What are the special rules for VAT on commercial property?

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VAT on Commercial Property is a complex topic and anyone wishing to understand these complexities in relation to their own situation should seek specialist advice. This article should give a broad brush general overview but you really should seek advice because errors can be irredeemable and penalties can be a significant.

Owners of Commercial Property can Opt in to VAT – the so call Option to Tax. There are pros and cons to this step. A developer or renovator of a property many gain by the fact that VAT can be reclaimed on supplies and materials, as can a landlord for ongoing costs, but it means that once opted in, VAT must be charged on rent and on the sale price of the property.

In some situations this can make the building uncompetitive on the rental market. For example if your tenant is a sole trader who is not VAT registered they cannot reclaim the VAT they pay on their rent, as also cannot an insurance company or a bank.

VAT can also cause cash-flow issues for buyers when purchasing a commercial property, with the 20 per cent VAT charge on top of the price. However there are now some innovative solutions to this problem – see below.

The Option to Tax

If the Option to Tax has been made, it results in rent and sale proceeds being subject to VAT at the standard rate, that is 20 per cent at the time of writing. If a prospective purchaser is not VAT registered it simply adds 20 per cent to the price for that buyer, whereas a VAT registered purchaser could reclaim the tax.

The Option to Tax once executed lasts for 20 years, so great care should be taken when considering such a decision.

The sale or letting of a Commercial Property or on land, unless it has been Opted in to VAT, or is a new-build, is by default VAT exempt. So a purchaser or a tenant would not have to pay VAT. The flip-side for the owner is that they cannot recover VAT on all costs associated with work on the property, the sale or the letting, which in some cases can be substantial and may outweigh the other disadvantages.

Transfer as a going concern

Special exemption rules apply. Transfer of Going Concern (TOGC) – where a property is sold as part of the transfer of a business as a going concern. Providing the new owner continues the existing business, the transfer is generally outside the scope of VAT.

One example may be a commercial property sold with an existing tenancy in place. The sale can be a TOGC providing other conditions are met. Great care is needed when buying a commercial property because it’s not always apparent whether it has been opted in for VAT – sales particulars and the asking price don’t always include or specify VAT.

To avoid VAT on a commercial property purchase it either means verifying that the property is VAT exempt (i.e. not opted into VAT) or you can obtain TOGC status. This is where professional advice is vitally important is this situation.

TOGS comes with some complicated conditions that must be met: for example, a company that owns the property and the trading business in a company, or is in separate companies, must pass to the buyer with the sale, and the buyer must carry the same type of business in the same companies as the seller did.

The sale of a new Commercial Property which is less that 3 years old cannot be a tax exempt building on the sale, and is subject to the standard rate of VAT. However, there are some special exemptions again, for example if the building is to be used by a charity or not-for-profit business.

If you sell a commercial building or you charge rent on an VAT opted in property, then you as owner / landlord are responsible for applying VAT as appropriate. If you make an error in this regard you could find yourself liable to HMRC for a very substantial amount of money. It is therefore essential that both sides of these commercial transactions seek specialist VAT tax advice.

Opting to tax is not a step to be taken lightly and all the pros and cons need to be taken into account. As well as the initial registration, VAT comes with the onerous task of completing regular VAT returns, accounting for all the relevant transactions and you will undergo VAT inspections from time to time.

The VAT charge may put off commercial property investors?

In an environment with threats of a recession and slowing business operations, according to Carter Jonas, this may cause businesses to reduce their spending and in turn it will reduce profits for property investors.

With higher costs and therefore restricted margins, confusion around the VAT status of a property could easily prevent investors from capitalising in a less optimistic market. However, according to Freddie Digby, CCO of Adsum, alternative-finance (alt-fi) can remove worries about that potential extra 20%, he says.

Commercial property has always been a wise, if turbulent, asset to invest in, says Digby, with consistent historical market growth – fuelled in large part by the rise of e-commerce and dwindling supply.

In May, falling Amazon profit forecasts caused a tumble in commercial property stocks due to reduced demand for warehouses, and now rising interest rates may start to punish investors who jumped in at the top of the market.

For office space, says Digby, Greater London is still the epicentre – but changes hint at limited cash flow. The city’s edges in the south east are seeing the most extensive growth at 2.1% to May 2022, compared to the centre’s increase of 0.7%, which could highlight that businesses looking for a new office market may not have the cash to expand into that central, expensive London postcode. This, in turn, could impact investors’ margins.

With so much market turbulence, VAT becomes an obstacle to market confidence. The extra 20% paid on completion of new builds can be a significant additional cost and if the property is over three years old, the confusion around its VAT status is still a concern, thinks Digby. Without payment, sales can’t complete, and with additional costs raised by a fifth, deals may fall through.

The challenge is finding out the exact VAT status of the building as this depends on a multitude of factors, including its deal history and the status of any commercial renters currently renting the property.

Technically, says Digby, HMRC can help in two ways: Firstly, by opening an investigation into its VAT status – but investors often do not have time for this in such a rapidly moving market. Alternatively, HMRC can refund the 20% after completion; however, many will not be able to continue operating with such a dent in cash-flow.

However, according to Digby, tech-savvy property investors should not worry about this potential extra cost. Instead, they can leverage it as an asset to secure immediate capital, should they have to pay VAT. A vibrant, new generation of the so called ‘alternative-finance’ (alt-fi) fintechs can put up HMRC’s refund upfront – ensuring on-demand, consistent and calculable cash-flow, without waiting for HMRC to refund.

Digby comments:

“Investing in commercial property has traditionally been a promising asset class if one of the more complicated. The VAT status of a building, or a shop or office within a building, is seldom clear cut. To make matters worse, there is a significant knowledge gap on the issue.

“Sometimes, businesses or investors in a VAT refund position are happy to wait for HMRC to send them that money back. However, as wages, inflation, and other costs eat into margins and with a recession looming on the horizon, weary investors have even more reason to need consistent, resilient cash-flow and reduce costs.”

“Put both factors together – and it is clear why property VAT is such a tricky issue. When a deal is on the line, and an investor finds out they must find an extra 20% to complete, alarm bells rightly go off.”

“It just shouldn’t be complicated. HMRC guarantees your refund, but the issue isn’t just having to find an extra 20% and surviving without it for months. Investors will often face compliance questions, taking time to register, submit claims, chasing, recovery, and lawyer or consultant fees, which take time and money.

“By leveraging the inevitable VAT refund as an asset, investors and businesses can use it as collateral to secure on-demand finance. This gives calculable, hassle-free capital when investors are facing a slowing market and shrinking margins.”

Established in March 2020 in Hammersmith, London, Adsum is a fintech tax credit specialist providing an advance funding solutions for UK business tax receivables

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