Property Development Company
Written by Ray Coman
Considering the prospect of a considerable gain, a property developer will be concerned to keep any tax liability to a minimum.
The tax treatment of profits will depend on whether the property is regarded as a part of trade or whether it is regarded as an investment. Tax is also affected by whether the property is held in the name of a company or in the developer’s own name.
The following table provides a summary of the tax implications:
|Owned personally||Owned via company|
|Subject to national insurance||Yes||No||No||No|
|Personal allowance not wasted (e.g. via director's salary)||Yes||No||Yes||Yes|
|Highest marginal tax rate (2015/16)||45%||28%||45%*||45%*|
|Interest capitalised||Yes||No||Yes||Probably not|
|Summary of tax implications||A sole trader or partner will suffer Class 4 NICs on which a company owner would not be liable. Tax as a percentage of overall profits will probably increase the greater the number of property owners in each venture.||For a buy-to-let landlord, by far the most common option is to hold property personally.||A developer has an advantage over an investor in being able to recover overheads. Unlike partners and sole traders, shareholders do not incur national insurance. However, there would be a double tax charge on extraction of profits.||Indexation allowance is the main benefit. However, unless there is significant inflation, or the property is held over a number of tax years, indexation is unlikely to have such a great comparable tax impact.|
* For companies the marginal rate is based on profits extracted as dividends. Where the company is dissolved on project completion the highest rate would be 28%.
** Similarly, the annual exemption would effectively be available on the disposal of a share, if the company is struck off after each property is sold.
Trading or investment
Whether a receipt of funds is understood as capital or revenue will depend on the so called ‘badges of trade.’ A property developer will usually be regarded as trading. A property held for long term investment will be capital.
Stock versus fixed asset
Fixed capital produces income without further action. Circulating capital, such as stock, is held temporarily for the realisation of a profits.
The property of an investor is regarded as a fixed asset, whereas the property of a developer would be regarded as work-in-progress and, when finished, as stock. There is nothing about the bricks and mortar itself which can explain whether the real estate is an item of stock or an asset. Whether a property is regarded as stock or a fixed asset depends on its intended use.
Running costs of a property developer
International Accounting Standard (IAS) 2.13 requires that the overheads of the business are allocated to the work-in-progress. Therefore, any running costs, such as motor expenses, administrative and financing costs are absorbed in the value of the stock which is eventually sold.
By contrast, the running costs of a property investment business are deducted from rental profits. If the investment business does not have any profit, then the running costs are ‘wasted.’ They cannot be capitalised. Improvement costs, and the fees of purchase and sale are tax deductible. Overheads incurred by an investor are not characteristically deducted from gains on eventual disposal.
International Accounting Standard (IAS) 23 makes a requirement that interest on money borrowed forms part of the value of a qualifying asset. In this context, a qualifying assets is one that takes a substantial period of time to prepare for its intended use, or for its sale.
Interest is therefore capitalised, starting with when the money is borrowed, and ending when the asset is ready for its intended use.
For a property developer, interest on project funding can be deducted from eventual profits.
Investment property is unlikely to take a substantial period to prepare, and it is therefore rare for interest to be capitalised. In practice, IAS 23 applies to large construction and development projects.
In a typical scenario, investment properties will produce rental income. Interest and other running costs can be deducted from rental profits chargeable to tax. If the interest is deducted from rental profits, relief is obtained when the interest is incurred. If interest is added to the property, tax relief would be delayed until the property is eventually sold. Given that the rate of corporation tax is the same for profits as it is for gains, interest is not usually capitalised.
Costs incurred on the property prior to letting, such as interest and repairs are likely to be treated as pre-trading expenses, and therefore deducted from taxable rental profits on the first day of trading.
Since it is a requirement for a business to be a company for IAS to apply, it is unlikely that interest can be deducted from gains on property held by individuals. Any eventual gain on disposal of the property would not be reduced by mortgage interest.
Loan to a company
Rental losses on property held personally can only be carried forward and set against other income. Rental losses cannot be set against other income. Where repeated rental losses are expected for many years, then the landlord will have to wait before obtaining tax relief on excess costs. If the property is sold and there are accumulated rental losses then the landlord may never obtain tax relief.
In these circumstances, the landlord could obtain tax benefit by placing his or her property unincumbered into a company. In practice it is harder to obtain borrowing secured on property held by a company compared with property held individually. The landlord could make a personal loan to the company (say mortgaged on his or her home.) Interest on this loan could be deducted from profits under ITA 2007, s 392.
Double tax charge
In general, a gain realised personally will result in less tax than a gain realised through a company. The reason is the so called ‘double tax charge.’ A gain in a company is subject to corporation tax. The proceeds from the transaction would need to be extracted from the company in order for the individual shareholder to realise that gain. To the extent that dividends make the shareholder a higher rate taxpayer there would be further tax to pay.
The result is that company gains are subject to 20% tax at the basic rate and 40% at the higher rate. T his compares to 18% at the basic rate and 28% at the higher rate for gain made personally. Furthermore, a company does not have an annual exemption. For this reason it is rare for a property investor to use a company.
However, a property developer will have not have capital gains tax exemption and relief. Rather, a developer can deduct overheads from profit on eventual sale of the property. Therefore, a property developer would be subject to the double tax charge. On the other hand, class 4 national insurance contributions would not apply to the company owner. The following guide provides further information about tax efficient extraction of company profit.
Whether a property developer will have a lower tax liability on profits within a company compared with profits outside a company will depend on the circumstances of each individual.
- Indexation allowance is available for companies on its investments. Indexation is not given to items of stock.
- Companies are not eligible for the annual allowance. However an asset owed by an individual would be eligible for the annual allowance.
- A developer making a loss has greater opportunity to deduct trading losses from other income. Capital losses can usually only be carried forward.
- As a developer, it is possible to write down the stock before it is sold (to its net market value) thereby obtaining loss relief prior to sale. This could be beneficial in a slow moving market.
- A developer should weight the double tax charge against NI payable on trading income in deciding whether to run the project through a company.
- For a developer the benefit of being a trade is the recovery of running costs, whereas the benefit of having a property investment is the annual exemption and lower tax rates applicable to a capital gain.
- The annual exemption and entrepreneur’s relief may be available if the company is wound up after the property is sold. This would help mitigate any double tax charge.