Navigating tax implications: Converting commercial properties to residential use

As companies explore ways to optimise their real estate holdings, converting commercial properties to residential use is one option they may consider.  

Carrying out such transformations comes with a number of challenges and understanding the tax implications will be an important start.  

In this article we have considered the conversion of a hotel into residential property. This single site hotel was owned by a company, there were no other activities of the company. The Directors considered two options; convert to hold or convert to sell. 

Convert to Hold

The closing of the hotel will result in a cessation of trade. As a result there may be capital allowance clawbacks potentially resulting in higher profits on cessation.   

With the exception of some costs in communal parts, no capital allowances will be available for the amounts spent on converting the properties. Instead, these amounts will become part of the cost of the flats, which can be deducted from the sales proceeds should they later sell them. 

In the main we would expect the conversion services to be subject to the reduced rate of VAT (currently 5%) when undertaken by a contractor subject to some exceptions. Professional fees associated with the works are standard rated (currently 20%). 

The rental of the converted property would be exempt from VAT which would prevent recovery of any VAT incurred on the conversion costs. There may be opportunities to mitigate this VAT cost and professional advice should be sought if this applies. 

The rental profits will be subject to Corporation Tax. Where financing has been used to undertake the building works then interest costs will be deductible against the rental profits. 

For the shareholders; prior to the closure of the hotel should they have disposed of their shares they may be able to claim Business Asset Disposal Relief (‘BADR’), reducing Capital Gains Tax (‘CGT’) from 20% to 10% up to the first £1 million of gains. After converting the properties, the company would no longer be trading and therefore BADR cannot be claimed. 

The change from a trading to investment company also has an impact on their Inheritance Tax (‘IHT’) position with the value of the shares becoming subject to IHT on death. 

Convert to sell

Under this option the company would continue to still be trading, albeit undertaking a separate trade. Our comments on the cessation of the hotel business and capital allowances are still relevant here. As costs of the conversion would be added to stock no capital allowances would be claimed on the property works themselves. 

When the properties are sold any profits realised will be taxable at Corporation Tax rates. 

The VAT position on the conversion is the same as converting the hotel to hold. The sale (typically a freehold of a house or long leasehold interest of a converted flat) will be subject to VAT at the zero rate (currently 0%). This would enable VAT incurred on the conversion costs to be recovered – not all VAT can be claimed as some items are blocked; these are also not subject to the reduced rate when installed. These blocked items include white goods, fitted furniture and carpets (if installed). 

For the shareholders; they will continue to hold shares in a trading company. Should they dispose of their shares we would expect BADR to be considered. Likewise for IHT, the value of the shares would likely continue to qualify for Business Property Relief so their value would be free from IHT on death. 

Planning opportunities

Where such a change in business strategy is being considered there are a number of tax planning opportunities for shareholders and the company. This is especially true for the convert to hold scenario, whereby it will be possible to maximise on the CGT and IHT reliefs ahead of the hotel closing to ensure more value is passed to the next generation with little or no upfront tax costs. 

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