Making a Profit from BMV
(Below Market Value) Property
Profit from Bargain Price Properties
WHEN the property market stopped rising in 2007, many property investors turned their attention to buying below market value (BMV) properties.
BMV investing involves buying property on the cheap from ‘distressed’ sellers (basically people who are broke and need to sell quickly).
The property investor will then rent out the property (often to the original owner), or sell it for a profit.
A whole industry has sprung up, teaching investors how to find these ‘motivated’ sellers, negotiate with them, and finance the deal with no money down (ie, no deposit).
Of course, there are lots of other ways to pick up below market value properties, including from property auctions and even estate agents.
The thing all BMV properties have in common is the investor ends up with an instant paper profit of perhaps 30% or more.
The question asked by many investors who buy below market value properties is: How will this ‘instant profit’ be taxed when the property is sold?
Many fear they will be classed as property traders and subject to income tax and national insurance at rates of 41% or even 51%. Property trading includes activities like property dealing (buying and selling properties), as well as property refurbishment and development.
Property investors, on the other hand, pay capital gains tax at a flat rate of 18% (and the first £10,100 is tax free).
Unfortunately you can’t choose how you are taxed – it all depends on how you act and your intentions. Nevertheless, there are a couple of things we can say with reasonable certainty.
If you buy a BMV property and rent it out for several years you will probably be treated as a property investor and will be subject to capital gains tax when you sell. Your capital gains tax will be based on the difference between the buying price and the selling price.
Helen paid £100,000 for a property valued at £150,000. She rented out the property for three years and then sold it for £200,000. Her capital gain is £100,000 and her maximum capital gains tax bill will be £18,000.
If you buy a BMV property with the intention of selling it immediately for a profit, you are a property dealer and will have to pay income tax and national insurance.
Helen paid £100,000 for a property valued at £150,000. Her intention was to sell the property immediately and realise a quick profit. She puts the property on the market days after completing the purchase and sells it for £150,000. Her £50,000 profit will be added to her other income and is subject to income tax and national insurance.
In reality, a BMV investor’s intentions may not be clear. If you ask someone what their plans are for their property investments you often hear answers like these:
- “I might sell it, or I might hang on to it for a while if I can’t get a good price.”
- “I’ll rent it out for a few years, but we might sell if we get a good offer.”
- “We’ll probably sell a few and rent the rest out.”
For tax purposes, however, what we have to do is establish what the investor’s main intention was, at the outset, when the investment was made.
The trouble with intentions, of course, is that they can be very difficult to prove. Only you know what was going through your mind when you purchased a property.
Looking at it from the taxman’s point of view, what you actually do may look very different to what you intended.
For this reason, it is sensible to document your intentions for any property purchases. This could take many forms. Some of the most popular are a business plan, a diary note, a letter to your solicitor, or a memo to a business partner. Remember to date your documentary evidence.
Having something in writing will not necessarily be enough, however. A business plan which says “we will rent the properties out for five years and then sell them” may not be very convincing if you actually sell all your properties very quickly.
If you sell properties quickly and want to avoid income tax you may have to prove to HMRC that there has been an unexpected change in circumstances which explains why you are not holding onto the properties. Acceptable reasons for changing your mind could include:
- An unexpected shortage of funds
- An unexpected and exceptionally good offer
- Relocation due to work, family or other reasons
- Divorce or separation
- Bereavements and inheritance
- Concerns over the property market in a particular location
- Funds are required for an exceptional investment opportunity elsewhere
Between the extremes of the long-term investor and short-term trader is the ‘grey area’ where investment meets trading. It’s not always so easy to be sure which side of the line you are on.
It is almost impossible for us to give you a definitive answer to explain exactly when investment becomes trading. Here, however, are some useful guidelines:
Renovation and Conversion Work
Renovation or building work may sometimes indicate that there is a trading motive behind buying the property.
However, if you continue to hold the property for several years after the work is completed, it is likely that you still have an investment property which will eventually be subject to capital gains tax.
On the other hand, if you sell the property immediately after completing the work, you may well be regarded as a property developer unless your original intention had been to keep the property and rent it out, but some change in circumstances led you to change your mind.
Frequency of Transactions
If you only sell a property once every few years, you are likely to be carrying on a property investment business.
If you make several sales every year, representing a high proportion of your portfolio, you may be a property trader or developer.
Number of Transactions
As well as their frequency, the number of property transactions which you have carried out can be a factor in deciding whether you are trading.
If you buy a BMV property every three months and sell them all immediately there is little doubt that you are a property dealer.
Long-term finance arrangements, such as mortgages are generally indicative of an investment activity. Buying properties with short-term loans, such as bank overdrafts, indicates that you are a property trader. Short-term finance tends to indicate short-term assets.
Length of Ownership
There is no definitive rule as to how long you must hold a property for it to be an investment rather than potentially trading stock. Naturally, however, the longer the period that you generally hold your properties, the more likely they are to be accepted as investment properties.
Renting the Properties Out
Renting properties out is usually definitive proof that they are being held as investments and not part of a property trade. Like everything else on this list though, it may not be conclusive on its own.
Each of the issues set out above is merely one factor amongst many to be considered in determining what kind of property business you have.
Ultimately, it is the overall picture formed by your intentions, your behaviour and your investment pattern which will eventually decide whether you have a property investment business or a property trade.
Mixed Property Businesses
If you have a ‘mixed’ property business, involving both investment and trading, there is a great danger that any property development or property trading may effectively ‘taint’ what would otherwise be a property investment business. The taxman may then attempt to deny you capital gains tax treatment on all of your property transactions.
To avoid this danger, you should take whatever steps you can to separate the businesses.
For example, you could:
- Draw up separate accounts for each business.
- Use a different business name for each activity.
- Report the non-investment activities as a different business in your tax return.
- Consider a different legal ownership structure for the non-investment activities (for example, put them in a company or a partnership with your spouse, partner or adult children).