If you are in property the real big question which dictates how much tax you pay is whether you are trading or investing.

This question is so fundamental because the tax code that applies to each category is completely different. The government has recently changed the tax planning considerations markedly. I thought that it may help if I visit this subject and spell out the basic rules. The tax rate is 18% for capital gains arising from investment activities but 40% or more for trading profits! However, if you are trading in property and suffering from the current downturn you could get a tax repayment against falling property values.

So how, in summary, can you tell the difference between property-trading and property­ investing activities? Put in a nutshell, the difference is mainly about the intention behind buying the property in the first place. If your intention is to sell the property at a profit, and that is the main motivating factor behind buying it, you are likely to be trading in property. If, in contrast, your intention is to find a home for your money, or hang on to the property indefinitely for the purpose of receiving a rent, then you are probably a property investor (even if you do have in your mind the prospect of capital growth).

The following are some of the relevant factors in reaching a decision:

• Length of the period of ownership;
• Frequency of transactions;
• The form of finance;
• Consistent accounting treatment of the property portfolio;
• Documentary evidence to show the underlying intention;
• Specialist industry knowledge;
• Enhancement expenditure; and
• The absence or existence of planning applications.

The new landscape

Since 6 April 2008 capital gains tax (CGT) is now charged at a flat 18% rate (subject to various reliefs). There are some big winners and some big losers from this change, but the biggest winners, unquestionably, are property investors.

Prior to 6th April 2008, property investors making gains from sales of their portfolio were liable to 40% CGT during the first three years of their ownership. The rate of tax fell over time due to the effects of taper relief. After a period of 10 years the effective rate of tax could be as low as 24%. This regime was abolished and a property investor is now subject to the flat 18% rate regardless of how long he or she has held the property.

I should make it crystal clear here that we are talking about properties owned by individuals, partnerships, trusts or limited-liability partnerships (LLPs). We are not talking about properties owned by companies. This is because companies don’t pay CGT but instead are charged corporation tax on their taxable gains.

Capital gains tax vs. inheritance tax

For individuals for whom inheritance tax (IHT) is an issue there has always been a conflict between the needs of IHT planning and CGT planning.

On the one hand, IHT is telling you, basically, that you want a property development (i.e. trading) business. This is because, if you bring your business activities within the property development category, their entire value is excluded from your estate due to 'Business property relief' from IHT, at 100%.

On the other hand property investment activities, though, are fully chargeable to IHT at 40% on your demise. So, although you won't live to see the benefit yourself, this is obviously a powerful motivation for arranging your business interests so they fall within the property development camp. If you are in the IHT favourable camp you will not also be able to take advantage of the 18% tax rate on property investment activities.

Property trading profits

Property development, as a trade, is liable not to CGT, in fact, but to income tax or corporation tax. If you are very successful making profits and buying and selling properties, there may be a heavy price to pay in the form of income tax or corporation tax liabilities for being a trading rather than an investing business. That said, if you are in the property field and are currently suffering due to the economic downturn a trading classification is better for you due to the much more favourable loss relief regime (more later).

The thing that has really changed as a result of the changes in the law is that the contrast between the rates of tax payable has just got more extreme. Previously you were in the position of possibly paying 40% CGT as an investor, versus 40% income tax as a trader, this aspect of your planning was less important. Now, though, the contrast is between 40% income tax as a trader and 18% CGT as an investor, on what could be exactly the same transaction! Clearly, it is possible to arrange your affairs in such a way as to achieve the desired outcome!

Property companies

I made the comment above that none of this changed landscape applies where the properties are in a company. The reason for this is that companies are still in the old regime as far as capital gains are concerned. They pay corporation tax on those gains, with the benefit of indexation, at the full marginal rate of corporation tax payable by the company. There are other tax problems that arise by holding investment assets in a company……… the ‘double charge’ to tax!

Property losses due to economic downturn

Given the current economic climate it is very likely that some property values are standing at less than the cost shown in the purchaser’s books of account. This is where it is a real advantage to be trading in property rather than investing. Accounting rules (which also apply for tax) require stock (including properties held for trading) to be shown at the lower of cost and net realisable value. You can write down the cost of your property portfolio to its ‘net realisable value’ and get tax back on the paper loss! This assumes that you have paid tax on non property income or gains elsewhere.

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