Many a property developer has spotted the potential of buying a
large property and converting it into flats in order to maximise profit.
However, converting a property into flats for financial gain is not the
sole preserve of the property developer.
A
landlord may decide to convert a property into flats to maximise both
rental income in the short term and profit on sale in the longer term.
Likewise,
a person may decide to convert a former family home into flats to
realise the maximum possible gain on disposal. However, as is often the
case, the tax implications will vary depending on the circumstances.
Scenario 1
A
developer buys up a large house in a poor state of repair for £400,000.
He spends a further £200,000 converting into four flats. The work takes
six months. Once complete, the flats are sold for £250,000 each.
The
nature of a property developer’s trade is to develop properties for
profit. As in this scenario the motive is to make a profit rather than
to buy the property as an investment, any profit on sale is charged to
income tax as a trading profit rather than to capital gains tax. The
trading profit would be computed according to normal rules and the
profit on this development (£400,000) would be taken into account in
computing the developer’s trading profits for the period in question.
As
the developer is trading, capital gains tax (CGT) is not in point.
Consequently, there is no CGT to pay when the flats are sold.
Scenario 2
A
landlord has a number of properties that he lets out. He has owned a
large property for a number of years which has been let out as a single
dwelling. He decides to convert the property into flats. He then lets
the flats for a further couple of years before selling them.
The
landlord will be subject to CGT on any gain made from the sale of the
flats. As the flats have always been let and have never been the
landlord’s main residence, neither private residence relief of letting
relief are in point.
For the purposes of illustration, it is
assumed that the landlord originally bought the house in 2005 for
£300,000 and let it as a single unit until June 2009, when he converted
the property into three flats. The conversion costs were £150,000. Each
flat has two bedrooms and is approximately the same size.
The
work was completed in November 2009 and the flats were again let until
January 2011, when they were put on the market. Flat 1 sold in February
2011 for £220,000, Flat 2 also sold in February 2011 but for £230,000,
and Flat 3 sold in March 2011 for £215,000. It is assumed that in each
case the costs of sale are £2,000.
The gains on disposal are as follows:
Flat 1
| | | £220,000
|
Less: cost of original property (1/3 x £300,000) | £100,000 | |
Conversion costs
(1/3 x £150,000)
| £50,000 | |
| | | (£150,000)
|
| | | £70,000
|
| Less: costs of disposal | | (£2,000)
|
| Gain on sale | | £68,000 |
Flat 2
| Proceeds | | £230,000 |
Less: cost of original property
(1/3 x £300,000) | £100,000 | |
Conversion costs (1/3 x £150,000) | £50,000 | |
| | | (£150,000) |
| | | £80,000 |
| Less: costs of disposal | | (£2,000) |
| Gain on sale | | £78,000 |
Flat 3
| Proceeds | | £215,000 |
Less: cost of original property (1/3 x £300,000) | £100,000
| |
Conversion costs
(1/3 x £150,000) | £50,000 | |
| | | (£150,000) |
| | | £65,000 |
| Less: costs of disposal | | (£2,000) |
| Gain on sale | | £63,000 |
The
total gains on the sale of the flats (£209,000) will be taken into
account in computing the landlord’s net chargeable gains for 2010/11 and
charged to CGT at the appropriate rate.
Scenario 3
After
his children have grown up, a homeowner decides to convert his property
into flats prior to sale to maximise the profit on sale. The flats are
sold as soon as the work is complete.
For the purposes of
illustration, it is assumed that the property was purchased in 1990 for
£100,000. It was lived in as the taxpayer’s main residence until June
2010, at which time work began to convert the property into three flats.
The work was completed in November 2010, and the flats were sold in
January 2011 for £275,000 each. The conversion work cost £180,000.
At
first sight, it may seem that the entire gain is covered by private
residence relief as it had been the taxpayer’s home throughout the
period of ownership. However, there is a trap that will catch the
unwary. This is because private residence relief is denied in respect of
a gain in so far that it is attributable to any expenditure that is
incurred after the beginning of a period of ownership that is incurred
wholly or partly for the purposes of realising a gain.
Broadly,
the provisions work to deny private residence relief in relation to
that portion of the gain that is attributable to the expenditure
incurred in order to realise a higher profit. It is therefore necessary
to obtain a valuation of the house assuming the work had not been
carried out and it was sold as a single dwelling. In this way, it is
possible to establish the additional profit attributable to the
conversion work.
In the above example, it is assumed that had
the property been sold as the original family home it would have fetched
£600,000. By converting it into flats, the sale proceeds increased to
£825,000 (3 x £275,000). The cost attributable to the additional
proceeds of £225,000 (i.e. £825,000 - £600,000) was the conversion
expenditure of £180,000. This expenditure effectively generated an
additional gain of £45,000 (£225,000 - £180,000). The development gain
does not qualify for private residence relief.
The computation of the gain is therefore as follows:
| | Total Gain £ | Exempt Gain £ | Non-Exempt Gain £ |
| Proceeds | 825,000 | 600,000 | 225,000 |
| Less: cost of property | (100,000) | (100,000) | |
| cost of extension | | (180,000) | (180,000) |
| GAIN | 545,000 | 500,000 | 45,000 |
The
non-exempt gain is reduced by the taxpayer’s annual allowance to the
extent that this remains available and charged to CGT at the appropriate
rate.
Scenario 4A
Homeowner
decides that her house is too big for her. She converts it into two
flats, one of which she sells. She continues to live in the remaining
flat.
The property was purchased in 2000 for £325,000. In
2010, the property was converted into two flats. The conversion work
was completed in May 2010. One flat was sold in June 2010 for £275,000.
The conversion costs were £40,000. At that date, the value of the
unconverted house was £500,000 and the value of the flat retained was
£350,000.
The combined value of the two flats at the date the
flat was sold was £625,000. This is £125,000 more than the value of the
unconverted property at that date. The conversion costs are £40,000,
giving rise to a gain attributable to conversion of £85,000.
This
gain is not covered by the private residence exemption. However, it
must be attributed between the flat to ascertain the amount that comes
into charge in respect of the sale of the first flat. This is done
simply on an apportionment basis by reference to the relative values of
each property on the date that the first flat was sold.
The non-exempt gain attributable to the flat sold is therefore:
£175,000*/£625,000 x £85,000 = £23,800.
(*£500,000 unconverted value less £325,000 cost)
This remainder of the gain attributable to the first flat is covered by private residence relief.
The
non-exempt gain (as reduced by any allowable losses and the annual
exemption to the extent that it remains available) is charged to CGT at
the appropriate rate (18% or 28% depending on whether the taxpayer is a
higher rate taxpayer).
The balance of the non-exempt gain will come into charge on the eventual sale of the flat which has become the taxpayer’s home.
Practical Tip
Converting
a property into flats to maximise profits on sale is not always
straightforward from a tax perspective. The end result will vary
depending on the circumstances.
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