Property Investment v Property Trading: Why Do We Care?

When looking at property investment and property trading activities, there are some major differences between the two approaches, within this report we take a look at these and their implications from a UK tax perspective. The report explores some of the opportunities and pitfalls of both activities, and evaluates different vehicles to undertake the respective activities.

The following is an extract from our popular property tax report Property Investment Vs Property Trading. Get the full report here.

Trading Or Investment: Why Do We Care?

Individuals and Non-Corporate Entities

There can be a substantive difference between the tax, etc., applied to a trading activity when compared to an investment activity – at least for unincorporated businesses. 

There can also be a difference in the treatment for losses. 

There is no ‘hard and fast rule’ as to which is the better approach; nor is there often a choice.

But let’s say for simplicity that a residential property is being sold by an individual for £500,000 that cost only £300,000. The profit or gain is £200,000. In such a simple example, the profit would be the same as the gain: 

(NB Income Tax rates differ in Scotland)

While the CGT Annual Exemption is slightly less generous than the Personal Allowance, capital gains are generally taxed less harshly than income. 

In fact, these are the rates for residential properties. For property disposals on or after 6 April 2016, where the capital gain is on a commercial property the rates fall to 0%/10%/20%. 

Furthermore, trading income attracts a Class 4 National Insurance Contributions charge:

(There is also a fixed Class 2 NICs charge, currently £145.60, for most trading activity)

On the basis that the band for the main rate of Class 4 NICs broadly overlaps the band for the Basic Rate Band for Income Tax purposes, the main combined rates for trading will be 0%/29%/42%/47%. 

This opens up a huge margin between the tax that will be levied on a trading profit, when compared to a capital gain on the same amount – the combined tax and NICs charge of 29% in the ‘Basic’ Rate is almost three times the rate of 10% that would apply to the capital disposal of a commercial property in that band. 

Since property tends to be ‘lumpy’, profits and/or gains commonly end up at many tens or even hundreds of thousands of pounds, so even relatively small rate differences can result in dramatically higher tax bills through being taxed as a trade, for non-corporates. 

This difference is exacerbated for non-corporates with long-term projects that might span more than one tax year because unused Personal Allowances/Basic Rate Bands, etc., in Year 1 cannot be rolled into the following year to soak up large profits from, say, a property development profit in Year 2. (While this rule applies also to capital gains, the rates are lower, so it is less problematic).

The end result is that a great deal of self-employed property development profit may well end up being taxed at 47%, compared to 28% at most for capital gains on the sale of a residential property. 

Investment income, such as from rental profits, has no National Insurance charge.

Companies

For companies, the rate of tax is the same regardless of whether it is trading profits or capital gains – currently 19%. Companies can also claim Indexation Allowance – a form of inflation proofing – on their capital gains, to further reduce the tax charge on capital disposals. (TCGA 1992 ss 53/54). Note that the 2017 Autumn Budget announced that Indexation Allowance would be frozen at December 2017 for future corporate capital disposals and is likely to be withdrawn completely at some point in the future (this is what happened to Indexation Allowance for individuals: frozen in 1998 and withdrawn completely in 2008). Until this happens, however, Indexation Allowance is likely to prove extremely valuable to many long-term corporate investors.

Companies are also potentially useful for holding residential property that would otherwise be subject to 18%/28% CGT if held personally: selling company shares is NOT selling the bricks and mortar that the company owns, so will be taxable at only 10%/20%, using the rates as above. (But see the next section).

Why Isn’t Everybody In A Company?

Given that companies pay tax at only 19% and can also access Indexation Allowance on capital gains, one might be forgiven for assuming that companies are clearly the best business vehicle in any circumstances. And that might be so in some cases – just so long as you never needed to take the money out for your own personal needs, such as living expenses. 

For more on this, please see ‘Corporation Tax Double Charge’, and the example, Hector Limited, below.

There is also the Annual Tax on ‘Enveloped’ Dwellings, (ATED), which applies a new kind of tax charge to companies that hold relevant residential property. Where ATED applies, the company’s capital gains on relevant residential property may also be subject to a special rate of ATED CGT, which is a flat 28%, with no Indexation Allowance. 

ATED currently applies only to dwellings worth more than £500,000, and companies can claim relief from the ATED regime where the property is being let on a commercial basis to third parties, or where it is being held for property development purposes. (But the relief does have actually to be formally claimed, rather than presumed).

Capital Gains Every Time?

So far, it looks as if the cards are stacked pretty heavily in favour of investment activity and capital gains – significantly lower rates for individuals, and even Indexation Allowance for companies (for now, at least). But there are various reasons why trading has its merits (not least of which is that it isn’t as simple as choosing which you prefer):

•         The range of allowable expenses/deductions is far wider for trades than it is for capital gains tax – notably loan interest, so where a venture is highly geared and the interest charge is significant, the capital gains route might prove surprisingly expensive
•         Access to making substantial pension contributions requires relevant earnings, and neither capital gains nor rental income comprises relevant earnings
•      Trades have access to more/better reliefs when making capital gains on assets used in the business. So, a property developed for re-sale will be sold for trading profit, but the sale of that business’ trading premises would ordinarily be a capital gain, and usually eligible for better tax reliefs for a trading enterprise. The outright sale of a trading business (rather than individual assets) would also usually be eligible for Entrepreneurs’ Relief at as little as 10% on the first £10million of eligible gain made in one’s lifetime.
•        Trades generally also have better access to tax relief for their losses.

By Lee Sharpe

This is an excerpt from our popular report Property Investment Vs Property Trading. For more information, click here.