We are increasingly seeing IRC and other retirement sector operators adapting their offer to provide a for-rent option to customers. This can be a permanent for-rent offer or a "rent to buy" or "try before you buy" model. While these options increase customer choice and can help fill villages more quickly where people don’t want to buy or need to sell an existing home first, there could be unexpected tax consequences, particularly in relation to VAT.
These may not make a rented offer uneconomic, but they can be difficult to manage if not given some thought in advance.
VAT – zero-rated sales good, exempt lettings bad?
The first sale by an operator 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. Operators intending to deliver a wholly for-sale model may not spend much time trying to reduce the VAT which they incur as normally it will all be recovered from HMRC – though for retirement operators there can be nuances, based on who will use the communal services provided and where they will be located.
Conversely, 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 will want to minimise their irrecoverable VAT. They can do this by minimising the VAT which they incur in the acquisition and construction of the dwellings or, potentially, by implementing a group structure will does allow recovery of VAT.
The worst case scenario is that a change of intention from making zero-rated sales to renting dwellings requires the VAT recovery position to be reconsidered and could result in an operator having to repay to HMRC all of the VAT which it has previously recovered. In addition, any VAT which is yet to be incurred would also become irrecoverable.
VAT costs will be determined by reference to the operator's intentions for the dwellings as between for rent and for sale. If those intentions change, 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. As such, operators need to consider VAT structuring and mitigation around these models, particularly if the strategy for how units will be offered to the market is flexible until relatively late in the development process.
Short term letting arrangements
The VAT exempt treatment of rented dwellings applies even if there is intended to be a sale shortly after an initial letting, such as in a "rent to buy" or "try before you buy" model.
The good news, however, is that VAT recovery for dwellings initially rented but then intended to be sold should produce a much lower VAT cost than dwellings which are rented out on a long term basis. Based on HMRC practice, there could be no VAT cost at all. In simplified terms, VAT recovery would be proportionate to the amount of zero-rated sales receipts vs the amount of rental income. There is even a de minimis threshold which needs to be breached, below which no repayment to HMRC is required.
How much VAT is at stake?
Operators must use a fair method to calculate their VAT liability. HMRC will accept some calculations without the need to expressly agree the method used with HMRC but only if the method used is in accordance with their guidance. In some instances, however, HMRC will always need to specifically agree the position.
It is important, therefore, for any calculations to be based on realistic expectations and to have a proper paper trail evidencing any change of intention to move from for sale to "rent to buy" or "try before you buy". A partial exemption method may need to be agreed in advance with HMRC where VAT continues to be incurred
If there would be a material VAT cost, e.g. because of a decision to offer units permanently for rent or because the partial exemption method for temporary rent offers result in unacceptably high irrecoverable VAT costs, it might be possible to mitigate this.
Subject to taking all non-tax considerations into account first (such as legal, financing and commercial issues), one option could be to structure things so that there is an intra-group transfer between non-VAT-grouped companies. his should allow full recovery of VAT incurred to that point. However, when considering just the tax position in such a case it is important to understand the SDLT position and whether the conditions for claiming group relief from SDLT can be met and to understand the corporation tax implications before making such a transfer as these could outweigh the VAT saving. Thought must also be given to the VAT implications of any additional building works which will be required after this intra-group transfer, to ensure this is structured correctly and efficiently.
How we can help
If you are considering offering a rental product of any kind, whether in advance of structuring a development project or as a result of changing your plans, please let us know. We can guide you through the available options to help maximise your after-tax returns.