Tax Efficient Property Renovation And Sale

Alan Pink considers two specific strategies for minimising the tax on ‘doing up’ a property for sale.

I’ll make it quite clear at the outset that, in writing this article, I’m referring to ‘second-hand’ residential property, rather than anything which qualifies as a new build, or commercial property. This is by far the most common situation in practice, and concentrating on this particular area of the industry means that we don’t have to get tied up in the complications of VAT. 

The VAT position of renovating and selling ‘old’ residential properties is simple: VAT can’t be reclaimed, and the only common VAT break that can be achieved is where the renovation involves changing the number of dwellings within the property. In this case, the lower, 5% rate of VAT is available – and you may need to jump through some hoops in order to achieve this lower rate. But that could no doubt form the subject for a whole other article.

The first strategy I’d like to consider is the common one of moving into a property, doing it up, and selling it at a profit. The idea is, of course, that you tap into the capital gains tax (CGT) exemption for a person selling their main residence. 

It goes without saying that you can’t get more tax-efficient than tax-free, and this is what, in principle, is the result where you sell your own home which you have lived in as your main residence throughout your period of ownership. And also, certainly in practice, this strategy is brilliantly successful. But do be aware of the very considerable dangers, lying in wait like robbers in the undergrowth. 

The first danger is that, on a correct interpretation of the facts and the rules, you should actually be paying income tax on the profit you make, rather than capital gains tax; and unfortunately, there’s no relief against income tax charges for dealings in one’s main residence. 

The question of whether a person owns a property as a fixed asset (whose sale is subject to CGT) or as trading stock of a development trade (the profit on which is subject to income tax) is a very thorny one. It depends ultimately on your intention when acquiring and then holding the property. And your intention can change, from one of long-term investment (or use as a residence) to one of trading, bringing any future profit after this decision has been made within the income tax net. 

Having said that, in my experience this is not a point which HMRC very often take up. That is, they will either argue that the property was always ‘really’ trading stock rather than having been bought primarily as a home; or they accept that the sale of your property is subject in principle to CGT rather than income tax.

However, in one of the oldest bits of anti-avoidance legislation on the CGT statute book, there is a further restriction in main residence relief. This applies where expenditure has been incurred on the home with a view to realising a gain. In this instance, the gain concerned isn’t strictly covered by the exemption. 

You’d have thought, in fact, that this piece of anti-avoidance would hit an awful lot of situations where a person’s main emphasis was occupying the property as a home, but that person builds an extension or generally improves the property so that it will realise a better price when sold. Again, however, this isn’t a point which HMRC seem to take up very often in practice, mainly because, one suspects, it is so difficult to sort out what people’s motives are when looking at the situation, as an HMRC officer does, from the outside.

So, HMRC have two weapons to counteract the serial main residence relief claimant, and probably there’s some overlap between the two. I think that the anti-avoidance rule, which charges CGT and excludes main residence relief, was probably put into the legislation to catch situations where HMRC are unable to establish conclusively that the person is actually carrying on a property development trade, but nevertheless don’t feel that the profit should be tax-free.

So, having given you the theoretical position, with the dangers presented by either an income tax charge or the denial of main residence relief under the anti-avoidance provisions, I would like to say a word or two about the practicality of the situation. 

In practice, I suspect that a lot of people who ought to be ‘caught’ and taxed under these rules escape by default, and they are more likely to do so if certain danger points aren’t present. Someone who is a property developer by way of business, and is doing this as effectively part of that business, is obviously much more visible to HMRC. Also, you are obviously much more likely to attract attention if you do this too often. A regular series of purchases, renovations, and sales indeed is itself evidence of the trading intention and, therefore, opens you up to the argument that the profits should be subjected to income tax. 

If you ask me: ‘what is too often?’ though, this is where I start scratching my head. There is, needless to say, no firm rule written down anywhere, and it’s a matter of vague impression at the end of the day. Buying and selling ‘main residences’ every year is obviously asking for trouble, whereas every four or five years you are probably safe, but where in the middle the dividing line comes can be very much a matter of who you get looking at your tax return. My apologies that this isn’t very useful; but it’s the way our tax system works.

Obviously, the use of the CGT main residence exemption is quite a niche relief, which won’t be available in most cases, so let’s move on from that to what you might regard as the more normal situation. 

Mr Brown has found a beaten up old place which he plans to refurbish, convert, and extend to produce a much more valuable property. His intention is very much to sell that property, rather than retain it as a rental investment, when he has finished the work.

The first thing to say is that this clearly falls on the trading side of the line. Remember, here, that the distinction between income tax and CGT is one of intention. If Mr Brown had actually intended to retain the property as a long-term investment, with the renovation being for the purpose of securing a higher rent, then any sale of the property would be within CGT, which of course could be highly advantageous as the top rate of CGT is 28%. However, if a sale at a profit is what Mr Brown has in mind, then it’s the income tax rates of up to 47% (including self-employed National Insurance contributions as a ‘tax’ for these purposes) that we are planning for. 

In almost all cases, in practice, it will be more tax-efficient for such a development to take place through the medium of a limited company. The company will be subject to tax at 19% (currently) on the profit, with this rate being promised to come down to 17% in the near future. The only situation where a company doesn’t save tax (in fact, it marginally increases it) is where the profits are immediately distributed in full as a dividend to a person who is in the top rate of tax or dividends because of having a total taxable income of more than £150,000 in that year.

In practice, as I say, companies can bring with them many advantages because in practice, one often won’t be looking to distribute the whole of the development profits as dividends. Alternatives to dealing with the profits in this way include:

more ambitiously, making the company a partner in a partnership or limited liability partnership (LLP), and introducing the funds into that partnership or LLP as equity capital.

In fact, in considering the tax efficiency of putting property renovations and sales through limited companies, we stray onto the whole area of tax-efficient extraction of profits from a company, and of course, these principles apply to any trade, not just property renovation.