Sounds like a simple question, however before walking into the nearest estate agent with your life savings, there are a few subtleties in the answer that will be worth considering. Subtleties that Her Majesty’s Revenue & Customs pay particular interest to and ones that could save you money and time in the future. Understanding the answer to what is an investment property and why this is important to you, are questions that you will gain valuable insights into by reading on.
Cut to the chase, what is an Investment Property?
To invest, technically speaking, is to devote time and effort into a project and to gain a return in the future. Property is obviously the bricks-and-mortar that we can see and touch. However, with regards to freehold property, the largest value is likely to be held in the land on which the property sits. The true value of an investment property, therefore, may not be in the property itself but in the land on which it stands.
Having established that the value of an investment property may be in the land, let’s look at what differentiates an investment property from other types of income generating property.
Broadly speaking we can identify three criteria that define its status:
- A property where we have prolonged ownership
- A property where we seek an income stream
- A property where we seek capital growth
1. A property with prolonged ownership
Now I expect you are thinking that your own home would qualify here. However, both primary residences and second homes are excluded. Having prolonged ownership of a property sets out to distinguish investment properties from flips. Whereas an investment property will generate income over an extended period of time, a flip will be completed as swiftly as possible.
2. A property where we seek an income stream
Flipping properties is the straightforward process of buying, refurbishing and selling to make a single and one-off profit. An investment property, if done correctly, will reward the investor with monthly rental income over a period of years or even decades.
3. A property where we seek capital growth
Linking back to prolonged ownership, one of the goals through letting a property long-term is to benefit from capital growth as hopefully the value of the property will increase. When using a flip strategy, the turnaround time from buying to selling will be relatively short and any increase in value will be driven by refurbishment instead. So what’s the big deal?
Investing or Trading
To trade or not to trade, that is the question on the desk of the tax inspector. In the interests of Her Majesty’s Revenue in the UK, the differentiation is significant because trading activities can fall into a lower tax bracket than investment activities. The difference in tax costs will be more than a few cappuccinos. The obvious question then is when is an investment an investment and when is a trade a trade?
Tax legislation very helpfully defines a trade as “any venture in the nature of trade.” Due to the ambiguity of this approach the decision has largely been left to the courts to decide using a set of guidelines called the Badges of Trade. Generally, these take into consideration such things as the frequency of transactions, the length of ownership, the method of sale and motives.
Very broadly speaking we can compare flipping properties to selling bananas. We buy bananas at wholesale prices and sell them on at a higher price to generate a profit, making it a trade. However, with regards to rental properties, they are comparable to buying shares in the banana-trading company. Over time we will be paid dividends from the company and hopefully the price of those shares will gradually increase, thus making it an investment.
This is obviously very simplified but I hope you get the idea. These points are examined in great detail on our fabulous Asset Protection course along with many of the other financial and legal considerations that fall under the eye of HMRC. So before we disappear completely down the taxation rabbit hole, let’s move on to the different types of investment property.
Investment property types
With regards to investing in property in the UK there are essentially only three types:
- Residential use
- Commercial use
- Mixed use
As its name suggests, residential use properties are those in which a tenant resides in return for paying rent. Residential lettings are the bread-and-butter of most property investors and with an ever-increasing demand for housing, there will continue to be growth in the market.
Commercial properties are any buildings used for business purposes. These can be workshops, small shops, industrial units and yards, so the customer base can be quite varied. Commercial property demand can fluctuate as the economy and business trends change, so it is important to be well informed before taking your first leap.
Mixed use properties combine residential use with commercial use. Think along the lines of a barber shop with a residential flat above it. As an investment these offer flexibility, and a trained eye will see great potential to increase their returns.
Knowledge first, investing second
What starts with a simple question can rapidly grow wings and take off. However, understanding a few basic concepts will build your foundations and give you a solid base from which to evade costly mistakes. It can be easy to become seduced by the glittery pound signs of temptation, just be smart and invest in some knowledge first to allow yourself to make informed decisions.