Commercial to residential conversions: Tax hurdles to overcome
Jerome Lane looks at the key tax issues when converting commercial property to one or more residential dwellings.
With the changing shape of the high street, empty commercial units are becoming more common. Considering the housing shortage, converting commercial buildings into residential properties may provide a great opportunity to enhance the appearance of town centres, once the planning office and the local community give their approval.
However, there are tax hurdles that need to be overcome when converting commercial property to one or more residential dwellings. Here are a number of the key issues of which agents need to be aware:
Notoriously complicated for property and construction transactions, and with a high transaction value, VAT mistakes in this area can be extremely costly. To appreciate the VAT implications, it is necessary to first understand some basic rules:
- The first disposal of a residential property just brought into existence is zero-rated for VAT purposes. The disposal must be either a freehold sale or lease exceeding 21 years (20 years in Scotland);
- The subsequent letting or onward sale of residential property as a dwelling is normally exempt from VAT;
- A disposal of a commercial property brought into existence in the previous three years is standard rated for VAT purposes; and,
- The letting or sale of older commercial property is generally exempt from VAT.
Option to tax
The effect of rule three above is that an owner or prospective buyer will often register for VAT and make an “option to tax” election with HMRC on commercial property in order to recover the VAT expense suffered. Consequently, they would be required to charge and account for VAT on future rents and other income earned from the property if they operate a commercial letting business.
The owner would also have to charge VAT on any onward sale. Once an election has been made, it cannot be revoked for 20 years, apart from an initial cooling-off period of six months in some cases.
When it comes to buying commercial property, a VAT-registered developer may face cashflow problems and a developer who is not registered for VAT would have to factor in the VAT cost. The option to tax can be overridden if the purchaser produces a VAT 1614D certificate declaring the intention to change the VAT status of the property to residential use.
Transfer of a going concern
Where a transfer of a property business is treated as one of a ‘going concern’ for VAT purposes, then the purchaser and seller can treat the transaction as not being a taxable supply if all of the requirements in VAT Notice 700/9 are met.
An important condition is that if the seller has opted to tax the property, then the buyer must also make their own option to tax election with HMRC before the deal takes place.
Where the intention is to develop the property into residential units, the transfer is unlikely to be treated as one of a going concern since the new owner will not be carrying on the existing business.
The reduced rate
There are a number of tightly defined circumstances in which the reduced 5% rate of VAT can apply to construction services supplied in relation to conversions of commercial buildings into residential units eg an office block is converted into apartments. The reduced rate will apply to both the contractor’s services and the materials they supply as part of their work.
However, many contractors may be reluctant to charge the reduced rate and seek to play safe and charge 20% VAT instead. This is incorrect, and the correct rate of VAT must always be applied because input tax can only be claimed on correctly charged VAT. The reduced rate applies to work carried out by subcontractors working for other builders, as well as the services of the builder (main contractors) working for the developer.
Having your cake and eating it too?
Where a developer plans to convert a commercial property into residential units and then let the dwellings out to tenants, they may find themselves stuck with costs on which they cannot reclaim the input VAT.
This is because the developer will not be making taxable supplies (as the letting is exempt) and thus will have a wholly exempt or at best partially exempt business. The only saving may be if they are charged the reduced rate by the building contractors.
However, if the owner disposes of the newly converted units (making a zero-rated supply), full VAT recovery will be possible. By developing the units and transferring to a connected party, full VAT recovery will be achieved while retaining ownership in the connected entity.
An individual developer could transfer the residential properties to a partnership or company they are connected with, while a corporate owner could transfer to a holding company.
Following the global financial downturn in 2009, HMRC confirmed in Brief 101/09 that it does not treat this planning as avoidance since the intention is to allow VAT recovery on newly created dwellings. Neil Warren explained how this old concession may help builders today.
SDLT (or LBTT in Scotland and LTT in Wales)
Where planning permission and an obligation to develop residential property exists within a contract, the purchaser may be able to make a choice between applying commercial SDLT rates or residential SDLT rates where multiple dwellings relief may be applicable, often resulting in an overall lower SDLT liability.
Accounting and direct tax
For accounting purposes, a developer should hold property as stock while an investor should hold property as fixed assets on its balance sheet.
Where property is transferred from stock to a balance sheet, a tax liability arises on the gain by reference to the current market value versus historical cost and allowable capital expenses. The tax exposure can be mitigated by timing the transfer ahead of the completion of the residential units when the market value should be considered to be lower.
Completion of the unit for CGT purposes is regarded as the earlier of when building regulations are signed off or a residential council tax liability arises.