Turning commercial property into flats?

September 28th 2022

You have planning permission to convert an empty commercial property into flats. You haven’t decided whether to let or sell the property when the flats are completed. What is the position relating to VAT for both renting or selling?  Tax expert John Craig discusses.

The VAT position for converting a property for rent or for sale is totally different.

Letting residential property is always an exempt supply and so VAT incurred on the associated expenses can’t be recovered.

Conversely, and subject to one condition, if you convert a commercial property to a dwelling and sell it, you are making a zero-rated supply which means you can reclaim the VAT on the conversion costs.

However, the condition mentioned above is that you must sell the freehold or grant a lease for 20 or more years for it to be a zero-rated supply. However, this condition doesn’t apply if you convert the property for use as short-term holiday lets. This counts as a standard-rated supply meaning that as with a freehold sale or long lease you can reclaim the VAT.

The VAT position can be difficult to determine if you’re undecided about what you will do with the property or if you change your mind. It depends on the first supply you make after the conversion has been completed. You then have up to six years (not the usual four) to reclaim VAT paid on the expenses. These are the so-called “payback and clawback” rules.

The key trigger for the payback and clawback rules is the date when you change your intention about whether to let or sell.

If you build a dwelling from scratch with the intention of selling it, i.e. a zero-rated sale, and have reclaimed the VAT on building materials and other costs and later decide to let the property instead (an exempt supply), you would need to repay any VAT reclaimed on your VAT return for the period in which you altered your plans. The rules work both ways, so if you didn’t reclaim the VAT because you intended to let the property but later you decided to sell, you can reclaim the VAT at that point.

It might be that you intend to sell your property once the conversion is finished and so have reclaimed the VAT you paid on your costs. But when the time comes the selling market is poor and so you temporarily let the property instead. In this situation you don’t necessarily have to repay all the VAT. There’s a tax break you can take advantage of.

HMRC allows you to take into account supplies of the property you have made over a ten-year period and adjust your VAT claim accordingly. For example, if you let the property for exactly two years (an exempt supply) and then sell (a zero-rated supply) you would only have to repay 20% (2/10 years) of the VAT you had reclaimed.

From a VAT point of view if you sell the freehold or grant a lease for 20 or more years, you can reclaim the VAT on the conversion costs. Whereas, if you let a dwelling it is an exempt supply and you can’t reclaim the VAT. However, if the letting is for less than ten years and then you sell, you can reclaim a proportion of the VAT.