Property development: Case studies (1)

Lee Sharpe takes a look at property development from scratch; a brand-new residential building. 

This first set of case studies will look at the key considerations when developing a residential property from a bare site. We shall throughout assume that we are referring to land owned personally by UK resident individuals, and we shall be ignoring the pandemic for the purposes of considering the principles involved.  

In this article, we shall look at developing residential property from the ground up, and: 

• The role that only or main residence relief (also known as PPR relief) has to play; 
• How VAT can be your friend (but one you still need to keep an eye on); 
• That the construction industry scheme (CIS) will probably apply; 
• Planning permission; and 

• Interest expenses.  

Case Study 1: Bill the investor 

Bill is an experienced residential landlord, with a substantial portfolio owned personally. Many years ago, he acquired a residential property on a corner plot with large gardens. It has been let ever since. Having recognised the potential for development, he has sought various planning permissions, the latest one being a couple of years old.  

In 2021, Bill decides to put two semi-detached properties at the other side of the plot, with independent access, as per the last permission, to enhance his letting portfolio. The build time will take approximately 10 months and the relevant costs/values are as follows:  

There is no capital gains tax (CGT) at this stage because all Bill has done so far is enhance an existing capital asset – the land he originally purchased. 

Case Study 2: Benita the one-off developer 

Benita is likewise an experienced residential landlady, with a substantial portfolio owned personally. Many years ago, she acquired her current main residence on a corner plot, with substantial gardens. Benita also wants to develop the spare land but she wants to sell the new property once complete, and will probably sell her current home, once the development has been sold on; she wants to move out of the area in the next year or two. Benita arranges for relatively short-term finance of up to £400,000 to cover the building cost, and seeks advice on the best way to exploit the ’spare’ land. She settles on building a single dwelling at the opposite end of her plot.  

Benita hopes to benefit from the fact that the land being developed is part of her only or main residence, so should be free of CGT. When she eventually gets round to consulting with her agent, she discovers: 

• The development will be free of CGT because it is actually subject to income tax (and potentially self-employed National Insurance contributions) as a ‘supervening trade’. This is because Benita has always intended to sell the new property once complete. To that extent, Benita is now a property developer, and the trading aspect overrides capital gains provisions. 
• There is still CGT PPR relief but it extends only to the value of the land when taken over for development. Unfortunately, HMRC may argue that planning permission – which enhanced the land value – was secured only after the intention to develop for sale had formed.  
• On the other hand, Benita is lucky that her main residence plot is just under 0.5 hectares (circa 1.2 acres) because, simply put, that is the standard limit for garden, grounds and main residence; any larger and some of the new development might well have fallen outside of the ’automatically exempt’ zone, leaving Benita with the task of convincing HMRC (or a tribunal) that her total permitted PPR area should be extended beyond 0.5 hectares as it is required for the ‘reasonable enjoyment’ of her main residence. Despite the fact that she is building a new house on some of it. 
• Her agent further advises her that she will be caught by the CIS regulations as a property developer. For the duration of the project, she will have to report payments made to sub-contractors (builders, etc.) on site and, where necessary, withhold tax from payments and then pay that tax over to HMRC. 
• Her agent also recommends that she register for VAT. While this may seem strange to a residential landlady, this is because she will make a zero-rated VAT supply when she sells the new dwelling. Zero-rating is quite different from the usual exempt supply of residential letting with which most landlords are familiar, because zero-rating means that the taxpayer can register for VAT, and reclaim all the VAT costs on construction services and materials supplied. 

Benita saves £20,000 by being VAT-registered and reclaiming the VAT on materials costs she incurs, and a further £20,000 by choosing the ’right’ builder; in this case, it is the VAT-registered builder who has the lower quote.  

Notes: 

(a) PPR relief: Benita is lucky she intended to sell her home after selling the development in her garden. Some homeowners have found to their cost that the PPR relief on otherwise eligible grounds generally evaporates as soon as the corresponding ’original’ main residence is sold, or simply no longer occupied as the main residence. 

(b) VAT: It might seem unlikely that a VAT-registered builder could charge less than a builder who is not VAT-registered. But VAT-registered builders will be charging both Bill and Benita zero VAT on most of their work on their new dwellings; while still being able to reclaim their own VAT costs (which builders who are not VAT-registered cannot do, so they could end up being more expensive). Benita might also be wary of any builder charging £220,000, while still saying they are not VAT-registered (the VAT registration threshold is £85,000 in any period of up to 12 months). While in reality, VAT recovery claims will be more complex than this (not all such VAT is reclaimable), even Bill may well benefit from carefully choosing his contractors (although he cannot register for VAT, because he is keeping the new dwelling, the builders can still charge zero-rate VAT). However, builders will need to be instructed that the zero VAT rate applies. 

If Benita were later to decide not to sell but to retain the new property, HMRC might soon be asking for her reclaimed £20,000 VAT back! 

(c) Construction industry scheme: The likelihood is that Benita and Bill will be ’caught’ for CIS purposes, because it applies even to ’pure’ property investors if they embark on a substantial development project. It is a pain to deal with, but even more so if it is not dealt with properly because (penalties aside) if HMRC cannot see that the CIS tax that should have been withheld has effectively been paid by the sub-contractors in their own tax returns, HMRC can recover that CIS tax from the contractor (Bill or Benita). This could be a very substantial amount.  

PAYE may even apply in some cases, where an individual works exclusively for Bill or Benita for several months, depending on the circumstances.  

(d) Planning permission: HMRC accepts that planning permission does not catalyse a trading activity (Bill needs planning permission, and he isn’t trading), but it can indicate when a trading intention starts. People (including advisers) tend to assume that trading starts after planning permission has been obtained. But Benita’s trading intention precedes the point at which planning permission is sought, and in my opinion the uplift in land value is taxable under trading principles. It might have been different if Benita could show that her trading intention and related activity started sometime after permission was granted – like Bill, say. 

(e) Interest: Benita will be able to claim relief for interest on funds borrowed in the course of her property development trade, while Bill is able to claim interest (albeit only at the basic rate) only because he is using the funds to augment his rental business (it is claimed against his property income, not in the above capital calculations). 

Conclusion 

In the next article in the series, we shall look in further detail at Bill and Benita, and what happens if they change their minds about their projects. Later case studies will look at house in multiple occupation (HMO) projects, void periods, and the risks when taking properties out of the rental business.