Are you a property investor or a developer? It can sometimes be a fine line that distinguishes the two but getting it wrong has important tax implications!
As programmes like Property Ladder attest, many people are keen to invest in property and are confident that they can make a sizeable profit by doing a property up and selling it on.
From a tax perspective, difficulties may arise in that it is not always clear cut whether a person is investing in property or trading as a property developer. This is an important distinction as it determines how any profit on sale is taxed. In the case of an individual, a gain on an investment property would be taxed as a capital gain whereas profits made by a person trading as a property developer would be liable to Income Tax. In a climate where Capital Gains Tax (CGT) rates are considerably lower than the highest rate of Income Tax, the attraction of realising a capital gain is apparent.
How Do I Know?
However, one does not get to pick which tax one pays (well, not after the event at least). Whether a person is trading is a question of fact and the normal ‘badges of trade’ apply. The starting point for deciding whether one is dealing with a trading or investment situation is the intention of the owner at the outset.
Example 1
Joe buys a two bedroom property. His intention is to keep it as a long-term investment. He does the property up with a view to renting it out. However, due to changes in his personal circumstances, he sells the property after two years having completed the renovations, realising a profit of £20,000.
Joe’s intention was to hold the property as an investment. Although he sold it after a relatively short period of time, the original motivating factor had not changed. The `profit’ that he made on the property would be a chargeable gain and Joe would be liable to pay CGT on it. Any gain would be reduced by the CGT annual exemption to the extent that this remained available.
Example 2
Jack buys up a dilapidated property with a view to doing it up as quickly as possible and selling it on at a profit. He plans to reinvest any proceeds from sale into further properties to do up and sell.
Unlike Joe, Jack’s main motivation in buying the property is to make a profit from doing it up and selling it on. Looking at the intention behind the purchase suggests that Jack is trading as he buys and sells the property with a view to making a profit. Consequently, any profit made by Jack on the sale would be liable to Income Tax rather than CGT.
Other Factors to Consider
Although the original intention of the owner is an important one, when deciding whether a person is trading HM Revenue & Customs will look at a variety of factors. These include:
- length of ownership
- whether the purchase and sale is a one-off or one of a series of transactions
- whether the property has been rented out
- whether the property was acquired for personal enjoyment
- whether there is a connection with an existing trade – for example a builder buying a property to do up and sell.
Together these will create a picture and help determine whether a person is trading or investing.
In a rising market a capital gain may be infinitely preferable to a trading profit. However, in a falling market the reverse may be true. The potential to relieve trading loss is much greater than for a capital loss.
Practical Tip
Although the tax consequences hinge on the facts, having in mind the desired tax outcome at the outset can be helpful in arranging one’s affairs to achieve that outcome. However, the tax landscape changes and the old adage of not letting the tax tail wag the dog should not be forgotten.
By Sarah Bradford
