Property Letting and Development

With the appreciation in property values proving attractive, as well as increased media coverage of the attractions of property renovation activity, more people are undertaking property development as a hobby or as a secondary or primary source of income.  Equally buy-to-let residential property investment has been very much in vogue in recent years, because, although property values may fluctuate, many people see bricks and mortar as the most solid investment they can make.

This memorandum outlines some tax planning opportunities with residential investment properties and also some recent tax changes which should be taken into account.  It also considers suitable structures for private property development.  It should be borne in mind that, as with all matters relating to taxation, the relevant rules are complex and detailed; accordingly only an outline of the relevant issues is presented here so that you can seek further advice if you wish to act.

Two categories

Property letting for tax purposes has in the past fallen into two broad categories: approved short-hold tenancies and furnished holiday lets.  Those who have properties let under short-hold tenancies will undoubtedly be broadly familiar with the income tax rules relating to rents received and so these are not detailed here, but instead we offer a brief outline of some tax planning opportunities in relation to the capital value in the properties.

The tax reliefs applicable to furnished holiday properties have been modified with effect from 6 April 2011. Previously the income from such letting qualified as trading income for income tax purposes so that the normal loss relief provisions applied; this enabled losses to receive tax relief against any source of income for the same tax year or the previous tax year, with losses remaining then carried forward against future letting income. From 6 April 2011 the extended loss relief provisions no longer apply and relief is now available only against income from the same furnished holiday letting business.

The qualifying conditions relating to furnished holiday lets are set to be tightened up from April 2012 as discussed later on in this memorandum.   Following the coalition government’s reprieve the tax reliefs also now apply to properties let under qualifying conditions throughout the European Economic Area; previously the property had to be located in the United Kingdom.

Approved short-hold tenancies

If a sale of a property, let since acquisition on short-hold tenancies, is envisaged at a future time, any profit realised over the acquisition cost will represent a gain chargeable to capital gains tax.  For gains realised on or after 23 June 2010, the rate of capital gains tax payable is 28% to the extent that the gain when added to the vendor’s income exceeds the income tax higher rate threshold.

It is sometimes possible to make a reasonable impact on the chargeable gain after the last tenant leaves by electing for the property to be your main residence.  This is not as straightforward as it sounds and it is essential to use the property as your only or main residence for a substantive period, or the claim will be refused by HM Revenue & Customs.  Where the property has been in the ownership of only one spouse, it can be possible by this method, coupled with certain other steps, to cover the entire gain with a main residence election.  Main residence “flipping”, as it has become known, is legitimate capital tax planning.   We can advise you further on this matter.

Those not planning a sale of a property in the future, but instead planning to keep the asset indefinitely for the benefit of the family, may wish to consider some estate planning.  Simply giving away the property to the next generation will amount to a disposal for capital gains tax purposes and the gain to date will be brought into charge to tax.  It is possible to ‘hold over’ the gain (i.e. elect for the transferee to take the property at your original acquisition cost), by passing the property through a family discretionary trust from which you or your spouse cannot benefit.  This requires detailed advice in relation to your personal tax position.

Alternatively, if paying tax on the gain is manageable, a substantial share in the property can be placed into a family trust in which you and your spouse can benefit.  Under this arrangement, you retain the rights to receive the rents in the future, but the capital value in the share in the property is given away as a lifetime gift and so passes out of your estate for inheritance tax purposes.  A transfer to a trust is chargeable transfer for inheritance tax purposes and so the value of the share transferred should be kept with the available inheritance tax nil rate band or the two bands of husband and wife.  Normally one must not reserve any benefit in an asset given away, or the gift will in broad terms not be effective for inheritance tax purposes but this rule does not apply to let property.

Furnished holiday lettings

Those who have properties let as holiday accommodation will probably be familiar with the broad requirements for the special reliefs which can be claimed for both the income from, and the capital gains arising on, such properties.  Very briefly, any one letting should not normally be for more than 31 consecutive days, and there should be overall letting for at least 70 days and the property should be available for 140 days in the tax year. From 6 April 2012 the 70 and 140 day tests will be increased to 105 and 210 days although businesses meeting the required threshold in one year may elect to be treated as having met it in the two following years (a “period of grace”), provided that certain criteria are met.

In the past, the rules have not applied to properties outside the United Kingdom, but it has been recognised that this restriction is incompatible with European law and as a result the special rules for UK holiday letting can now apply to properties located anywhere in the European Economic Area. However any such foreign holiday lets must be treated as a separate business and must not be included for tax purposes with any UK holiday letting business.

The comments here relate only to lettings outside a company, but the corporate position is summarised later.

The existing tax reliefs can be summarised as follows:

1. If the letting in any year produces a loss, that loss can now be relieved only against profits of the same holiday letting business of any future tax year.
2. The income counts as earned income against which pension premiums, for example to a SIPP, may be deducted.
3. If the property is sold realising a capital gain this may be taxed at the beneficial rate of 10 per cent under the entrepreneurs’ relief provisions in place of the normal 18 or 28 per cent rates. This relief requires that the property is used for the letting business throughout the 1 year period up to cessation of letting.
4. Alternatively the capital gain realised on disposal may be ‘rolled over, that is, the gain is not taxed but is instead deducted from the cost of a replacement asset which is used for the purposes of some other trade, or another property for furnished holiday letting. Note that if there is some private use of the property it will not be possible to roll over all of the gain, but only an appropriate proportion of it.
5. If the property is given away, say to the next generation, the capital gain which is treated as realised by the gift is eligible for ‘hold over relief’ as a trading asset, in other words the transferees can be treated as acquiring the property at the donor’s original base cost so that the donor realises no gain on which tax need be paid.

It does not matter for the purposes of the income tax loss relief if there is private use of the property, but this will have an impact on expenses claimed for income tax purposes, as these must be time-apportioned between private use (non-allowable) and use for letting (allowable).

Rent-a-room relief

There is a very useful relief available where an individual lets rooms in his/her private residence to domestic lodgers.  If the annual income from this activity (before deducting expenses) is £4,250 or less, then the income is exempt from tax.  In addition, when you sell the residence in due course, there will normally be no capital gains tax to pay, whereas in other circumstances letting part of your private residence can lead to a capital gains tax liability.  Please contact us if you would like more information about this relief.

Property development

Those considering this line of work should seek advice on the best tax structure to be adopted, given that profits from successful renovation or redevelopment of properties can be substantial.  Some relevant points to bear in mind are as follows:

1. If you are not already registered with HMRC as a self-employed person, you should do so within three months of acquiring your first development project.
2. Profits from each project will be liable to income tax and not capital gains tax, and in addition National Insurance contributions will apply at self-employed earners rates.  It will be appreciated, that rates of income tax in 2011/12 rise to a maximum of 50 per cent.
3. Should losses be realised from a project, these can be relieved against other income of the same year or a previous year or alternatively they can be carried forward.  Where the structure involves a Limited Liability Partnership (LLP) then there is a restriction on relief for a loss against general income where the time engaged on the loss making business is under 10 hours per week; in that event relief set against other income is restricted to £25,000, and the balance must be carried forward to be set off against the future profits of the trade concerned.
4. Although the capital gains tax rules have a mechanism by which traders can avoid a tax liability on the sale of a property by reinvesting the gross proceeds into a replacement property, there is no similar rule for income tax purposes.  So if a property project results in a profit, tax will be payable, probably out of the realised profits and only the net amount will be available for reinvestment in the next project.

Property development by a limited company

1. The small companies’ rate of corporation tax is 20 per cent for the financial year to 31 March 2012, applicable to annual profits up to £300,000.  This can be significantly lower than the equivalent personal tax rates and therefore offers an incentive to operate through a limited company.
2. However, if profits are drawn out of the trading company by means of dividend, the dividend is not a deduction from the profits for corporation tax purposes.  Nevertheless the dividend in the hands of a higher rate taxpayer gives rise to an income tax liability.  For higher rate taxpayers, this gives an approximate overall tax liability of 40 per cent, adding together the liabilities within the company and on the shareholder for the distributed profit. For those with income in excess of £150,000  subject to the additional rate of tax, the dividend  tax rate is effectively 36.11% which results in a combined tax take on company and shareholder of nearly 50%.
3. If losses are realised, they can only be carried forward within the company for set off against future profits.  There can be no relief for them against the shareholder’s own income.
4. A limited liability company protects the shareholder from personal liability in the event that a project results in serious losses.

Operating through a limited liability partnership

A limited liability partnership is taxed in the same way as an ordinary partnership, so that the profits belong to the partners for income tax purposes; this applies so long as the partnership conducts some form of business.  The benefit from this type of partnership is that it is a corporate entity for other purposes and therefore gives the same protection as a company in relation to personal liability for losses (see (d) above).  Also see above at point 3 regarding the use of losses generally for tax purposes.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so.  It is designed to alert clients to some of the issues.  It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.