James Bailey explains why distinguishing between property development and property investment is important.
When you sell a property, are you making a trading profit or are you making a capital gain on an investment?
The tax treatment of property developers and property investors is significantly different. Property developers make profits chargeable to income tax (unless they are limited companies), whereas property investors make capital gains when they sell a property. Property developers are required to operate the ‘construction industry scheme’ (CIS) and deduct tax from payments to subcontractors; property investors are not.
In some cases the distinction is clear.
Example - Investor vs developer
Mr Mole buys a house, which he refurbishes and lets for five years before selling it. Clearly, Mr Mole is a property investor and has made a capital gain on the sale of the property.
Mr Rat buys the house next door, and immediately puts it on the market while he refurbishes it. Within three months, he sells it at a profit. Equally clearly, Mr Rat is a property developer and will pay income tax (and Class 4 National Insurance contributions) on his profit. He will also have had to operate the CIS on payments to the subcontractors who did the refurbishment.
In real life, of course, things are generally not so clear cut. HMRC will tend to argue for property development wherever possible, as the rates of income tax are higher (at 20%, 40%, or 45%) than those of capital gains tax (at 18% and 28%).
What do HMRC look for when deciding whether a sale of a property is trading or not?
Intention
This is crucial. In order for the sale to be a trading transaction there must have been an intention to trade. This intention may have been formed at the time the property was acquired, or it may be formed later.
In the above example, if instead of just selling the property Mr Mole had demolished it and built a block of flats in its place, which he then sold off on long leases, the fact that he originally bought it as an investment would not prevent his having subsequently (when he decided to build the flats) started a trade of property development and transferred his investment property to trading stock.
Repetition
Even if he lets a property before sale, if a person routinely buys properties, lets them, and then sells them, he is probably trading.
Similar Activities
A property developer may acquire a buy-to-let property as an investment, but HMRC will be more suspicious if he then sells it quickly than they would be with another person who did not have such a track record.
Finance
Where the acquisition is financed with short-term funds so that it is essential to sell it quickly, this is good evidence of trading.
Timing
A property investor might buy a property intending to let it, before receiving an excellent offer for it, leading to a quick resale – but HMRC will take some convincing that a quick turnover of a property is not trading.
Acquisition
If you inherit a property, the presumption is that you are not trading when you sell it, though if you develop it significantly before you sell it that could change – as with Mr Mole (see ‘Intention’ above).
These points are called the ‘badges of trade’. They do not all need to be present for a transaction to be a trade, but they illustrate the thought processes behind the distinction.
Practical Tip:
It is important to be clear whether you intend to trade by selling a property at a profit, or to invest by deriving a continuing rental income from it. The tax treatment will depend on whether you are trading or investing, as will your responsibilities under the CIS.
