Trading or investment: Why do we care?

In this sample excerpt from the newly updated guide ‘Property Investment v Property Trading’, Lee Sharpe looks at key tax considerations when investing or trading in property. Learn more about this popular tax saving report and save 30% today.

Individuals and non-corporate entities: Income tax v CGT 

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 (by ‘unincorporated’, I mean those run by individuals solely or together, as distinct from those run in a company).  

There can also be a significant 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, but not by so much as to substantively affect result.) 

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 CGT 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 £158.60 for the year, for most trading activity.) 

On the basis that the band for the main rate of Class 4 NICs broadly overlaps the Basic Rate Band for Income Tax purposes, the main combined rates for trading are 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 rate of 29% in the ‘Basic’ Rate Band is almost three times the rate of 10% that would apply to the capital disposal of a commercial property in that band. (Investment income, such as from rental profits, has no National Insurance charge.) 

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 approach 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 profits may well end up being taxed at 47%, compared to 28% at most for capital gains on the sale of a residential property (or as little as 20% for a commercial property gain).  

We wait with great interest – and no little trepidation – to see if the Chancellor bows to pressure to increase capital gains tax rates, etc., to help pay for the immense financial cost of COVID support. There are (at least) one or two reasons why raising CGT is not a simple or immediate fix: 

1. If CGT is dramatically increased, it will discourage people from selling their assets, at least in the short term, which would risk throttling the hoped-for ‘bounce-back’ in the economy 
2. Capital gains by their very nature accumulate over several years, so it would arguably be quite unfair to tax them at the much higher rates for those who earn similarly large-scale profits in a single tax year 
3. It is also unfair to tax any part of a capital gain that is not a real gain but has come about merely by reason of simple price inflation – a significant factor for assets that may have been held for a decade or more 

The Chancellor may be sufficiently canny to realise that ‘trialling’ a CGT hike in, say, 2-3 years’ time is likely to encourage people to sell before the deadline to maximise their personal returns – while also netting the Exchequer a substantial one-off windfall in the short term. Something similar happened just before the Additional Rate was introduced in 2010 for incomes exceeding £150,000, and was considered by the government to be ‘entirely legitimate’ – probably because it raked in £billions in early tax receipts.

Companies 

For companies, the rate of tax is the same regardless of whether it is trading profits or capital gains – currently 19%. For now, 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 remain extremely valuable to many long-term corporate investors, who hold assets acquired before December 2017. 

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 ‘non-residential’ CGT 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 some capital gains, and can potentially shield the owner from 28% CGT on residential property disposals, one might be forgiven for assuming that companies are the best business vehicle in any circumstances. And that might be so in some cases – particularly so long as you never needed to take the profits out for your own personal needs, such as living expenses. But it will normally cost additional Income Tax (and potentially NICs) to extract the company’s funds into your personal bank account, etc. 

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 levies a new kind of tax charge on companies, each year, simply for holding relevant residential property. Up until 6 April 2019, disposals of properties subject to the ATED annual charge were also caught for a special rate of ATED CGT, which operated at a flat 28%, with no Indexation Allowance. Thankfully, ATED CGT was withdrawn for disposals on or after 6 April 2019 (FA 2019 s 13, Sch 1). 

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

Is a capital gain always better than trading? 

So far, it looks as if the cards are stacked pretty heavily in favour of investment activity, rental and capital gains – significantly lower rates for individuals on disposals, and in some cases 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 (interest relief is allowed against property rental income, subject to restriction as per 7.1 below, but only while the property is being used in a rental business) 
• If you want to make substantial pension contributions, you need to have ‘relevant earnings’, and while property development trading profits qualify as relevant earnings, capital gains and rental income do not 
• Trades have access to more/better reliefs when making capital gains on assets used in the business. So, while a property developed for re-sale will be sold for trading profit, the sale of that business’ trading premises would ordinarily be a capital gain, and usually eligible for the better tax reliefs available to a trading enterprise. Similarly, the outright sale of a trading business itself (rather than individual assets) would also usually be eligible for Entrepreneurs’ Relief (Business Asset Disposal Relief) at as little as 10% on the first £1million of eligible gain made in one’s lifetime 

• Trades generally also have better access to tax relief for their losses