Lucy Mangan, tax partner and property sector specialist at accountancy firm, Menzies LLP.

Tough market conditions are leading some developers to rethink their business model by choosing to rent out a number of the properties in their portfolio. While this can prove an effective way of propping up margins, considering their long-term strategy and the most tax-efficient way to structure investments is important to optimise their profitability.

In the current economic climate, many developers are finding that they are unable to sell their properties quickly, or for their full value, so more and more are opting to split their investment portfolios. Rather than making a loss, this strategy allows them to ‘wait it out’ until the market picks up, whilst bringing in some rental income. However, deciding to retain properties can have various tax implications for developers, and identifying a long-term strategy is vital to realise the potential of their portfolio whilst not incurring unnecessary tax costs.

A crucial first step for investors looking to rent out some of their properties is to decide on their ultimate objectives. For example, are they still planning to sell the properties eventually, or are they aiming to rent them out for the foreseeable future?

For accounting purposes, where developers are renting properties out in the short-term with the intention to sell them as soon as possible, they may remain in stock. This means that they are not subject to any inherent profit on their asset. For example, a property that cost £500,000 to build, with a market value of £700,000, would have an inherent profit of £200,000. However, if they are planning to rent out the property over a longer period of time, they may need to transfer the properties out of stock and into investments in the accounts. This process effectively crystallises the inherent £200,000 profit, on which the developer would then be liable for corporation tax (currently at 19 per cent). There may also be a VAT clawback, meaning that some or all of any input VAT recovered by the developer on the property would need to be repaid to HMRC.

Mixing trading activities (the development activities) and investment activities (the rental activities) in the same company or group can also have wider longer-term implications. Holdings shares in trading companies can have benefits for both capital gains tax and inheritance tax as they could both qualify for Entrepreneur’s Relief (ER) and Business Property Relief (BPR). Whereas pure property developers would clearly be trading companies if rental properties are held in stock, this can muddy the water and depending on the balance of activities, could mean that valuable tax reliefs are at risk.

Due to the immediate and potentially longer-term implications, developers who view rental properties as a long-term investment may wish to consider transferring these assets into a separate company. The process of splitting property interests between companies raises a further question; should the new company be a subsidiary of the parent company, or a standalone entity? Both options have advantages and disadvantages.

By transferring rental properties to a subsidiary company, the developer would avoid paying any stamp duty land tax (SDLT) on transfer, as both the trading and investment companies would belong to the same group.  Another positive is that from a VAT perspective, there should be no input VAT clawback. The downsides are that the developer company would still crystallise the inherent profit in the property and if the subsidiary remains part of the group, it would not improve the ER or BPR position.

On the other hand, moving rental properties into a separate, standalone company would ensure the development company was not at risk of losing ER or BPR relief but would result in a SDLT charge arising on the market value of the property transferred. Whereas the tax on the crystallisation of the inherent profit could only really be viewed as a timing difference, the SDLT charge is an actual cost and could be expensive. What is best will depend on both the current circumstances and the longer-term intentions and should be reviewed in each situation.

In order to stay on the right side of HMRC and optimise their tax position, developers should also keep documentary evidence of each stage of their decision-making process. For example, keeping a thorough record of director’s minutes, which detail the thought processes behind their commercial strategy, can help to support VAT claims. Seeking expert support from a professional experienced in helping developers to combine property interests can also help them to arrive at a decision which supports the company’s long-term objectives.

For many developers, splitting property interests could prove a wise commercial strategy, allowing them to ride out tough market conditions while still turning revenue. By carefully considering the different options for structuring their investments and the various tax implications, they can maximise the value of their portfolio, whatever 2020 has in store.