Property Trading vs Investing: What Do You Want It To Be?

In this article Lee Sharpe looks at the tax implications of property trading versus investing.

For more in depth discussion on this important area of property taxation, please see our recently updated guide, 'Property Investment v Property Trading'.

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Tax advisers may recoil from a title that might be inferred to suggest that a business can be trading or investing depending on the whim of the taxpayer concerned – the correct position is always dependent on the facts, rather than what we might like the facts to have been – but a key factor is the taxpayer’s intentions for the property/ies. In other words, what the taxpayer wants, or plans for.

Intentions can change, and there are some potentially nasty tax traps to beware of if that happens.

Trading

Property developers are trading if they intend to sell the property/ies they work on, essentially as processed goods. This is the same regardless of whether or not the developer starts with bare land and a few pallets of bricks, or an existing property to which the developer is merely adding a bit of gloss.

While there are several ‘badges’ (i.e. indicators) of trading activity, it should usually be reasonably straightforward to spot a trading developer, since the property will be marketed for sale – potentially some time before the development phase has ended.

Tax implications of trading status

These include:

profits from the sale of a developed property will be taxed as income, to a maximum rate of 45%;
National Insurance contributions (NICs) will also be due;
if the business makes losses, they can be set against income from other sources;
finance costs are allowable in full:

o there is no restriction for dwelling-related loans; and

o the interest costs for the entirety of the project period will be allowed against income derived therefrom.

Investing

Property investors hold on to their property assets for the long term, as fixed assets. Whilst it is possible to hold property assets only for their long-term growth potential, most property investors will, of course, let their properties out to raise revenue. This is perhaps similar to interest received on bank deposits, or dividends from holding share investments. A property investor may build his or her own property/ies, as with trading developers, but this time they will not be marketed for sale immediately after they are built.

Broadly speaking, investment income is deemed for tax purposes to be passive in nature since, unlike with trading, no effort is required from the investor in order to generate income. This has always been an issue for ‘career landlords’, who may actively manage their letting business on a full-time basis. Many busy landlords struggle to understand why such intensive activity is not considered to be trading. However, some landlords delegate day-to-day duties to a letting agent, and in those circumstances, it could be seen to be quite similar in nature to holding shares or bank deposits.

Perhaps the key distinction between property and other investments is that there can be much greater emphasis (and energy expended) on the ongoing income yield, rather than capital growth.

Tax implications of investment status

These include:

profits from the rental activity are subject to income tax, at rates of up to 45%;
but profits from the sale of investment properties are subject to capital gains tax (CGT), at no more than 28% (20% for non-residential properties);
there are no NICs;
simply, losses from letting one property may be offset against income from other properties, but a business-wide net loss must be carried forward to set against future rental profits;
finance costs are deductible from the property business income, but:

o tax relief is restricted to no more than 20% for residential lettings, and

o costs are not allowable once the property is no longer being let.

In fact, tax relief for property expenses – not just interest – is not allowed unless the property is being let (i.e. it is part of the taxpayer’s property business).

If you bought a painting as an investment, any finance costs or repairs would not be allowable for CGT purposes, when sold. The same principle applies to investment property unless it is being let out.

Example 1: Plans can change

Jennifer buys a property to live in as her only home. She has no other property. She is seconded to Germany in 2018 for a minimum of five years there but keeps her UK home.

After a while, she decides to let her UK property. The letting lasts for several years, off and on, but as her stint in Germany draws to a close, she takes the property off the rental market, so it is available for her to live in, on her return to the UK.

Before she comes back, however, she is seconded to Venezuela for a further long-term assignment, and after a year or so, Jennifer decides to sell the UK property as she is unsure if she will ever return.

Clearly, Jennifer gets no tax relief for expenses such as mortgage interest while she is living in the house. She can claim for finance costs, maintenance, etc., while the property is being let out, or available to let (void periods are fine), but once she decides to take the property off the market pending her re-occupation, she cannot claim any tax relief.

Once she decides to re-let the property, when it becomes clear she will not be coming back to the UK from Germany as originally intended, her expenses once again become deductible. However, when she takes the property off the rental market again to sell it, the costs from that point are non-deductible. Her intentions for the property directly affect the tax position.

Changing intention – beware moving between trading and investing

Some potentially quite nasty tax issues arise if someone changes their intentions from investing to trading, or vice versa.

Example 2: Changes of intention to trade/invest

Bill has let a large property out for several years and it is now standing at a substantial capital gain. He decides to develop the plot into several houses, to sell. He has taken his investment and put it into a trading activity. Tax law effectively says he makes a capital gain on ‘selling’ it to himself as the property developer (TCGA 1992, s 161). By default, CGT will be due, even though no money has changed hands.

Bill is, however, allowed to make a tax election, which essentially converts that capital gain into part of his trading profit on sale of the new houses. But note that this converts a gain taxable at no more than 28%, to enhance a profit taxable at as much as 47%, including NICs. An election may be better for Bill’s cashflow, but worse for his bank balance when the project has finished (you used to be able make the election even when the property was standing at a capital loss, but the government recently decided this was unfair (in F(No 2)A 2017), presumably because they weren’t able to make more money out of it).

Freddy, on the other hand, develops a property for re-sale, then decides he wants to keep it and start a rental business.

Tax law deems him to have sold the property to himself, again at current market value, but this time for a trading profit, taxable at up to 47% (ITTOIA 2005, s 172B). This time, there is no election to roll the profit into a capital gain to be accounted for when the property is eventually sold. Freddy might wish he had always intended to develop the property for rental, rather than for resale.

Conclusion

A taxpayer’s intention is a key factor in determining the tax treatment of a property. Advice should always be sought before selling or developing property, to ensure the tax treatment is as expected.

Practical Tip:

Contemporaneous correspondence with third parties (e.g. solicitors and lenders) can be persuasive evidence, if HMRC questions what was intended for a property, and when.