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Julie Butler FCA considers some important tax issues for property owners and investors.

Julie Butler

Introduction

It is fair to say that the “property owner” client sector forms a large part of the client base of all firms who advise on tax and there is great scope to attract new property clients to those firms.

For the smaller organisations this type of client is interesting, varied, demanding and often unaware of potential tax problems, potential tax planning and potential tax savings.

What has caused the growth of this property sector?  The influence of television programmes such as “Changing Rooms” and “Property Ladder”. What about the impact of the property price boom and the availability of mortgages and relatively low interest rates? Enthusiasm for the market has been bolstered by the much-discussed city bonuses. Children in their 40s, 50s and 60s have parents who are now not just leaving two tins when they die, one marked “funeral” and the other marked “funeral party” – there is often substantial property in the Estate and a lot of associated planning.

Ten year rule – inherited property

The inheritance tax rules have the advantage of a payment term over ten years. But many clients forget that this crystallises when the property is sold.

It would be easy to focus on “buy to lets” (BTLs) but there are permutations and combinations of client tax problems in all areas of the small property investor, speculator and trader – how can we help these clients?

Dwelling house rebuilds and flat conversions

With the housing shortage reaching critical levels and the need for more affordable housing increasing, it is becoming rather popular for certain home owners to consider either converting their homes into flats or possibly knocking down the whole house and building a block of flats or affordable housing on the plot.

There would appear to be some confusion as to what taxes are involved with such a project and conflicting advice appears to be being given in relation to the possible profits and gains made from the project. Some may say that this is a trade and taxed as income, some may say that it is ITA 2007, s 756 (ICTA 1988, s 776) and some may say it is tax free.  The actual legislation that comes into force is TCGA 1992, s 224(3).

Taxing the profits of property conversions – TCGA 1992, s 224(3)

S 224 Amount of relief: further provisions:

(3) Section 223 shall not apply in relation to a gain if the acquisition of, or of the interest in, the dwelling-house or the part of a dwelling-house was made wholly or partly for the purpose of realising a gain from the disposal of it, and shall not apply in relation to a gain so far as attributable to any expenditure which was incurred after the beginning of the period of ownership and was incurred wholly or partly for the purpose of realising a gain from the disposal.

This section of the principal private residence (PPR) relief provisions basically enables HM Revenue & Customs (HMRC) to adjust the level of PPR available on the sale of property that has been sold wholly or partly for the purpose of realising a gain.

Just an extension?

Before anyone panics and decides not to build the extension for the kitchen or landscape the garden, the rules are in place to capture those who enhance their properties for profit and not those who wish to improve their homes and enjoy their improvements.  An example of those who would be captured, would be those who build an extension and sell the property immediately to benefit from the increase in value of the property.

Two flats?

An even better example would be those who renovate their house into two flats.

The rules for applying TCGA 1992, s 224(3) do not just apply to visual changes to the property but also financial changes.  As per guidance given in HMRC's Capital Gains Manual at Paragraph CG65257, if your client purchases the freehold of their flat to enhance the value of the property before sale, the profit will be captured and PPR will be restricted.

Renovation for a profit?

There may be cases where people have not renovated their properties for profit but have been forced by other reasons to sell their properties.  If the taxpayer can prove that the motive to sell was not for profit then he should avoid the rules.  An example of this would be clients who run out of money for a project and have to sell.  However, it would not be possible for this misfortune to be used in a flat conversion, due to the obvious motives behind the project although, if you were creating a flat for granny this could possibly avoid the rules.

Purchase of a property with a view to profit – ITA 2007, s 756 (Old ICTA 1988, s 776)

Any property purchased with the profit motive in mind could be caught under S756.

To silence those homeowners who fear the horrors of ITA 2007, s 756 (the old ICTA 1988, s 776 rules) which convert capital gains into income gains, this legislation cannot come into force because ITA 2007, s 767 basically says that if the property falls under CGT legislation regarding principal private residence at TCGA 1992, ss 222 to 226, then ITA 2007, s 756 cannot apply.

Adventure in the nature of a trade

This is a very interesting question and one in which I think that those knocking down their houses may come unstuck.  The knocking down of a house and building of a new house or flats to sell is most likely to be ‘an adventure in the nature of a trade’ and as such, any profits earned from such a venture should be taxed as a property development business.

How the capital gains and income tax would operate in such a case would be similar to the rules under ITA 2007, s 756 and effectively the client would have a mixed capital gains tax and income tax liability at the date of sale of the developed property.  ITA 2007, s 765 confirms that the part of the income made on sale which is fairly attributable to a period before the intention to develop was formed is exempt from income tax and therefore this would be taxed under capital gains tax rules.  This principle would no doubt be applied in the case of trade.

Property development

The property would be entered into the property development business as stock at the market value and all costs and sales dealt with through a profit and loss account.  Simple!  But what if the client is going to live in one of those houses or flats?  This is where it all becomes extremely complex and ‘true and fair’ principles need to be applied. 

Principal private residence – the large garden

Disposal of part of the garden structured correctly can be tax free under the PPR rules of half-a-hectare or, if larger, provided it meets the “character appropriate” rules.  To take full advantage of PPR on the large garden there has to be a sale for development as opposed to self development which would be caught under TCGA 1992, s 224(3).

The Buy to Let (BTL)

Many BTL owners have purchased via a mortgage where the interest and expenses exceeds the income.  The negative income position leads the owner to consider that there is no need to disclose the income stream to HMRC.  This creates a huge market of potential tax clients that need tax help with non-disclosure, unclaimed losses, future CGT problems and possible FHL conversion.

Furnished holiday lets (FHL)

Most tax advisers are well versed in the income tax rules of FHLs but what of Business Property Relief (BPR)?  BPR can be achieved on one FHL property provided that all the business services conditions are achieved.  This can make vast differences to a family who inherit an FHL and want to keep the property in the family without large inheritance tax (IHT) penalties.  The key is the provision of services.  Please remind clients now of the future benefit.  The need to keep photographic, contemporaneous evidence of the “meet and greet” can prove very useful…

Rolling over a gain into an FHL

If a business gain is rolled over into the purchase of an FHL, tax planning can be achieved around the future status of the property.

The FHL can change status to a normal furnished let and CGT will only crystallise upon the disposal.

The FHL (with the rolled over gain) can be gifted to the owner’s children with a holdover election as a business asset.  The child can then use the PPR provisions to minimise CGT on disposal.  The potential for efficient interaction of FHL and PPR is huge.

Conclusion

Many taxpayers are entering the Tax Return compliance and tax planning markets due to the growth of the smaller property investor.  Strong links should be formed with our local estate agents and conveyancing solicitors to attract the new client and make them aware of the advice on offer.

Many existing clients are “developing” (excuse the pun) their property portfolios and again need compliance and planning help.  Have they recently been asked about their expanding property interests?  There is strong marketing potential to capture and serve these clients and one thing is certain, this DIY property magnate client base will not be dull and undemanding.