Do I pay capital gains tax or income/corporation tax?
It can sometimes be a fine line that distinguishes the two but getting it wrong has important tax implications! As programmes like Property Ladder show, many people are keen to invest in property and are confident that they can make a sizeable profit by doing up a property and selling it on.
What are the tax implications?
A property investor is liable to Capital Gains Tax on the difference between the original cost plus any enhancement expenditure and the disposal proceeds. The legal and other costs of acquisition and sale including Stamp Duty Land Tax can be deducted from the gain as well as the cost of capital improvements). However, loan or mortgage interest, maintenance or other running costs cannot be deducted from the gain, but these can be claimed against any rent received from the property for income tax purposes. Any capital losses can only be relieved against other capital gains in the same or future tax years.
An individual may buy a property to live in as his only or main residence and normally any gain on this property is exempt from Capital Gains Tax.
Any gain is assessed to Capital Gains Tax after deducting the annual exemption 2022/23 £12,300 at an effective rate of between 18% and 28% for residential property or 10% and 20% for non-residential property, depending on the level of an individual’s income. It is unlikely that an investment property will qualify for Business Asset Disposal Relief formerly Entrepreneur’s Relief at 10%.
A property developer is treated as carrying on a trade and is liable to Income Tax and National Insurance on his/her trading profit or Corporation Tax if operating as a limited company. The trading profit would include a deduction for all expenses incurred wholly and exclusively in the course of the trade. So, unlike the property investor, loan or mortgage interest would normally be an allowable expense in calculating the profit although for an individual, relief on mortgage interest is restricted to relief at basic income tax only, not higher rate.
However, if anyone helps the developer, they are either an employee of the developer so a PAYE/NIC scheme would need to be operated or they would be a sub-contractor in the building industry so regular returns would be required and tax may need to be deducted.
Any losses, provided that there was an intention of profit, can be relieved against other income. If the property development continues over more than one tax year then the income may be spread over those years. Assuming that the property developer is not a limited company, the rate of income tax after the personal allowance is (currently) 20%, 40% or 45% depending on the total income. As a self-employed individual, he/she would also be liable to pay Class 2 National Insurance at a weekly rate of £3.15 if profits exceed £6,725 pa and Class 4 National Insurance at a rate of 10.25% of profits exceed £11,909 and 3.25% on profits over £50,270. As already indicated a Capital Gain may be preferable to a trading profit. However, the potential to relieve a trading loss is much greater than for a capital loss.
For a limited company, the rate of Corporation Tax is currently 20% on profits including capital gains.
So, what am I?
A lot has to do with your intentions. If you buy a new property to let it out for the long term, then you will be a property investor. But what if you do some work on the property? This again will depend on a number of factors including the extent of the renovation work, the length of time that the property was held and let out. Let’s consider some examples:
Simon buys a two-bedroom property. His intention is to keep it as a long-term investment. He does the property up with a view to renting it out. However, due to changes in his personal circumstances, he sells the property after two years having completed the renovations, realising a profit of £20,000.
Simon’s intention was to hold the property as an investment. Although he sold it after a relatively short period of time, the original motivating factor had not changed.
The profit that he made on the property would be a chargeable gain and Simon would be liable to pay Capital Gains Tax on it.
Bob buys a dilapidated property with a view to doing it up as quickly as possible and selling it on at a profit. He plans to reinvest any proceeds from the sale into further properties to do up and sell.
Unlike Simon, Bob’s main motivation in buying the property is to make a profit from doing it up and selling it on. Looking at the intention behind the purchase suggests that Bob is trading as he buys and sells the property with a view to making a profit. Consequently, any profit made by Bob on the sale would be liable to income tax and National Insurance rather than Capital Gains Tax.
In a climate where Capital Gains Tax rates are considerably lower than the highest rate of Income Tax, the attraction of realising a capital gain is apparent. It is important to ensure that the distinction between investing in property and trading as a property developer are correctly established. The last thing you want is an enquiry from HMRC.
How can I be sure?
You cannot pick which tax you pay. Whether you are trading is a question of fact and the normal badges of trade apply.
The starting point for deciding whether there is trading or investment is the intention of the owner. Whilst the original intention of the owner is an important one, when deciding whether a person is trading HMRC will look at a variety of factors including:
- The length of ownership;
- Whether the purchase and sale is a one-off or there are a series of transactions;
- Whether the property has been rented out;
- Whether the property was acquired for personal enjoyment; and
- Whether there is an existing trade – for example, you are a builder buying a property to do up and sell.
- The length of ownership;
Together these will create a picture and help to determine whether you are trading or investing. It has been known for a builder, who buys and moves into one property, does it up, sells it and moves on to the next property repeating the process a number of times, to be treated as trading. He thought that he was a property investor and that, as they were all his private residences, he would be exempt from tax!
If in doubt, please contact us. As you can see it’s important to understand your situation.