Jennifer Adams considers the reasons a landowner may wish to separate land from their main residence and the possible tax implications in doing so.
Subdividing land will generally be for one of the following three purposes; where the owner intends to:
-
develop the land to retain it for a specific purpose (e.g., building a separate 'granny annexe');
-
develop the land for selling at a profit or for renting out; or
-
sell the land to a third party for development and sale.
Building a ‘granny annexe’
Building a 'granny annexe' in the grounds of an existing main residence does not have any immediate direct tax implications. However, issues may arise when considering the main residence's capital gains tax (CGT) position should the separated land be sold or gifted.
Unless the owners sell their main residence and move into rented or other accommodation, as soon as the 'annexe' is habitable, the landowner will own two ‘dwellings’ of which only one can be their principal private residence (PPR). If the transaction takes place within nine months, no CGT will normally be due under the PPR relief rules. If this is not possible, an election can be made to nominate one of the residences as the PPR, reducing or eliminating any CGT payable. This election must be made within two years of the date that there is a new combination of residences.
Whatever the final outcome, it is advisable to make the election as soon as possible after the move into the 'annexe', as this will provide flexibility if the sale of the original property takes more than nine months.
Inheritance tax (IHT) implications may arise should the 'annexe' be built and the original property be gifted rather than sold. Typically, a gift is a ‘potentially exempt transfer’ falling outside of the donor’s estate for IHT purposes after seven years, provided there is no ‘gift with reservation of benefit’ (GROB). There is no GROB if the property is enjoyed to the exclusion, or virtually the entire exclusion, of the donor (and there is no benefit) during the relevant period. Problems could arise if (say) the donee goes on holiday for two weeks, and the donor stays in the gifted property to look after it. HMRC accepts that such a situation would come under the heading of 'de minimis' benefits and not invoke the GROB rules.
Stamp duty land tax (SDLT) (in England and Northern Ireland) is where the problems are more likely to arise. Any sale will be subject to SDLT even if sold to a child. SDLT will also be due on a gift should the child assume their parents’ mortgage debt. The SDLT calculation will be on the amount of debt outstanding at the time of the gift.
Building a new separate annexe is usually zero-rated for VAT purposes, being the construction of a new residential building.
Self-development
Should the landowners develop the land themselves, intending to sell at a later date, this will generally be treated as a trade and taxed as a business.
The distinction between trading and investing in property is based on intention. It is investment should the intention be to keep the property for the long term for rent; trading is the intention to develop and (hopefully) sell for a profit at a later date. As soon as work starts on the development, the land is held as trading stock within the business having deemed to have made a ‘disposal’ of the land to themselves. Such a transfer would normally trigger a CGT charge as an 'appropriation to trading stock’ (TCGA 1992, s 161). However, a CGT 'holdover' relief claim is generally possible, effectively introducing the property at original cost into the trading account and deferring any gain until the property is sold (TCGA 1992, s 161(3).
When the new property is sold, the CGT calculation will be on the sale proceeds, less the value of the land introduced as stock. If the landowner carries out the development as a sole trader or through a partnership, the trading profits will be liable for income tax at the landowner's marginal tax rate and National Insurance contributions (NICs) may be due. No CGT relief under business asset disposal relief (BADR) can be claimed (where distributions are taxed at 10% on business closure) as the conditions will not be satisfied. For this reason, property developers commonly structure developments as a separate company (a ‘special property vehicle’ (SPV)) as corporation tax rates are usually lower than an income tax and NICs combined charge. Withdrawing monies from a company as dividends attracts tax at the dividend tax rate. An SPV could be a trading company or a limited liability partnership that is subsequently used for a lettings business, but it is usually a new company with no prior record of trading.
Where a property or land (say, in London) is initially held by a landowner personally and is transferred into a limited company, both SDLT and CGT charges potentially apply (although CGT may be deferred by incorporation relief or a 'holdover' relief claim if the relevant conditions are satisfied). The disposal is deemed to take place at market value because the sole trader and the company are 'connected persons'.
On completion and sale of the development, the company is liquidated, and proceeds distributed to the shareholder or landowner, which will usually qualify for BADR, subject to 10% tax on lifetime gains of up to £1 million (assuming the relevant conditions are satisfied, including tests of 5% ownership and employment for two years are met).
One of the benefits of property development being a trade is that the business will generally qualify for business property relief (BPR) for IHT purposes, assuming the other BPR criteria are met. Provided an individual holds an interest in the business for more than two years and the business trades rather than carrying out property investment, BPR may be available at the 100% rate.
Sell land to third party
In this instance, the usual CGT charges apply as with the sale of any other asset. However, the impact on principal private residence (PPR) relief on the sale needs to be considered.
Whilst land sales are not usually subject to VAT, the VAT position of any development fees and professional costs must be considered, which may be substantial. 'Opting to tax' may allow recovery of input VAT, but VAT would have to be charged on the land sale.
Some contracts of sale give the landowner the right to share in the proceeds of any subsequent development by the purchaser. The landowner receives a fixed sum at the time of disposal to the developer followed by a percentage of the sale proceeds of each building subsequently constructed. Under the ‘transactions in UK land’ rules (ITA 2007, Pt 13, Ch 3; CTA 2010, Pt 18), although the land is being developed with a view to making a profit, HMRC generally accepts that the initial payment will be treated as a capital disposal subject to CGT and any subsequent receipts will be subject to income tax.
PPR relief claim
In all the above scenarios, landowners should consider whether PPR relief is available to negate any CGT charge where the plot divided is attached or surrounds the main residence.
If land disposed is within an area of 0.5 hectares (1.2 acres) of the landowners’ main residence, PPR relief will automatically apply, meaning no CGT charge. For larger houses, HMRC allows PPR relief on grounds over the normal 0.5 hectares limit, provided the land is ‘required for the reasonable enjoyment of the property’. The garden and grounds must be occupied and enjoyed with the residence when sold.
Practical tip
HMRC may resist any claim on land which is some distance from the residence even though it is in the same ownership and used as a garden. However, building another property in the grounds of a larger plot is fairly strong evidence that the developed land is not needed for the ‘reasonable enjoyment’ of the original property, and HMRC may well challenge PPR relief claims in such circumstances.
