on account (again, note that Sean has no proceeds at this point).
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Sean could instead elect to postpone the CGT due on the capital gain to date by effectively ‘converting’ his capital gain up to that point into additional profit on the ultimate sale of the property. But that will usually result in a much higher eventual tax bill overall – swapping a CGT bill at 28% now on residential property, for a 40% (or quite likely 45%) income tax charge on the equivalent amount, on its sale.
Conclusion
When it comes to changing the use of a property and its eventual sale, the timing and recording of events and decisions are crucial. In particular, note that HMRC will look to determine if a property was actually removed from the property business an appreciable time before it was sold, as that may well restrict the relief available on that property from that point onwards. For example, taking Option 1, when trying to sell to landlords, it is often seen as advantageous to sell with tenants. But if Sean were instead to remove the HMO from the rental business, with no ongoing seeking of tenants, but marketed as an empty property, then he would forfeit any mortgage interest and potentially even repair costs after taking that decision; it would no longer be a rental property, and there is no capital gains tax relief for simply maintaining an investment asset.
For Option 3, Sean might alternatively try to sell the property as it stands (as an HMO) to a developer, effectively foregoing any participation in the profits from further development and ‘sticking’ at the capital gain to date. Some developers would offer Sean a cut of the subsequent development profit, usually to offset a lower offer price for the immediate sale. I’ll be looking at this in more detail in the next case study.
