When zero tax is payable on property income
Philip Spencer FCA, senior tax writer, Croner-i explains the scenarios where tax is not chargeable on residential and commercial property from primary residences to pension funds
In a recent presentation on property tax, I said that the key to many issues in property tax is to focus on those situations where no tax is payable at all. From there, you start to unravel the topic along with many planning opportunities and complications.
The starting point is to consider which entities pay no tax on property income and gains. These include the following more typical examples.
Pension funds come in various shapes and sizes. Almost every reader is likely to have some involvement in a pension arrangement. This may be a large corporate fund, a small Self-Administered company scheme or Self-Invested Personal Pension Scheme.
Putting a commercial investment property in a pension fund can be an attractive proposition. It might be a pure investment scenario, or this could be the property that is occupied by a related business.
In either case, the removal of the lifetime allowance for pension funds proposed together with the raising of annual tax-deductible contributions in the 2023 Budget could enhance the potential for tax-free capital growth.
A couple of caveats here. Residential property is generally not an acceptable investment for pension funds. Furthermore, with any commercial property, the independent trustee will want to ensure that the investment is a prudent one particularly in relation to meeting the fund’s ongoing and future liquidity needs.
Real Estate Investment Trusts (REITs) and Property Authorised Investment Funds (PAIFs)
PAIFs and UK REITs pay no tax on the income and gains generated from their property investment portfolio.
There are over 50 listed UK REITs, with names such as Segro, Land Securities, British Land, Unite and Tritax among the biggest. It is also possible to invest in residential property via Reit shares – like the Residential Secure Income Reit.
PAIFs, which are open ended funds, have been launched by companies such as CBRE and Abdn (formerly known as Aberdeen).
The other entity that can avoid tax on property income and gains is charities. Readers and their contacts may well be associated with a charity that owns or is contemplating owning property either as investment or to be occupied for the purposes of the charity’s activities.
Investment versus trading
One caveat is that the exemptions in each case above applies only with investment property as opposed to a property acquired to make a profit out of its disposal, either by way of dealing, refurbishment, or redevelopment.
What do we mean by investment? It means buying property for the rental income it generates and generally that would be for the long term. It might also apply in a couple of other situations.
A property bought purely for very long-term capital growth could conceivably be an investment. Also, a property which is bought as premises from which to operate would be an investment property.
A pension fund or charity would not or should not normally trade in property, whether it is dealing or developing – at least in its own right. They might, instead, invest via companies that trade but they themselves should not really be indulging in property trading.
A REIT or PAIF may well be engaged in trading but of course they must primarily be investment vehicles in order to retain their REIT/PAIF status.
The REIT must have at least 75% of its income derived from real estate investment and a similar percentage is applied to its assets. For PAIFs, the figure is 60%. If these entities then have income or gains from other activities, these are subject to corporation tax.
Main residence exemption
An important capital gains tax (CGT) exemption applies to main residences. While we should be familiar with the basic concept, it is an area that is fraught with complications once you stray beyond the straightforward home owning scenario.
These include individuals attempting to exploit the exemption with a regular and frequent pattern of buying properties that they occupy for a short period and then selling off at a profit. A gain on a property bought with the main objective of selling at a profit can fall outside the exemption.
If repeated, HMRC may consider that is a trading activity. Similarly, when a former main residence undergoes a major redevelopment before being sold off, that may expose the gain related to the development to income tax or CGT.
Other issues arise where more than one residence is owned. The last nine months of main residence ownership are accepted as within the exemption whether occupied or not in that period. Also, when an owner has to leave the home for a period, eg, for work or other reasons, then the period of absence may be ignored providing that the owner eventually returns to occupy the property.
These periods are generally up to three years but can be four years if the individual has to work elsewhere in the UK. A longer period can be allowed where the owner or a spouse is working abroad, even if the property is let in the meantime.
Where more than one residence is owned, the owner can elect which one is to be treated as the main residence for the purposes of the CGT exemption. Otherwise, HMRC will decide on the facts.
When letting out furnished residential space in the main residence, there is an income tax exemption for a maximum of £7,500 gross rental income together with any other charges to the tenant. This is known as rent a room relief. Where a residence is partially let in this way, the CGT main residence exemption can be restricted although a CGT letting exemption of up to £40,000 can be claimed.
Several years ago, a non-resident company or individual was exempt from tax on capital gains on investment property. A company would pay income tax on property investment income at the basic rate only.
Since April 2015, non-residents have been subject to tax on residential property gains and commercial property gains since April 2019. However, as the properties are rebased to market value at those dates, gains accrued up to that point can avoid tax.
Tax-free property income for individuals
Apart from rent a room relief mentioned above, and the annual exemption for small property investment income of £1,000 or less, an individual can avoid tax on property income. This is achieved by owning shares in a UK REIT or certain PAIFs through an ISA.
Any dividends received in an ISA should be income tax free. Dividends paid by REITs and PAIFs out of profits from their investment portfolios are property income dividends – or PIDs – and are treated as property income subject to a 20% tax withholding which ISA managers should reclaim.
Impact of finance costs
Turning to the impact of finance costs, these have increased significantly recently. In many cases, landlords have not been able to pass on that extra cost to the tenant.
A company with rental income that is completely offset by finance costs can normally reduce its tax to zero. That assumes the finance arrangement is on reasonable commercial terms and does not trip several anti-avoidance measures. Furthermore, it also assumes that it does not fall foul of the complex corporate finance restrictions where the interest exceeds £2m a year (group wide).
The position for individuals depends on whether they are letting residential or commercial property. With commercial property there is no restriction on the deduction of finance costs. However, with residential property only basic rate tax relief is allowed. If residential property income results in the owner being subject to tax at 40% or 45%, then there will always be a tax charge even if all the rental income goes in interest costs.
There is an exception for residential property which qualifies as furnished holiday lettings, where finance costs are normally fully deductible.
This is the position for investors. Trading is a different matter. Finance costs incurred as part of the funding of a property which is required to buy and sell on, would normally be set off against any trading profit on sale. That is regardless of whether an individual or company is involved. Furthermore, losses may be offset against other income and gains.
This trip around the subject of zero tax situations is aimed at highlighting the need to analyse several factors in diagnosing the tax situation. These include:
• whether the situation is investment or trading;
• what entity is involved in the transaction? Apart from those mentioned above, there are partnerships, trusts, property unit trusts and open-ended investment companies (OEICs), together with hybrid variations;
• whether the property is residential or commercial.
About the author
Philip Spencer FCA, senior tax writer, Croner-i
Croner-i Property Tax Adviser is a tool that looks at property tax situations considering these alternative scenarios
This article was first published in Croner-i Tax Weekly > Issue 71 > 7 June 2023 > Analysis > When zero tax is payable on property income and/or gains
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