Which would you prefer - a capital gains tax bill of 18% or an income tax and national insurance contributions bill of 29% or 42% (or possibly even 52%) on the profit made on the sale of a property? The choice can be yours but planning is needed. This article considers the difference between being considered a property dealer (i.e. short term ‘buy to sell’) and a property investor (i.e. long term ‘buy to let’) and the different taxes each pays on a property sale. As the distinction is not always clear the article ends by considering the practicalities for a transaction that could be classed as ‘borderline’.
Usually the distinction between dealing and investing is relatively straightforward: a purchaser buying property to let out on a long term basis is an investor; someone buying property to refurbish then sell, whether resulting in a capital gain or not, will most likely be a trader - the main difference being intention.
This point was illustrated in the recent tax case of Azam v CRC 2011 where the major issue of contention was the intention of the taxpayer at the time of purchase. The taxpayer said that his intention had always been to trade; that the properties had been purchased for resale at a profit within a short period. However, because of the market downturn the properties could not be sold and were therefore rented. The taxpayer claimed the losses as trading losses to be offset against general income. HMRC refuted this, contending that the taxpayer had always intended to rent out the properties (ie was an investor) and as such the losses could not be claimed against general income - and the court agreed.
Why it matters
Whether it is more favourable for a property transaction to be taxed as a trade or as an investment depends upon a number of factors, not least whether the taxpayer is an individual or a company, whether losses have been incurred and the overall sums involved. Property dealing, if deemed a trade, is liable to income tax or corporation tax; a property investment transaction resulting in a gain is charged to capital gains tax (CGT). There can be advantages in this latter situation for individual investors, given the current CGT rates being substantially less than income tax plus the individual may have available the annual CGT exemption. An individual with trading income also pays NIC, whereas there is no such cost with a capital transaction. Thus unless losses are involved it is preferable for the transaction to be of a capital/investment nature but conflict may arise when considering inheritance tax (IHT) planning.
For IHT purposes, the entire property value is exempt from IHT under 'Business Property Relief' (BPR) if a trading business. Property investment, on the other hand, is fully chargeable at 40%. Therefore if you want your property investment portfolio to be exempt from IHT you will not be able to take advantage of the favourable CGT rate.
The disposal of shares in a company engaging in property development or dealing, rather than as an investment company, might entitle the owner to claim entrepreneurs’ relief for CGT purposes. However, shares in a property dealing company do not qualify for BPR for IHT purposes.
Hence, wherever possible, if a property transaction is taxed as investment then the property should be held personally rather than through a company because of the lower CGT rate. If the transaction is in a property dealing/trading situation, the reverse is often true because the charge to income tax as well as NIC is much higher than the corporation tax rate.
What does HMRC look for?
There is no definition in the legislation as to what constitutes a ‘trade’ although it is stated that ”trade includes any venture in the nature of a trade” (ITA 2007, s 989). The tests for whether one is dealing in property or making a property investment are the same as for any other trade. In 1955, a Royal Commission report on the taxation of profits and income identified six ‘badges of trade’.
These ‘badges of trade’ are now a recognised formula to assist in the decision-making process of whether an individual is undertaking a trading activity, and as such they can be applied to property transactions just as they are to a variety of other activities.
The 1955 report was the starting point since supplemented by case law; HMRC’s Business Income Manual (at BIM 20205) now lists nine ‘badges of trade’ to consider when determining whether a trade activity has taken place:
- profit seeking motive
- number of transactions
- nature of the asset
- existence of similar trading transactions
- changes to the asset
- method of sale
- source of finance
- interval of time between purchase and sale
- method of acquisition.
It is not necessary for a transaction to have all of the ‘badges’ in order to be regarded as dealing/developing/trading and clearly some badges will carry greater weight than others, given differing circumstances. Indeed, in some cases the existence of one single badge can be enough.
In cases brought before the courts where the question of property trading is in point ‘intention’ and ‘badges of trade’ are always considered, as in the case of Marson v Morton 1986 where the ‘badges’ were used to decide that the profit on a single transaction in land was a capital receipt, rather than arising from a trade. The land was purchased with the intention to hold as an investment. No income was generated by the land, but there was planning permission. The land was sold following an unsolicited offer. HMRC contended that as the seller was a trader then the property transaction should be taxed as part of that trade. However, the court ruled that as the transaction was far removed from the taxpayers’ usual trading activity but was similar to an investment, it was not a trading profit. The judge stated:
“It is clear that the question of whether or not there has been an adventure in the nature of trade depends on all the facts and circumstances of each particular case and depends on the interaction between the various factors that are present in any given case”.
Consider this situation - a not unusual one for farmers or former farmers having to sell parcels of land to survive in this financial climate.
Mr A inherited a farm in 1991, traded as a farmer and in 1999 wound down the farm, selling stock etc and instead started a limousine hire business from the now disused barns. In 2001, he sold three parcels of land (qualifying for Agricultural Property Relief for IHT purposes) and then over the next three years sold four sites in succession with outline planning permission because he needed to generate cash. HMRC want to treat the latter four disposals as trading income - but are they right?
There are strong arguments for investment that could refute any contention of trading using the 'badges of trade' tests:-
- The farm was inherited; not acquired to resell at a profit. The intention is to raise capital and it would assist the argument if it could be proved that he was unable to sell or rent the land as a farm, and therefore the only way to raise capital was by selling as potential residential property. No-one will buy farmland for housing unless planning permission has been granted thus, in order to sell the land (and realise the capital from his asset), planning permission is needed (i.e. to change the asset)
- There are repeated transactions but this is usual when attempting to sell a large farm divided into a number of building plots - again, stress the need to raise capital from the sale of his asset.
- The land was an asset of the trade of farming - which again supports the contention that the sale of the land is not trading of itself.
- The interval/timing between purchase and sale was years even though the land was sold in succession.
Practical Tip :
As the distinction between investor and trader is not always, clear it is recommended that guidance is sought from a tax adviser.