Build to rent - VAT issues
The VAT rules for residential development can be complex, particularly in the build to rent sector where there are various potential traps, as well as structuring opportunities to minimise irrecoverable VAT. This note highlights a few common VAT issues that arise in this sector.
VAT on site acquisition
Where VAT is incurred on development of residential property, this can only be recovered via the “zero-rating” regime. Under this regime, if a developer constructs a residential building and either sells the freehold or grants a long lease (over 21 years) of it, this will be zero-rated. This means that the buyer does not pay VAT on the purchase price, and the developer is entitled to recover most VAT incurred on the development. For housebuilders in the build-to-sell sector, VAT recovery is generally straightforward, because they will sell the freehold or long lease interests in the properties they construct.
The position is more complicated for developers who are building to rent. The grant of short leases to tenants are not zero-rated and will not entitle the developer to recover VAT on development costs. Typically a residential developer will not have paid much VAT on the construction costs, because the building of new residential property is itself zero-rated. However a substantial amount of VAT may still be incurred by a developer, particularly where they have had to pay VAT on the purchase price for the site.
In these circumstances it is possible for the developer to recover VAT it has incurred by transferring the site, or granting a long lease of it, to a group entity. This group entity would then grant assured shorthold tenancies of the completed flats to tenants. Provided the transfer to the group entity happens after the foundations are above ground level (this is often referred to as the “Golden Brick” stage) it will qualify for zero-rating and entitle the developer to recover the VAT incurred on site acquisition and most other costs. This type of structuring is commonly used by developer operators in the build-to-rent and student accommodation sectors.
Where the structuring set out above has been used by a developer, care needs to be taken to avoid unwanted tax charges arising on an exit. Broadly, if a lease has been granted intra-group and the lease is collapsed within 10 years, this can trigger a “clawback” of some of the VAT recovered on site acquisition and development costs. The straightforward way to avoid this is for the lease to remain in place and, if the property is sold within 10 years of completion, the buyer would acquire both freehold and leasehold interests in separate entities.
This structuring can present problems for buyers, and will often prejudice their ability to claim the lower rate of SDLT applicable to transactions involving “multiple dwellings”. There is a tension here between the parties’ conflicting tax requirements, which can often result in an adjustment to price.
The planning described above is effective in securing recovery of VAT on most development costs. VAT incurred on “white goods” (for example fitted kitchens, bathrooms) is never recoverable and will always represent an additional cost to the developer. This is as a result of legislation (referred to as the “Blocking Order”) which denies recovery of VAT for these items. The housebuilder Taylor Wimpey has challenged the inability to recover VAT on white goods, however they lost in the most recent judgment given in this long running litigation and it seems unlikely that the position here will change.
Building services only benefit from the zero rate where they relate to the construction of new buildings. Where an existing residential building is refurbished or substantially redeveloped, VAT will generally apply to the building costs, although the reduced rate of five per cent will sometimes be available, for example where the redevelopment involves a change in the number of residential units. Where the development does not involve the construction of a new building, it is not possible to recover VAT on building and acquisition costs by way of the lease structuring described earlier in this note. There is therefore clearly a significant benefit to developers if the reduced rate applies to the build costs rather than the standard rate of 20 per cent. The rules in this area are particularly complex and often quite restrictive.
Zero rating is available where a commercial building is converted to residential although there are also limitations here. For example, where an existing building has a mix of residential and commercial use and is redeveloped to be exclusively residential, the zero rate may well not be available. Advice should be sought at an early stage to determine whether the conditions for the reduced rate can be met, and reduce the risk of a subsequent HMRC challenge.
Student accommodation and care homes
Developers of other types of residential accommodation, for example student housing and care homes, are subject to the same VAT regime as developers in the build to rent sector. There are often additional hurdles to VAT recovery for developers of these asset classes, with VAT recovery dependent on the use of the property falling into a particular category (or “relevant residential purpose”) for the 10 years following practical completion. This can cause problems where for example a student property is used for short term lettings during the vacation period, or a care home includes some non-residential use, e.g. a pharmacy.