Alan Pink considers the tax charges that can arise when a trading property becomes an investment and vice versa.
Tax planning for property can be fraught with problems, particularly in relation to the all-important question of whether a property-based activity is trading or investment for tax purposes.
The distinction is crucially important, because profits from disposing of trading properties are treated as income, and profits from disposing of investment properties are capital gains. Not only are the tax rates for individuals very different, with income tax being chargeable at effective rates of up to 47% (including National Insurance contributions), as against capital gains tax (CGT) which has a maximum rate of 28%; but also, the treatment of any losses is very different. Income losses, subject to certain constraints, can generally be offset against other income or against capital gains. Capital losses, on the other hand, are generally relievable against current or future capital gains. So, capital losses are not particularly useful in most real-life situations.
Trading or investment?
So, how can you tell property trading and property investment apart? Since the tax consequences can be so different, presumably the distinction is a clear one?
Guess again! In fact, fundamentally, the distinction between trading and investing in property is one of intention; if you intend to hold on to the property long term for rent, you are an investor. If, on the other hand, you intend to make a profit in the foreseeable term by selling the property (perhaps having developed or redeveloped it in the interim) you are trading. The problems arise where you start off wanting to do one of these things and change your mind. Because the distinction we are talking about here is one of intention, a change of mind results in a change in the very nature of the property itself as it is seen for taxation purposes.
A trading property becomes an investment property
This change can have distinctly unfavourable consequences! It’s also, unfortunately, more common in practice than the opposite change. Here’s an example.
A developer buys a plot of land with a view to building ten houses on it and selling them at a profit. The development is successfully completed, but when the time comes to sell the properties, he finds it difficult to sell the last two. So, he makes a policy decision to keep these remaining two properties indefinitely and find tenants for them.
Leaving aside the potentially disastrous VAT consequences of this (which can be avoided relatively easily if the eventuality is foreseen when the development starts), we have a somewhat bizarre case of a ‘dry’ tax charge occurring. Let’s say that each of these houses cost the developer £200,000 to build, but each has an (at least theoretical) sale value of £350,000. When the decision is made to move the properties over, so to speak, from trading stock to fixed asset investment property, the tax rules (following a fairly old case, Sharkey v Wernher HL 1955, 36 TC 275, which has since been legislated) will treat the developer as if he had sold these houses to himself for their market value. So, in this example, he has a tax charge of two lots of £150,000 (that is £300,000), with no real profits to pay the tax out of.
This is obviously a highly undesirable result, as well as being a very perverse tax law; so how, if at all, can it be avoided?
The truth of the matter is that it can’t always be avoided. However, clearly, it behoves any developer, who feels that it might be possible that he may retain some properties long term as investments, to identify these at an earlier stage, and categorise them from the outset as fixed assets. Sometimes commercial considerations make this impossible. However, if the future investment properties can be identified at as early a stage of the development as possible, it may be possible for them to be re-categorised before too much damage has been done in the way of inherent development profit.
Investment properties becoming trading properties
Unlike the converse situation, there is no necessity for a tax charge to arise where a property which was previously held as an investment becomes trading stock. Whilst this ‘appropriation to trading stock’ (as it’s called in the Taxation of Chargeable Gains Act 1992, at s 161) gives rise to a deemed disposal of the property for CGT purposes, it’s possible to elect to ‘hold over’ the profit, and effectively introduce the property at original cost in to the trading account.
Of course, the effect of putting the property into trading stock, so to speak, is that a future profit on its sale will be taxed as income. However, if the property is owned individually, it is sometimes possible to bring about the result that a limited company (with its much lower tax rate on income) receives a share of the ultimate profits. One way of doing this, for example, is for a company to be formed as the developer, and for that company to realise a reasonable profit as part of the process.
Other effects of the change can be favourable. For example, if the property concerned is held within a limited company, the change of status from investment to trading means that the company may acquire trading status for CGT purposes, potentially making its shares eligible for entrepreneurs’ relief on a sale. Arguably even more importantly, a property or property portfolio which was previously held as an investment and which gets turned over to an active property development trade should in principle qualify for business property relief from inheritance tax (IHT). As a trading business, indeed, this could be eligible for 100% relief.
This opens up the possibility of this situation being deliberately engineered in order to qualify a property portfolio for IHT relief. In principle, even if the portfolio has been held for a great many years and the owner is now approaching his demise, an active decision to redevelop the portfolio could convert it into 100% relievable value.
This is the case in principle. In practice, of course, the key point is going to be convincing HMRC, in an enquiry, that this is actually what has happened, and that it is not merely an example of ‘window dressing’ to save potentially huge sums of IHT. So, acquire as much evidence of the change of intention as you can, including minutes of directors or ‘partners’ meetings, correspondence with contractors, active seeking of planning permission for redevelopment, and various other features of a ‘proper’ property development business.
1. If you are developing property and may retain some of it as an investment long term, make the decision as to which property is to be retained as soon as possible, and take active steps to evidence your re-categorisation of that property as an investment.
2. If you decide to redevelop property which has hitherto been a fixed asset, bear in mind that this decision is a disposal for CGT purposes; but, providing an election is put into HMRC, this is a decision where the tax consequences can be deferred.
3. Bear in mind that, in principle, a property portfolio which is fully chargeable to IHT could become a fully relievable portfolio if a genuine change of intention, fully evidenced, takes place.
This article was first printed in Property Tax Insider in October 2018.