You are buying properties. But is this trade or investment?
It is your intention to start buying and renovating residential properties, before selling them and reinvesting the proceeds. But should you operate this through a limited company? And what key issues should you be addressing from the outset? Helen Johnstone discusses in more detail below.
The first thing to do is to consider whether you will be trading in property, or merely holding the properties as an investment. The question is crucial, as the answer determines how the receipts from the venture will be taxed, i.e., as income or gains.
Whether a taxpayer is trading is always dependent on the specific facts of each case, as there is little in statute to define what a trade actually is. Instead, the “badges of trade” are often used as a guide to determine whether an activity amounts to a trade.
Crucially, not every badge need be present for there to be a trade, and even a single badge can be indicative of trading activity; it all turns on the facts of each case. The existence of a profit-seeking motive can be an indicator of trade, but it is not conclusive on its own. The courts have sometimes taken a slightly different approach when assessing if there is a trading activity.
As you have indicated that the proceeds of sale will be used to fund further acquisitions, it is highly likely that this will be a trading activity. Once the fact that a trade will be carried on is established, you can determine the best structure to use to ensure an optimal tax outcome.
If you were to carry out trading activities as an individual, this would mean your profits would be subject to income tax at up to 46% plus NI. As the activity would be treated as a general trade, not a property business, there would be no restriction on any losses arising, i.e., these could be relieved against general income.
As this would mean losing nearly half the profits in tax and NI, an alternative would be to incorporate and carry on your trade through a limited company. This has the benefit that profits arising in the company are taxed at the lower corporation tax (CT) rate of 19%. Even after the scheduled increase in the main rate from 1 April 2023 to 25%, this is still favourable compared to carrying on the trade as an individual, where profits could be taxed at the higher or additional rates.
From 1 April 2023 the main CT rate of 25% will apply to profits over £250,000. A small profits rate of 19% will remain where profits are £50,000 or less. Companies with profits between these thresholds are taxed at the main rate, with marginal relief.
Although lower CT rates may initially make a company structure seem an obvious choice, the tax benefits of operating through a company need to be considered in the round. In other words, the tax impact when those profits are extracted must also be considered. In many situations, the tax benefit of operating through a company structure is only modest, especially where retained earnings are fully distributed each year.
The 2021 Autumn Budget announced that from April 2022 dividend tax rates would also increase by 1.25%.
A company would be a good choice if you have no immediate need to extract the profits, which appears to be the case as you intend to reinvest these anyway. The company could be used to supplement existing retirement plans.
Of course, there can be non-tax considerations that drive the choice of business structure. The limited liability protection offered by a company, for example, is a powerful motivator for many taxpayers, although this needs to be weighed against the higher administrative costs.
It’s also worth considering the benefits that can attach to operating a property development trade. Speaking from the perspective of operating through a company, business asset disposal relief (BADR) may be available to a property developer when selling their shares in the company. Business property relief (BPR) may also in set circumstances be available to provide relief from inheritance tax (IHT). However, for such reliefs to be available, the property development activities carried on must be trading.
The test of what amounts to a trade differs across reliefs. It can be difficult for certain types of activities to meet the criteria for BPR. Furnished holiday letting businesses are a common example of where the income tax treatment differs from the IHT treatment. Shares in a company that is “wholly or mainly dealing in land or property” are specifically prohibited from BPR.
Sole traders can also access some reliefs, such as BADR if they exit the business. However, BADR will not be available on the disposal of individual properties as the profits will be subject to income tax.
The most important question to ask is “what are you trying to achieve?” In our scenario, you are clearly looking to use any proceeds for reinvestment, and as such the company route is likely to be the better option from a tax perspective, as the lower tax hit would mean more retained funds being available for reinvestment. The opportunity for growth is therefore greater.
Conversely, if you are looking to generate funds for your personal use, the company route might not offer much in the way of tax savings. If they you can set up the company with a spouse, or other family members, the tax efficiency can be restored due to multiple personal allowances and basic rate bands.
Of course, the company option presents IHT planning opportunities – particularly if the shareholdings are set up properly at the outset.
The first challenge is to establish whether or not you are trading in property. If so, the profits will be subject to income tax and NI if you operate as a sole trader. Therefore, a company is likely to be the more efficient option if you don’t wish to extract profits as they arise, and this can also mean good inheritance tax planning opportunities are also available.
As you will see there is a lot to consider regarding the best business structure for a venture like this, if you are planning to buy, renovate and sell residential properties, please do not hesitate to get in touch with me to discuss the various options and implications.