There has recently been a swathe of tax legislation increasing the tax burden for investors in UK residential property. If you’re a residential landlord, you’ve probably had to review your strategies.
Some residential landlords are exiting the market completely. For others, incorporating rather than holding property personally is a possible solution. However, some are looking at diversifying into commercial property. The differences between investment in residential and commercial property, tax and non-tax alike, are worth considering.
If you are a residential property investor in the UK, you may have seen substantial gains over the last couple of decades. This may have caused you to query whether the trend can continue and whether it is worth looking at commercial property as an alternative.
Commercial property, by contrast, has not seen the capital growth returns seen by residential. However, rental yields on commercial property tend to be greater than for residential.
Commercial property can also be easier for the landlord to manage as, by and large, commercial property leases are full repairing and insuring. This means the tenant rather than the landlord is responsible for upkeep. For residential property, the landlord is normally responsible for most repairs, which can involve the landlord in considerable time and cost in dealing with tenant requests, especially for older properties.
Inexperienced landlords tend to feel more comfortable with residential property. Most will have had initial experience through the purchase of their own home, and many start their landlord careers by retaining rather than selling their previous home when buying their next one. By contrast, many investors will have little or no real experience of dealing with commercial property.
An entry level commercial property might be a small high street shop. While this may feel like a fairly safe bet, even this small step may entail considerable risk: with the uncertainty caused by the advent of online shopping and the deterioration of many high streets, traditional retail is working out its future. Properties of the future might be large retail warehouses of the kind used by Amazon, but these will often be vast and beyond the budget of many private landlords.
The legal and regulatory frameworks are different too. Commercial property is governed by the Landlord and Tenant Acts. Residential property comes under the Housing Acts, with most new tenancies now being Assured Shorthold Tenancies (ASTs). ASTs aim to find a balance between giving tenants reasonable security of tenure and making it easier for landlords to evict tenants, particularly in circumstances where the tenant is at fault.
Recent events, such as the furore over agents’ fees, suggest a public feeling that matters have swung too far in landlords’ favour and that on a political level, the balance will start to shift in favour of tenants. While commercial tenancy law will also change over time, it seems less likely to be subject to the same political pressures as residential.
For UK investors, commercial property offers a number of tax advantages over its residential counterpart which are worth examining.
Stamp duty land tax (SDLT)
SDLT rates on the initial acquisition are up to 5% for commercial property, but can be as high as 15% for residential! Not only are residential property SDLT rates much higher, but the rules are more complicated, with different rates for individuals depending on whether you are buying your first residential property or replacing your main home; special reliefs for first-time buyers and for those buying several properties in one go from the same vendor.
For individuals, taxation of ongoing income from residential property can be higher than for commercial. If an individual holds a commercial property, he will in principle secure a full tax deduction for any bank interest he pays. Under new rules which apply from April 2017, his residential counterpart will eventually get tax relief for interest only at basic rate (20%) even though they are taxed on the rental income at rates up to 45%. These rules, which do not apply to companies, can create punitive rates of tax for highly geared residential individual landlords.
Some residential landlords are seeking to address the interest restrictions by transferring their portfolios to companies. There are downsides to this strategy. Using a company can lead to double tax charges, once on the company and then again on the shareholder(s) when profits are distributed, which combined are now normally more than for direct ownership of property.
A commercial investor can claim capital allowances (tax depreciation) on plant and equipment contained in the building. These allowances are not generally available to the residential landlord, who does not normally obtain any relief for fixtures in the building. A curious feature of the UK tax system is that capital allowances are not clawed back on sale of the property.
When a commercial landlord comes to sell property which he owns personally, it is subject to capital gains tax (CGT) at the normal rates, currently 10% or 20%. A residential landlord by contrast is taxed at 18% or 28%. Using a company doesn’t always help here. The company is subject to 19% corporation tax, but on distribution the overall rate on the distributed capital gain is currently around 50% for a 45% taxpayer.
For non-UK investors acquiring UK investment property, the UK has been an extremely benign tax jurisdiction. By holding their property in a non-UK company the landlord could generally be exempt from both UK CGT and inheritance tax (IHT). That advantage has already ended for residential property, which since 2015 (or from 2013 for certain companies) has been within the scope of CGT for non-residents, and from April 2017 within the scope of IHT, even when held in an offshore entity.
In the capital gains area, however, commercial property is catching up – from April 2019 it is proposed that commercial property will also come within the scope of CGT. It is proposed that not only will direct sales of UK property come within the scope of CGT, but also sales of so-called property rich entities, where 75% or of the entity’s value derives from UK real property, and the seller owns 25% or more of the company. There is no discrimination here between residential and commercial property other than the rate difference referred to above. So in the capital gains area for non-resident landlords, from 2019 we can expect to see a more level playing field between commercial and residential. We have more information on the CGT proposals here.
For the time being, commercial property owned by non-UK domiciled investors can still be exempt from IHT if it is held in a non-UK entity. This is an important consideration, particularly for those investors in countries which don’t impose IHT or at lower rates than the UK’s 40%.
Some non-UK investors are therefore looking at diversification into commercial property as a way of preserving wealth across generations. For UK investors, IHT rates are the same for let residential and commercial property, and so it makes no difference which is held. (Reliefs are available where the property is used for a trade or qualifying business.)
This is another area where commercial enjoys an advantage. A landlord who elects to charge VAT on a commercial property can recover any input VAT he suffers on his costs. However, there is no such election for the residential landlord, who cannot normally recover VAT. (The position is different for residential property developers, who can normally recover their input VAT.)
If an investor is looking to hold some property in his pension fund, again commercial enjoys an advantage. There is no bar to holding commercial property in a pension fund, but there are penal tax charges applied where a pension fund invests in residential property, except in limited circumstances.
Although pension funds are not debarred from investing in residential property, the charges are sufficiently high that, to all intents and purposes, pension funds cannot invest in most residential property.
Best of both worlds?
The targeting of the residential sector for high levels of taxation has led to some investors looking for “hybrid classes”, those which replicate the returns on residential property but which enjoy the tax advantages of commercial.
One such asset class is student accommodation. For tax purposes, traditional halls of residence and certain purpose-built student accommodation are generally treated as commercial property. This means that the 20% CGT rate (not the 28% rate) applies and for non-resident landlords, until April 2019, such accommodation is outside the scope of UK CGT. Such student accommodation also remains outside the scope of IHT if held in a non-UK entity.
Other asset classes which are useful in this regard include retirement and other care homes and furnished holiday lettings.
Small retirement and care homes are often established by combining a number of houses, which at the end of the business’ life might be turned back into domestic houses and sold at residential prices. However, during the lifetime of the business, it is treated as commercial – and on sale, commercial rates apply for the period while it was a nursing home.
Furnished holiday lettings (FHL) have a dedicated, very favourable tax regime. This gives FHLs many of the benefits of commercial property, as well as the special 10% CGT rate for traders, even though the FHL may be little more than a private house. Properties let through Airbnb can sometimes qualify as FHLs, even where they are not situated in holiday areas.
Making a decision
It would be quite wrong to invest in commercial property simply because the tax is lower. However, if you’re an investor considering commercial property, it’s clear that across many areas, both for UK and non-UK landlords, commercial offers a more favourable tax position than residential.
For more information, please get in touch with your usual BKL contact or use our enquiry form.