Tax Questions: Changing Commercial Property to Residential Use

Tax - Converting Commercial to Residential

As a property owner, best outcomes for your portfolio can often involve arranging a change use on existing properties. For example perhaps you own a pub or school property and you wish to convert the property to accommodation for local residents. How this be done and whether it is commercially viable from a tax point of view is obviously key here.

Assuming you’ve the necessary planning to convert your empty commercial property into flats but haven’t yet decided whether to let or sell the property when completed, at this point, what are the VAT pros or cons that might affect your decision?

VAT considerations on conversion costs

The VAT position converting a property for rent versus converting a property for sale is different. Letting residential property is always an ‘exempt supply’ which means VAT incurred on expenses can’t be recovered.

Subject to one condition, if you convert a commercial property to a dwelling and sell it, then it becomes a ‘zero-rated supply’ which means you can reclaim the VAT on conversion costs. However, you must sell the freehold or grant a lease for 21+ years (20 in Scotland) for it to be considered a zero-rated supply.

This condition doesn’t apply if you convert a property into short-term holiday lets. This would then count as a standard rate supply; similar to a freehold sale or long lease where you can reclaim VAT.

Type of supply – ‘first supply after conversion’ rule

The VAT position can be tricky if there is uncertainty over what you will do with the property or if you change your mind. The VAT position does depend on the first supply you make after the conversion is completed. You then have up to 6 years (not the usual four) to reclaim VAT paid on expenses. These are ‘payback and clawback’ rules .

Dates for VAT claim & change of intention

The key trigger for payback and clawback rules is the date you change your intention about whether to let or sell. If you build a dwelling from scratch with the intention of selling, i.e. a zero-rated sale, and have reclaimed VAT on building materials and other costs and later decide to let the property instead (an exempt supply), you would need to repay any VAT reclaimed on your VAT return for the period within which you altered plans. The rules work both ways, so if you didn’t reclaim the VAT because you intended to let the property but later you decided to sell, you can reclaim the VAT at that point.

Temporary let tax break

It might be that you intend to sell your property once the conversion is finished and so have reclaimed the VAT you paid on your costs. But when the time comes, the selling market is poor and so you temporarily let the property instead. In this situation you don’t necessarily have to repay all the VAT. There’s a tax break you can take advantage of.

HMRC allows you to take into account supplies of the property you made over a 10-year period and adjust your VAT claim accordingly. So if you let the property for exactly 2 years (exempt supply) and then sell (zero-rated supply) you would only have to repay 20% (2/10 years) of the VAT you reclaimed.

From a VAT point of view if you sell the freehold or grant a lease for 21 or more years (20 in Scotland) you can reclaim the VAT on conversion costs. Conversely, if you let a dwelling it is an exempt supply and you can’t reclaim the VAT. However, if the letting is for less than 10 years and then you sell, you can reclaim a proportion of the VAT.

HMRC’s notice covering the payback and clawback rules 

Let’s Talk

To find out your own unique position as a property developer looking to perform a change of use, our dedicated tax team can help with your VAT calculations to ensure the best possible outcome for you. Let’s Talk.

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