Passive Property Profits, Property Income or Not?

12 February 2018

Profits from property are taxed to either income tax or capital gains tax, depending on the nature of the transaction.

Normally it is clear which tax should apply, but there are certain circumstances where it’s not so obvious.

Passive property profits are earnings that are neither from property investment nor from a property trading business.

Property investment is where a business holds properties as long term asset and earns rental income, while a property trade is where a business holds properties as short term trading stock, hoping to make a quick profit from the margin between the buying and selling price of the properties.

Key features of passive property profits are:

·        As you would expect the investor plays a passive role in the transaction

·        Transaction is entered with the expectation of short term profits

·        Profit is achieved from a disposal of the investment rather than an income stream

Let’s try to explain this further in the example below.

In this case the investment is an existing interest in a property that ceases to be a long-term investment and becomes subject of a passive property profit transaction.

Alan is approached by his friend Tony with an idea to build a second house in his rather large garden, Tony promises Alan to give him a quarter of the sales proceeds made on the development.

The part of the garden used for development is valued at £25,000 before construction and the new development is sold for £300,000 making Alans profit of £50,000 (£300,000 * ¼ - £25,000).

Because Alan’s share was dependent on the final sales proceeds of the new development, the profit will be treated as income in nature rather than a capital gain.

Alan’s role was totally passive in this scenario as he did not participate directly in the construction of the new development and as a result Alan cannot be regarded as a property trader which makes the £50,000 profit made a “passive property profit”.

Most people in Alan’s position would prefer this profit to be treated as a capital gain rather than income. This is so they can utilize their annual CGT exemption of £11,300 against their profit and the reminder would be taxed at either 18% or 28%, subject to main residence relief. However because Alan took a share in the development of the new development, his profit cannot be treated as a capital gain.

If Alan had sold his extra land for a fixed price of £75,000 then it would have been subject to capital gains tax instead, again potentially subject to main residence relief.

Passive property profits are “other income” for tax purposes, so it’s not taxed as property income nor as trading income, however it is subject to income tax at the usual rates.

When Alan gave the land to Tony the value of the land was £25,000 however if the original cost was lower, then Alan would need to account for the capital gain on the land separately to the £50,000 of profit made on the development of the land.

One upside of passive property profit is that since it’s not a trade it should not attract National Insurance, which is a saving of 9% or 2% depending on the individual’s circumstances.

If you require any assistance with any aspect of your tax affairs please contact us or get in touch today by calling 0203 039 3993.


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