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Case Study 2 – David considersthe different tax treatment of property investment compared to property trading.

It looks at how profits and capital gains can be split between spouses/civil partners compared to non married partners. And how letting or selling to a ‘connected person’ could significantly increase the tax payable. But how operating as a limited companyor living in the property as your home could be a real tax saver.

The key points are:

  • David is a self employed joiner who purchases a residential property with a view to renovating it and selling it on. What are the tax implications?
  • If instead of selling, he rents it out, will this alter the tax treatment?
  • This is a property trader versus property investor scenario. Ultimately, the tax treatment on the disposal of the property will be determined by David’s intention at the outset. This may mean that David will pay income tax & NIC as a trader rather than the more favourable capital gains tax (CGT) as an investor.
  • Operating via the medium of a limited company could save tax.
  • The tax implications of letting and/or selling to a ‘connected’ party.
  • The huge CGT benefits arising from having a property as a principle private residence & letting relief that flows from such occupation.

David is a self employed joiner who has just received an inheritance. He decides that he will buy a rundown two bedroom semi in a nearby town and renovate it. What part of the renovation he can’t do himself, he will get some of his mates to do. Once complete, he does not know what he will do with it, i.e. should he sell it straight away or let it out?

Below are just some of the issues facing him, which may have an impact on the tax he, ultimately, pays:

  • Should he buy the property with his (live in) partner (Debbie) or on his own? Debbie is a non taxpayer whilst he is liable to tax at 40%.
  • He is aware that a company only pays tax at 20% where as he is already paying 40% tax on his ‘day job’. Does this mean he would be better off operating via a company?
  • Will he be able to treat his own time working on the property as an allowable expense?
  • Can he pay Debbie for helping him out with the decorating etc? If so, will she be an employee? Does this mean that he will have to operate PAYE? He has recently seen advertisements for workplace pensions & auto enrolment. With him being such a small business, this will not impact on him. Or will it?
  • He will be using his mates to undertake some of the work such as the electrical and plumbing. How does he deal with paying them? They are unlikely to be employees but should he be applying the Construction Industry Scheme (CIS)?
  • He is below the VAT registration threshold in his day job and so is not VAT registered. Should he now register so that he can reclaim the VAT on materials he purchases? Will his day job and the proceeds from this renovation mean that he is obliged to register for VAT if his turnover exceeds the threshold?
  • What taxes will he/Debbie/his company pay when the renovation is complete? His builder mate (who has done this kind of thing several times before) suggests that Capital Gains Tax (CGT) is preferable to paying Income Tax (IT) because the first £22,200 (2015/16 rate) of any gain/profit is exempt from CGT (if you can involve your spouse/civil partner) with any balance subject to CGT at 28% (or, possibly, 18%). This compares favourably to IT payable at 40%. If he has to pay IT, will he also have to pay NIC?

His choices once the renovation is complete are:

  • To sell it immediately, i.e. a ‘one off’ exercise.
  • To sell it immediately and with the profits buy another property to renovate (as he makes considerably more money doing this than his regular joinery work), i.e. renovation becomes his business.
  • To let the property out for a year or so and then sell it once the market has picked up a bit and before it will need redecorating, recarpetting etc again. He has become aware that that the train station in the town that closed down in the 1960s may be reopening and, if this takes place, this could add on about 10% on to property values in the town.
  • To retain the property and let it out as a long term investment. When his teenage children move out of the current family home he and Debbie may even consider downsizing and living there themselves. The only possible set back to this option might be that houses where they currently live are just not selling so this may mean that they have to let their current home.
  • His eldest daughter, Sally, (from a previous relationship and who does not live with him) is hoping to purchase in the town where he is renovating the property. She has been pestering him for a deposit on a house she has seen. Could he possibly let his property out to her at a rate just enough to cover his mortgage payments? Alternatively, could he sell the renovated property to her at the price it cost him to purchase which is actually about £50,000 cheaper than it will be worth once the renovation is complete?

We could go on and on with possible scenarios that may arise from what is not a particularly farfetched situation. Some of my clients will certainly recognise their roles in this!

Options

Via the renovation & sell option (i.e. trading) David will have a tax and NIC liability of 42% of the profits if he continues in a sole trader capacity.

The company option –this could save tax due to the fact that companies only pay tax at 20%, reducing to 19% by April 2017 and 17% by April 2020.

However, there is the issue of getting the post tax profits out of the company and into David (& Debbie’s) hands.

Savings can be made by paying a small salary (just sufficient to obtain a NIC credit for state benefit/pension purposes with the balance of any remaining profits deducted from the company by way of a dividend.

Until 05/04/2016 no personal tax is paid on a dividend if the individual receiving the dividend is not subject to 40% income tax on their taxable income; i.e. Debbie. A 40% taxpayer pre 06/04/2016 would pay 25% personal tax on any net dividend received (David).

Changes in the taxation of dividends from 06/04/2016 mean that no tax is payable on the first £5,000 of any dividend received but, thereafter, 7.5% personal tax is paid by those liable to 20% income tax and at 32.5% by those liable to 40% income tax.

By April 2017, 40% tax will only be payable by individuals once taxable income exceeds £45,000. By April 2020, the intention is that 40% tax will not be payable until taxable income exceeds £50,000.

Such tax rates will certainly promote the use of a company as a trading vehicle rather than operating as a partnership.

On a smallish one off renovation project like this, the ability to extract £10,000 out of the company by way of a dividend by David & Debbie with no personal tax payable from 06/04/2016 could make the company route more attractive. It really is a number crunching exercise to see which trading medium produces the best result. See our note ‘Salary v Dividends’ for further details.

If he purchases with Debbie (not as a company) this will be a trading partnership and the profits can be allocated between them as tax efficiently as possible, i.e. potentially, all to Debbie as she is a non taxpayer.

Via the renovation & let out option (and sell a few years down the line - i.e. as an investor) it would be beneficial to purchase jointly with Debbie. This is because there would be capital gains annual exemptions of £11,100 x 2 (2015/16 & 2016/17 rate) available to cover a good chunk of the profit/gain on eventual disposal. Any sum that remains taxable would be so at the rate of 28% for David and 18% for Debbie.

Income tax (but not NIC) would be payable on any rental profits prior to disposal. As David is a 40% taxpayer, whilst Debbie is a non taxpayer, allocating as much of the rental profit to Debbie as possible will be tax efficient.

Note that if Debbie and David were married allocating the rental profit as they see fit would NOT be an option. HMRC treat investment income (rental income is investment income) that is owned jointly between spouses/civil partners as held 50/50 by default.

When married/in a civil partnership, it is possible to elect to HMRC have the income taxed in accordance with the underlying ‘beneficial’ ownership of the asset. In this instance, if David owned 99% of the property and Debbie 1%, an election could be submitted for tax on the rental income to be levied on such a ratio.

However, this would not be sensible because David is a 40% taxpayer and Debbie is a non taxpayer; the default 50/50 taxation would be most appropriate.

However, if married and Debbie had been the spouse with 99% ownership, it would make sense for an election to be submitted for taxation based on underlying ‘beneficial’ ownership – i.e. 99% of income tax on rents and CGT on gains to Debbie.

One of the options mentioned above was for David and Debbie to, ultimately, reside in the property. This is potentially the most tax efficient undertaking they could ever choose because of two very significant Capital Gains Tax (CGT) reliefs:

  • Principle Private Residence Relief (PPRR) &
  • Lettings Relief

It is probably easiest to reflect the tax efficiency by way of an example:

Purchase date / Apr-16
Disposal date / Oct-20
Period of ownership / 54 / months
Period occupied as PPR – final months / 7 / months
Period let out / 47 / months
£
Gain after improvements / 123,000
CGT position if not occupied as PPR
Annual exemptions x 2 / 25,000
Taxable / 98,000
David 50% share / 49,000 / 28% / 13,720
Debbie 50% share / 49,000 / 18% / 8,820
Total tax due / 22,540
CGT position if occupied as PPR
PPR exemption for final 18 months / 47,106
Letting relief / 75,894
Taxable / -
Tax saving / £22,540 / plus the annual exemptions remain intact
for any other gains arising in that tax year.

Notes regarding CGT PPRR & Letting Relief

  • If a property has qualified as a PPR at any point in the period of ownership, the final 18 months are exempt even if the property has only been lived in for a lesser period, as in this example. I have assumed that David & Debbie moved in for the final 7 months prior to sale. If they had moved in, say, at the beginning of ownership, the PPRR would have been the final 18 months plus the 7 months of actual occupation.
  • To obtain PPRR the property must be occupied as a home. Cases have been lost where PPRR has been claimed where occupation was only temporary, say, as a result of occupying only for a few months whilst the new main home was being prepared for occupation.
  • Letting relief can only apply if a property qualified as a PPR in the first instance.
  • The maximum letting relief is £40,000 per individual owner; i.e. up to £80,000 for a couple.

The option of letting to his daughter (Sally) and (potentially/ultimately) selling to her at below open market value (OMV) have tax implications wrapped up in father and daughter being connected persons.

http://www.hmrc.gov.uk/manuals/pimmanual/PIM2220.htm confirms that ‘if the taxpayer lets a property below the market rate to, say, a relative (as opposed to providing it rent-free), they can deduct the expenses of that property up to the rent they get from it. This means that the uncommercially let property produces neither a profit nor a loss’. Not too bad.

However, the connected party tax rules would be significantly more detrimental to David if he was to sell to Sally at below OMV. David would still be taxed on the OMV of the property even if he was to gift the property to Sally for nothing or at undervalue.

As David & Debbie are not married (and Debbie & Sally are not related and, thus, not connected) any letting & disposal by Debbie to Sally, would not be subject to these rules.

The 3% Stamp Duty Land Tax (SDLT) hike applying from 01/04/2016 may also need to be considered. See note ‘Extra Stamp Duty on second homes’ for further details.

Conclusion

Whilst ‘the tax tail should never wag the dog’, it is important to try to factor in the tax costs right from the outset of any project. Ultimately, these tax costs may determine whether the project is viable or not.

Having evidence to support an intention (e.g. a business plan or a written note of a planning meeting) could help in obtaining a favourable tax treatment if challenged by HMRC.

Next Steps

If you have a property tax issue and would like to discuss your situation with me please call, email me or fill in the contact form.

Kevin McDaid, ATT, CTA

For & on behalf of Tax Facts Limited

March 2016

Disclaimer

  • Tax rules and legislation are constantly changing. Please note that this fact sheet is correct as per the date above this disclaimer.
  • Whilst care has been taken to ensure the accuracy of this fact sheet, no responsibility for loss or damage occasioned to any person(s) acting or refraining from acting as a result of any statement contained in this work can be accepted by the author.
  • As individual circumstances can vary this fact sheet should not be treated as anything other than general tax guidance.
  • There is no standard solution to minimise tax. Every situation is unique and requires a bespoke strategy. You are invited to contact me to discuss your own specific circumstances.

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