Commercial Property vs Residential Property Tax (2024)

By Carl Bayley BSc ACA

'Where there's muck there's brass' - it's an old saying; old enough, in fact, to have more than an element of truth about it. In the context of property investment, the 'muck' I'm talking about is, of course, commercial property and it has enough advantages over residential property to yield plenty of 'brass'!

In a UK taxation context, there are several key differences between the treatment of commercial and residential property. Commercial property has a number of tax advantages not available to most residential property investors, including capital allowances, superior taper relief on capital gains and the ability to use pension funds for investment.

First though, let's consider what we mean by commercial property for tax purposes.

What do we mean by 'Commercial Property'?

From a tax viewpoint, commercial property is pretty much anything which isn't residential. The most common types of commercial property are shops and offices, but broadly similar rules also apply to restaurants, pubs, doctors, dentists and vets' surgeries, hotels, sports centres, warehouses, factories, workshops, garages, schools, hospitals, prisons .. you name it really.

Capital Gains

Possibly the greatest advantage to commercial property investment is the prospect of a potential 75% Capital Gains Tax exemption. This is known as 'Business Asset Taper Relief', and, where it applies, the full 75% can be achieved after owning the property for just two years. (With a potential 50% exemption applying if you sell between one and two years after purchasing the property.)

By contrast, residential property will generally only qualify for the slower and less valuable non-business asset taper relief. This lesser relief begins with a paltry 5% exemption after three years of ownership, then rises in additional 5% steps with each successive anniversary, until reaching its maximum of just 40% after ten years.

What this means in practice is that a great deal of commercial property investment will be subject to a maximum long-term Capital Gains Tax rate of just 10%, whereas the effective rates applying to residential property generally remain in the range of 24% to 40%.

There are, however, a few problems to watch out for in the context of business asset taper relief on commercial property.

The main requirement to enable you as the landlord to get this generous exemption is that the property must be let out to a qualifying trading business. The problem here is that this puts your fate somewhat into your tenant's hands. If they cease to carry on a qualifying business you lose your taper relief.

Quoted Tenants

Generally speaking, where your tenant is a quoted company, you will not be entitled to Business Asset Taper Relief on the property and will instead receive only the rather measly non-business asset taper relief, just like most residential property.

However, as so often happens in the tax world, the exception itself has an exception. If you were an employee of the quoted company, you would be entitled to Business Asset Taper Relief.

To be an 'employee' for this purpose, you could take on any job you like, and even the smallest of part-time jobs qualifies.

Property Companies

Taper relief is available to sole owners, joint individual owners, partnerships and trusts. It is not, however, available to companies.

Hence, beware! If you are buying commercial property and expect to make substantial capital gains in the short or medium term, you may lose out quite significantly on your potential Business Asset Taper Relief if you were to buy the property through a company.

Of course, eventually, the company's more advantageous tax regime on your rental income might outweigh the lost Business Asset Taper Relief. Hence, if it's a long-term investment, you may still wish to consider owning your property through a company.

Capital Allowances

Another area where commercial property provides many advantages is capital allowances. These are a statutory deduction allowed against your income in respect of capital expenditure incurred for business purposes.

Most residential property does not attract any capital allowances, neither on the fabric of the building itself nor on any fixtures, fittings or furniture. Furnished residential lettings are, however, eligible for a 'Wear and Tear' allowance equal to 10% of the gross rental income which is given to cover the cost of furnishings.

For commercial lettings, there is no 'Wear and Tear' allowance. What you will get, instead, though, is a system of capital allowances.

Unlike most rental losses (or, indeed, the Wear and Tear allowance) made by individuals or partnerships, capital allowances may be set off against your other income if you are not making a rental profit that year. For many people this provides the opportunity to get a significant tax repayment.

Flat Conversions

Lastly, on capital allowances, it is worth mentioning that converting the upper floors above some commercial property back into residential use will attract an immediate 100% allowance. When we bear in mind the fact that capital allowances may be set off against other, non-rental, income of the same year, this represents a powerful incentive.

VAT

The letting of residential property is an exempt supply for VAT purposes and residential landlords are therefore generally unable to recover any VAT which they incur.

For most commercial property, however, you will have the choice whether or not to charge VAT on your rent. Why would you want to do this? Well, simply because if you charge VAT on your rent, you are able to recover the VAT on your costs and expenses, including building, renovating and redecorating costs.

Charging VAT on your commercial property rent is usually known as 'exercising the option to tax'.

If your tenants have a registered and fully taxable business for VAT purposes, then everyone's happy. The problem comes when your tenants cannot recover the VAT which you are charging them. And remember that you cannot change your option on a property once it has been exercised (well, not for 30 years anyway). Hence, if you opt to charge VAT to a fully taxable tenant, you will still need to charge VAT to the next tenant in the same property, even if they cannot recover it.

Sometimes, though, when your tenant is unable to recover VAT and you have not yet exercised your option to tax on the relevant property, you might wish to consider refraining from exercising the option and negotiate a higher rent instead. The higher rent should more than compensate you for your loss of VAT recovery on your own costs, whilst also reducing the overall cost to your tenant - a true 'win-win' situation for you both.

And Finally ..

My final major notable 'difference' between commercial and residential property is the fact that, subject to certain conditions, you can buy commercial property through a Self-Invested Personal Pension Scheme (often known as a 'SIPP').

This has some great advantages as income and gains within the SIPP are tax free. You can also get tax relief yourself for payments made into the SIPP, for example to fund a deposit on a new commercial property.

Following Gordon Brown's famous 'U-Turn' in December 2005, it is not generally possible for SIPPs to invest directly in residential property.