Property Tax Traps – Are You Trading or Investing?

 

HMRC’s Property Income manual states (at PIM1020):

‘Profits from UK land or property are treated, for tax purposes, as arising from a business.’

 

‘Trades’ have a special status in tax legislation. They are generally allowed to access the most generous tax reliefs for losses, capital gains, etc. A trade is a form of business, but not all businesses are trades. A business of making or holding investments (such as land) would not be considered a trade. 

 

Where a person buys a property with the intention of developing it for re-sale, then the level of business activity is such that this will almost certainly be considered self-employed in a trading activity, and little different to buying leather to make shoes. 

 

Where the intention is to hold on to an asset for an indefinite period, with the asset essentially unchanged, but nevertheless being exploited to derive an income, then this is generally considered a ‘passive’ investment business. I am guaranteed to get a fairly agitated response when I tell landlords that, so far as HMRC is concerned, they can sit back and just watch their rental income roll in every month, with no more effort required than, say, depositing funds in a bank account to generate interest.

 

But there are landlords who let properties through agents, and have negligible involvement with the day-to-day running of the property or properties that they own. The letting agents themselves are, of course trading, because they are providing a service to their landlord clients. 

 

To the extent that the letting activity derives from letting UK properties on a commercial basis, all profits and losses are aggregated. Any net deficit is carried forward against future profits from that property business. 

 

There are some exceptions to this rule, such as for properties which are let overseas, ‘furnished holiday lettings’, or properties which are not let on a commercial basis, perhaps because they are let to friends or family. 

 

Basically, trading losses can be carried forward or backwards, or ‘sideways’ if the taxpayer has other income in the tax year of loss. They can even be set against capital gains, in some cases.

 

Clearly, trading losses are more flexible than rental losses. There is occasionally scope to set rental losses against other income of the year, (or the following tax year), where losses have arisen thanks to a claim to capital allowances. But such claims are generally found only in commercial lettings, rather than residential. 

 

Unfortunately, a person generally needs ‘relevant earnings’ in order to make pension contributions. Earnings basically derive from employment, or from self-employment – trading. Anyone can pay in up to £2,880 (which counts as £3,600) into a ‘stakeholder scheme’ without having any relevant earnings at all, so property investors can make at least some pension provision. Many landlords will simply say that their property portfolio is their pension.

 

In fact, it is possible to put property into a pension fund but this would normally apply only where there was a trading activity in the first place, to support the pension scheme.

 

Trading activities enjoy numerous ‘perks’ when it comes to capital gains tax (CGT), such as:

• entrepreneurs’ relief – a 10% tax on the gain arising from a qualifying disposal, basically in a trading business or company. Property investors cannot access entrepreneurs’ relief, and will pay CGT at up to 28% on any gains from property sales. Property developers are eligible for entrepreneurs’ relief, but only if they sell their business or a stake in it; property sales themselves will be taxed as income; 
• replacement of business assets relief (‘rollover relief’) – allows a business that has made a capital gain to reinvest the proceeds of the disposal into a replacement qualifying asset and postpone tax on the gain until the replacement asset is sold. In fact, the gain on the replacement can also be postponed. Unfortunately – and despite using the word ‘business’ in the legislation, only trades are eligible. This would potentially be of great benefit to property investors, but they are ineligible; and
• gift of business asset relief – allows a gain to be postponed when an eligible asset is disposed of for no (or reduced) consideration. Again, despite using the word ‘business’, only trades may qualify, so if a landlord gives one of his properties to his children, CGT will normally be due, even if he has received no money in return.

 

Property developers may seem so far to have had a good run. However, there are some disadvantages. 

 

Profits on property sales count as trading income so are therefore liable to income tax at rates up to 45%. A property investor’s capital gain on a property disposal will be taxed at only 28%.

 

Property investors are exposed to National Insurance contributions (NICs) on their trading income. Landlords are not required to pay NICs on their letting incomes – although HMRC did recently try to force some landlords to pay Class 2 contributions; the case of Rashid v Garcia [2003] SSCD 36 explains why HMRC should be given short shrift. 

 

Property developers also have to contend with the construction industry scheme (CIS), which requires them to report all payments made to people whom the developer contracts in to assist with building or renovating a property, such as electricians, plumbers, plasterers, etc. The developer may have to retain some of the payment made to the sub-contractor and pay it over to HMRC instead, on account of the subcontractor’s own tax bill. There are quite severe penalties for failing to apply the CIS regime correctly. HMRC has previously contended that property investors are not immune to the CIS, if they are undertaking substantial building works. This is arguable.

 

A property investor may buy a plot of land to develop for residential letting purposes and then at some later point decide to sell the property instead. This might be, for instance, because (s)he has read that (s)he will no longer get full tax relief on her finance costs, when the residential mortgage restrictions come in over the next few years. It is a fact of business life that intentions do change, and tax law has to accommodate. 

 

Where a landlord takes a fixed asset investment to trading stock (say, for property development for re-sale, as in the previous paragraph), then the landlord is basically deemed to have made a capital gain on a sale to himself, at the prevailing market value. At first glance, this may seem like bad news. But this is effectively recognising a capital gain instead of a trading profit:

 

Jane bought a plot of land adjacent to one of her investment properties 20 years ago, for £10,000. It is now prime development land, easily worth £200,000. With a further £100,000 of expenditure, she could sell a house worth £500,000.

 

Jane should:

Recognise a capital gain of £190,000 in respect of the uplift in land value to today’s prices.

Recognise a trading profit of £500,000 – £100,000 – £200,000 = £200,000.

 

Jane could make an election to ‘hold over’ today’s gain, and reduce the cost of the land when calculating her trading profit (TCGA 1992, s 161). In effect, her trading profit would be £500,000 - £100,000 – £10,000 = £390,000. 

 

While Jane might be delighted at the thought of putting off paying CGT on a property she has not yet sold, she will be less inclined when she realises that she has avoided paying CGT at 28% but will pay more income tax at 45%. 

 

If a developer later decides to hold on to a property for the long term, say to generate rental income, then he may be in for a shock. Tax law again basically requires him to recognise a sale to himself, amounting to a trading profit at full market value, but without any actual sale proceeds. See HMRC’s Business Income manual at BIM33630, and guidance specifically for builders at BIM51625. There is no corresponding election, which might allow the transferor to postpone/convert the deemed trading profit.

 

Property investors should be aware that they enjoy fewer reliefs than their trading counterparts. Property developers may be able to avoid both high personal income tax rates and NICs by operating through a company.

 

There are potentially serious implications to a change of intention regarding a property. It may be possible to conduct a lettings management activity as a trade, separately to the activity generating rental income. Careful planning is, however, essential.