If you are considering buying a freehold or leasehold property, you cannot assume that the gain on the eventual sale of the property will be subject to capital gains tax (CGT).
If a property is developed and sold as part of a ‘trade’, any profit on disposal will be subject to income tax at rates of up to 45 per cent plus national insurance.
However, if you buy a property to retain as a long term investment and rent it out, any gain on the sale should be subject to CGT at rate of up to 28 per cent .
Are you trading?
Determining whether or not you are trading is not always straightforward. The courts have developed a number of considerations to establish whether trading exists, known as the ‘badges of trade’. These include:
- the frequency and number of similar transactions;
- the length of ownership;
- modifications to the property; and
- the reason for the acquisition (and, potentially, subsequent changes of intention) .
Your intention when you purchase a property is one of the most important considerations. If, for example, you purchase the property with the intention of improving it to sell on quickly at a profit, you are very likely to be trading as a property developer.
What is the tax effect?
Assume that you purchase a run-down house for £300,000, undertake repairs and renewal work to bring it up to modern standards at a cost of £25,000, then sell the house for £360,000. You have a cash profit of £35,000. How this profit is taxed depends upon whether you are trading.
If you are trading, the £35,000 profit will be subject to income tax (at your marginal rate) plus national insurance. Any repair, renewal, renovation or improvement work undertaken is allowable expenditure when calculating the trading profit.
If you are not trading, the gain will instead be subject to CGT. However, your taxable gain could be as high as £60,000 , rather than £35,000. Many costs which would have been allowable for income tax purposes (such as repair and redecoration costs that simply refresh or renew the property and that are not capital improvements ) are not allowable for CGT. Consequently, you are taxed on a gain of up to £60,000 at tax rates of up to 28 per cent.
Living in the property
If you are living in a property whilst repair work is undertaken and you then sell the property, you may be able to reduce or extinguish any gain subject to CGT through a claim for main residence relief (MRR), but even though you live there, MRR may not be available . If, based on the facts, you are trading, your profits are subject to income tax. This means that you cannot claim MRR for your occupation of the property, as this relief is only available for a capital gain, not income profit.
Furthermore, even if you are not trading and any gain is therefore subject to CGT, a claim for MRR is precluded where a property is acquired at least partly for the purpose of realising a gain from its disposal.
What should you do?
The taxation of property is a complex area so it is important to seek advice on the tax treatment of property transactions, ideally in advance. Indeed, if you are thinking about more than one transaction, ownership of properties via a company may be more appropriate.
You can also find out about RSM’s dedicated real estate and construction group, consisting of over 80 professionals around the country who advise property companies on a range of topics.