Rent-free period on commercial property deal

January 6th 2020

Mr Brown owns a warehouse that he rents out and the income that he receives is exempt from VAT. He has offered a new tenant a three month rent-free period at the beginning of a new rental agreement. Does this create any VAT problems? Our VAT expert John Craig discusses.

Rent-free or not?
The first question to consider is why he has offered the tenant a rent-free period and the conditions attached to the deal. For example, the reason might be because the tenant will need to fit out the premises to suit the nature of their business, therefore creating a trading delay before they can earn sales from their intended business activity.

Alternatively, a landlord might offer an initial incentive to a tenant in order to secure a deal without impacting on the market rental value of the property. In both of these situations there is no VAT issue, i.e. there is no risk that the tenant is making supplies to the landlord in return for the rent-free period which might be subject to VAT if the tenant is VAT registered.

EXAMPLE: Landlord David has agreed a 30-month rental agreement with tenant Mary in relation to a shop he owns. Mary’s business is registered for VAT. The market value of the rent is £1,500 per month. Mary has asked for a 10% discount so that her business will only pay £1,350 rent per month. David has refused this suggestion but instead offers a rent-free period of three months.

The saving to Mary is £4,500, i.e. the same amount as a 10% discount of £150 for 30 months. She does not need to account for output tax on this amount of money. David benefits from keeping a higher base rental charge, which might help him as a starting point for future rent reviews.

Any rental agreement signed between landlords and tenants should make the terms of any rent-free period very clear. HMRC has the power to see the agreement as it is a relevant document for VAT purposes.

Tenant services
If a landlord offers a rent-free period in return for the tenant agreeing to carry out certain works to the building, or any other services, then VAT needs to be considered on these extra services.

The most common situation is where the tenant agrees to do building repair or improvement works. The reality is that these works benefit the landlord because they are improving the value and condition of the property asset. Output tax will be payable by the tenant if they are VAT registered because they are making a supply to the landlord in return for consideration.

Option to tax election
If Mr Brown’s deal with his new tenant creates a VAT charge, he could register for VAT himself as the landlord and make an option to tax election on the property. He can then claim input tax on all costs linked to the property.

Once an election is made, it means that VAT will apply to all future rental income earned from the building by the landlord for at least 20 years before it can be revoked. VAT will also need to be charged if the building is sold during that time. This is not a problem if tenants and buyers can always claim input tax but this might not always be the case.

There will be no VAT issue if the rent-free period has no strings attached. But if it is being granted in exchange for services, e.g. refurbishment, these could be VAT’able if the tenant is VAT registered. The landlord could consider making an option to tax election on the property to permit recovery of any input tax.