Investing in property is almost always a good idea, you invest your cash in an asset that will more than likely appreciate in value over time, with very little effort required to add this value. Perhaps the biggest question is what type of property venture you will embark upon?
Beware though! Intentions can change along the way, and there are some potentially nasty tax traps that can spring up as a result of this.
Trading vs. Investment
First, we have to establish if the property is considered to be trading or investment property. Broadly speaking:
- Property developers are trading if they intend to sell the property they work on, essentially as a processed good. This can be as a result of an investor purchasing a bare piece of land and building a property from scratch, or buying a rundown existing property and getting it ready for the market.
- Property investors hold on to their property asset for a longer period. This asset can be held in an empty state, purely to accumulate value over time, or as properties let out to tenants to receive rental income. It is important to note that a property investor can still build their own property (as a property developer does) but this time the property will not be put up for sale immediately upon completion.
If an individual keeps their property in one state (either trading or investment) over the entire time that they own it, then the tax implications are fairly straightforward and as expected. A sole trader property developer will pay standard income tax on all profits from property sales, as its deemed trading income. A property investor will pay income tax on rental profits, and then additionally capital gains tax on any future sale of the property.
Beware The Bear Trap!
The danger comes when switching the intentions of the property from investment to trading, or vice versa.
When switching property intention, tax law effectively says a ‘sale’ has taken place, even though no money has exchanged hands. This means capital gains tax or income tax will be due (depending on the use of the property previously) without any of the cash benefits of having actually sold the property!
Take for example a sole trader who has owned a large property for a long period of time, having previously only ever let out the property. The individual now wants to sell the property but decides due to the healthy property market to develop the property into a number of smaller houses to generate the most return. This is changing the intention of the property from investment to trading. A deemed sale takes place, and by default capital gains tax is due on the market value of the property.
The situation is even nastier if switching from trading to investment. Consider now a property developer who has built a number of flats from scratch, with the initial intention to sell immediately upon completion. Toward the end of the build, they decide instead that they’d prefer the long-term passive income that renting out the individual flats would provide them with, so decide to keep the property instead of opening to the market for sale. The intention of the build has changed from trading to investment. A deemed sale again takes place, but this time income tax (and National Insurance contributions) will be due on the market value of the property.
If you have any questions about your property or if you would like to find out more about the potential tax traps, get in touch on 01872 300232 or email us at [email protected].