Tax-smart ways to build a house in your back garden

From time to time an Englishman stands and stares at his back garden and thinks, “You know, I think there’s room to fit another house in there.” The question of how to develop your property while minimising the potential tax liability then arises – and it’s a regular one for tax advisers.

With the pressure on housing nationally, together with planning rules often looking more favourably upon an in-fill plot for new housing as against greenfield sites, backyard property development is on the increase.

There are many ways to manage the process, all of which can lead to very different tax consequences. It is particularly important to watch out for a specific tax trap that can catch those who develop a property for sale themselves.

1. Seek planning permission and selling the land

The costs of seeking planning permission for the development of the land are borne by the owner, but there is the possibility of selling after the permission has been granted, and the profit will be subject to capital gains tax (CGT). In the right situation you may even be able to claim main residence relief and pay no tax at all.

2. Pass to a promoter

Pass to a promoter

Often the most straightforward method, you can contract with an experienced promoter who will seek planning permission on your behalf. In return they will ask for a payment of fees, or more usually an arrangement whereby a portion of the proceeds of an eventual sale are paid to the promoter. This should normally attract CGT treatment. If you are interested, local estate agents or builders may be a route to finding the right person to work with.

3. Develop and sell the property yourself

This is where a tax trap awaits the unwary. Once you start the actual construction process the property is deemed for tax purposes to have been sold for its market value. This means that capital gains tax will be payable on this deemed profit in due course, regardless of whether the property has actually been sold.

The second part of the activity, property development, is a trading activity even if only performed once, and the profit on development is likely to be liable to income tax. If you bought the property intending to sell it on at a profit, then the whole transaction will potentially be regarded as a trade and all the profit will be liable to income tax.

4. Transfer to a limited company to develop

This route can give protection against unlimited liability, which can be a sensible step in building a property where there is a risk that many things can go wrong, from poor build quality to health and safety issues.

The transfer of the undeveloped property to the company should be liable to CGT. Using the company as a vehicle to develop the property also allows the builder to benefit from the lower corporate tax rates, but of course the net proceeds will remain in the company once the project has finished.

5. Develop and retain to let

This route can avoid the capital gains charged on the deemed disposal mentioned in point three. HM Revenue & Customs (HMRC) does not normally treat improvements to your own investments as being trading activities, and so the profit on a sale in due course should be subject to capital gains tax, not income tax, although the letting income itself will be liable to income tax. 

There is no rule for how long the property must be let before sale, it is simply that if you develop intending to sell then you are likely to be charged to income tax. But if your intention was to retain the property as an investment and you can persuade HMRC that was the case, then capital gains tax treatment is more likely.

These are just a few examples of the many different routes by which you could carve part of your garden away for development. The tax consequences vary greatly and we would strongly recommend that you consider whether you have the appetite to deal with the build process yourself, and seek specialist tax advice.