A quick guide to property development tax
Feeling clueless about capital gains? Has stamp duty left you stumped? Find out how taxes might affect your property development plans here
Whether you’re considering property development as an investment opportunity or have grand plans for a property development empire, you’ll need to factor in the impact tax could have on your profits.
In this quick guide, we’ll explain the different taxes that impact buy-to-let and buy-to-sell property investment. We’ll look at mortgage tax relief, the extra stamp duty that you’ll pay on investment property, and how the taxman differentiates between property investment and property trading.
We’ll also touch on whether you should form a limited company to invest in property, and generally tell you everything you need to know to avoid a hefty tax bill ruining your property development dreams.
This guide will cover:
What is property development tax?
Let’s get one thing out of the way first – there’s no such thing as a ‘property development tax’. Which taxes will affect your property development investments depends on your chosen strategy – most notably, whether you want to buy an extra property that you then rent out (buy-to-let), or you plan to buy a property, do it up, and then sell it (buy-to-sell).
Here are the taxes most likely to affect you, and a brief idea of what activities they apply to:
- Stamp duty – This one is pretty much inescapable. If you buy an additional property – in other words, one that isn’t your main home – then you’ll pay extra tax.
- Income tax – If you receive buy-to-let income as an individual, you’ll need to declare that income and pay income tax on it.
- Corporation tax – If you receive buy-to-let income as a company, you’ll need to declare that income and pay corporation tax on it.
- Capital gains tax – If you sell your property for a profit, then you’ll need to pay capital gains tax (CGT) on the proceeds.
(Various reliefs, exclusions, and limits apply to these taxes – these are discussed in the relevant sections below.)
Bearing this setup in mind, you might be tempted to form a limited company for your property investment activities. After all, corporation tax is significantly lower than income tax, and you’d then pay the corporation tax rate on your buy-to-let income instead of income tax.
However, the real picture is much more complicated:
You probably already know what stamp duty is, or Stamp Duty Land Tax to give it its proper name. If not, the Money Advice Service has a great breakdown – it’s the tax you pay when you buy a property in England and Northern Ireland.
What you need to know as a property developer, though, is that stamp duty is higher on any additional residential property – with an extra 3% charged on top of the normal bands.
The price at which you pay tax is also much lower, starting at £40,000 (as opposed to £125,000 for standard house purchases).
Here’s what this means in practice. You’ll pay:
- 3% tax on the first £125,000
- 5% on the portion up to £250,000
- 8% on the portion up to £925,000
- 13% on the portion up to £1.5 million
- 15% on everything above that
If you’re confused by that “on the portion up to” stuff, it essentially means that different parts of your purchase are charged at different rates. You’ll need to do a bit of maths to work out what you’ll actually pay.
Let’s say, for example, that you buy an additional property worth £500,000:
As stated above, you’ll pay 3% tax on the first £125,000.
To work out 3% of £125,000, the easiest thing to do is multiply £125,000 by 0.03
£125,000 x 0.03 = £3,750
Next, you’ll pay 5% on the amount between £125,000 and £250,000 (the next threshold)
£250,000 – £125,000 = £125,000
So, you’ll pay 5% on this £125,000 – to work this out, multiply £125,000 by 0.05
£125,000 x 0.05 = £6,250
Finally, you’ll pay 8% on the amount between £250,000 and £500,000 (the next threshold is at £925,000, so in this example, you’re now just calculating up to the purchase price)
£500,000 – £250,000 = £250,000
To work out 8% of £250,000, multiply £250,000 by 0.08
£250,000 x 0.08 = £20,000
Your total tax bill is therefore the sum of these three figures:
£3,750 + £6,250 + £20,000 = £30,000
So, on a £500,000 additional property purchase, you’d pay £30,000 in stamp duty.
If you want to work out your actual stamp duty rate, divide this figure by the purchase price, then multiply by 100.
In this case:
£30,000 divided by £500,000 = 0.06
0.06 x 100 = 6
In other words, the actual stamp duty rate on a £500,000 additional property purchase is 6%
You probably won’t be too surprised to learn that, if you receive regular income from a buy-to-let property (i.e. rent payments), you’ll need to declare and pay tax on that income.
The amount of tax you pay will depend on what tax band you fall into.
As of 2019/2020, these bands are:
- 0% on anything up to £12,500
- Basic rate: (annual pre-tax income of £12,501 to £50,000) – 20%
- Higher rate: (annual pre-tax income of £50,001 to £150,000) – 40%
- Additional rate: (annual pre-tax income of over £150,000) – 45%
Mortgage interest tax relief
Once upon a time (before April 2017), you were able to claim a hefty tax relief for mortgage interest, as you could deduct your mortgage interest from your rental income before working out your tax liability.
However, that system is in the process of being phased out, in favour of a 20% reduction in the amount of tax you pay (rather than the amount you pay tax on). This also applies to higher and additional rate taxpayers, so no matter how much tax you pay, you’ll only be able to claim a 20% reduction.
In the 2019/2020 tax year, you’ll be able to deduct 25% of your mortgage interest from your rental income, and get a 20% tax credit on the remaining 75%.
From the 2020/2021 tax year, however, you’ll only be able to claim a 20% tax credit on your mortgage interest.
Analysis from mortgage broker L&C indicates that a basic-rate taxpayer should expect to pay the same amount of tax under both systems, while a higher-rate taxpayer would face a significantly larger bill under the new system.
However, these changes may have an impact beyond these calculations – an increase in taxable income could affect entitlement for Child Benefit and Income Tax Credits, for example.
The other legal way to reduce your income tax bill is by factoring in what are called “allowable expenses”. This is a list of things that the government considers to be related to the management and ownership of your property, and that are therefore not liable for tax.
Aside from mortgage interest (which is discussed in detail above), the main ones include:
- Council tax, insurance, and ground rent payments
- Property maintenance (this does not include substantial improvements, such as extensions; these may however reduce how much capital gains tax you pay if you come to sell the property)
- Letting agency fees or property management fees
- Fees associated with advertising for new tenants
(This is not a comprehensive list – for more details, check the official government page on income tax and property letting.)
Compared to the complexities of stamp duty or the multiple bands of income tax, corporation tax is mercifully straightforward.
The basic corporation tax rate for company profits is 19%.
The complications come when you’re trying to work out how to reduce your corporation tax bill.
The basic idea is that you can take the cost of business expenses away from your profits, and then reduce the amount of profit that you pay tax on.
In practice, there are limits on what you can and can’t claim for. The most important guideline is that you can claim for expenses that have been genuinely needed by your business, and that have been exclusively used by your business.
There are also different restrictions according to what type of property company you are operating (see the investment vs trading section for more details). If you’re not sure about a particular expense, talk to your accountant, or contact HMRC directly.
With those caveats in mind, here’s an idea of what you might be able to claim as a legitimate business expense:
- Company salaries
- Travel and parking costs
- Office supplies
- Business insurance
- Company mobile phone contracts
- Business calls on your home phone
- Home office expenses
- Professional fees, such as those paid to accountants and solicitors
With any expenses, make sure you keep your receipts, as HMRC may want to see these as evidence of your spending.
Investment vs trading: What is your property development plan?
Before we dive into the world of capital gains tax, this seems like a good time to discuss the thorny issue of what is a property investment company, and what is a property trading company.
This is an important distinction to make, as they are treated differently for tax purposes.
Let’s consider each in turn:
This is generally considered to be on a smaller scale than property trading, and is often more associated with renting out properties rather than selling them on. However, this is not a hard and fast rule.
If, for example, you buy a dilapidated property with the intention of refurbishing it and then letting it out, but then need to suddenly sell it, this will still be considered investment activity as the investment intention hasn’t changed (see below for more discussion of this rather blurry dividing line).
For tax purposes, the profit made on an investing property sale would come under capital gains tax (which, after the £12,000 tax-free allowance, is charged at either 18% or 28% on residential property depending on your income tax band).
This is usually on a bigger scale than property investment, and is generally associated with buying, renovating, and selling multiple properties. If, for example, someone bought a property, did it up, sold it, and then used that profit to invest in another property that is also then done up and sold, this would be a classic example of property trading.
For tax purposes, trading profit would come under income tax. Once the personal allowance of £12,500 is used, the rate is charged at either 20%, 40%, or 45% depending on which band the taxpayer falls into.
Drawing the line between these activities can be difficult, but the factors that HMRC will consider include:
- how long the property has been owned for
- whether the purchase/sale is part of a series of transactions
- whether the property has been rented to a tenant
- whether the property was acquired for personal use
Capital gains tax
The simplest way to understand capital gains tax (CGT) is that it is a tax on individual profits. It is generally applied to one-off gains on investment (such as selling shares), but different rates are applied to sales of property.
(It’s worth noting here that you won’t pay CGT if you sell your home, as this is not considered an investment for tax purposes.)
Everyone has a CGT tax-free allowance of £12,000, so if your profit is below this amount, you don’t need to report it and won’t pay tax on it.
Once you go above this level, your CGT tax rate will depend on your income tax band:
- Basic rate income tax payers (those with an annual pre-tax income of £12,501 to £50,000) will pay 18% CGT on property sales
- Higher or additional rate taxpayers (those with an annual pre-tax income over £50,000) will pay 28% CGT on property sales
There may also be costs you can deduct from your taxable profit. For property, the principal examples are:
- Fees paid to solicitors/estate agents
- Substantial improvement works, such as building an extension
While this guide should give you a basic overview, property development tax is a complex area, and we would recommend consulting the services of an accountant who has experience dealing with property before making any significant decisions.
Similarly, carefully research any tax area that affects you to get a good idea of what would be best for your individual circumstances, and always research whether you might be able to use reliefs or allowable expenses to reduce your tax bill.