Tax implications of the temporary letting of new residential units


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The housing market has been affected as much as the rest of the economy by the current lockdown, and businesses which have built new residential units for open market sales (including shared-ownership) may be considering letting the units until the market improves. 

Whilst the key driver behind such a decision would be to generate a return from the dwellings, there could be unexpected tax consequences, particularly in relation to VAT.  The tax considerations are unlikely to be so severe as to make the letting uneconomic but they can be mitigated and this may affect how the new intention is put into operation. These considerations are discussed below.

VAT – zero-rated sales good, exempt lettings bad?

Housing developers will know that the first sale of new dwellings which they have constructed (whether a freehold sale or the grant of a lease for more than 21 years) is zero-rated for VAT purposes.  In general terms, this allows them to recover the VAT incurred in relation to the development, ranging from VAT on the upfront costs, such as the purchase of the land and planning costs, to VAT incurred as part of the sales process, such as marketing and legal fees.  These businesses understandably may not spend much time trying to reduce the VAT which they incur as normally it will all be recovered from HMRC.

Conversely, residential landlords will know that the letting of dwellings is an exempt supply for VAT purposes.  This means that VAT which is incurred in relation to the letting business cannot be recovered from HMRC.  As a result, businesses which are developing housing for rent (such as registered providers of social housing and residential REITs) will want to minimise the VAT which they incur in the acquisition and construction of the dwellings.

The worst case scenario is that the change of intention from making zero-rated sales to letting out the dwellings could result in the business having to repay to HMRC all of the VAT which it has previously recovered (and that any VAT which is yet to be incurred will not be recoverable either).  

The good news, however, is that this should only happen where the new intention was to keep the dwellings and rent them out indefinitely and not to sell them.  An intention to rent the dwellings out for a limited period of time should produce a much lower VAT cost and, based on HMRC practice, there could be no VAT cost at all.

As the VAT cost, if any, will be determined by the new intention it is important to take the VAT position into account during the decision making process.  If VAT is only considered after the decision has been made then the VAT cost will already have been triggered.

How much VAT is at stake?

A business needs to use a fair method to calculate its VAT liability and HMRC's guidance confirms that, in respect of historic VAT recovery,  it will accept a method based on expected receipts over a ten year period without the need to expressly agree this method with HMRC.  In over-simplified terms, VAT recovery would be proportionate to the level of zero-rated sales receipts vs the level of rental income. There is even a de minimis threshold which needs to be breached, below which no repayment to HMRC is required. 

For this reason it is important that any calculations are based on realistic expectations and there is a paper trail evidencing the temporary change in intention such as business plans, board minutes and valuations for the anticipated rental income.

In some situations the position will need to be agreed with HMRC.  This would include if the property concerned is within the capital goods scheme (which is more likely with blocks of flats than houses); if the business has previously used a partial exemption method and if the business simply wishes to use an alternative method in order to improve its VAT recovery. 

Ongoing VAT recovery

As mentioned above, to the extent that VAT continues to be incurred in relation to the exempt lettings then a partial exemption method should be agreed in advance with HMRC, which one would expect to be on similar lines to the method described above.

Other options

If there would be a material VAT cost, it might be possible to mitigate this.  One option could be to sell the units intra-group to a non VAT-grouped company.  This would produce the zero-rated supply which was always intended so that there was no loss of VAT recovery.  The new owner could then let the units out on a temporary, or permanent, basis (but would not be able to recover VAT incurred in relation to those lettings).  In such a case it is important to ensure that the conditions for claiming group relief from SDLT are met and to understand the corporation tax implications before making such a transfer as these could outweigh the VAT saving. 

Another option could be to let the dwellings as short-term or holiday accommodation as this would be subject to VAT.  Whilst VAT would have to be paid to HMRC from the rental income, the historic VAT recovery position would be protected.

How we can help

If you are considering changing your plans and letting out residential properties which were originally intended for sale please let us know.  We would be happy to help you consider the available options to maximise your after-tax returns before making your decision.

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