Opting to tax and subletting

The tenant that rents one of your properties wants to move to smaller premises and sublet your property to someone else. You have no objection, but as you opted to tax the property how might this affect your VAT position?

VAT and property

The default VAT position for a supply of land and buildings, whether for commercial or private purposes, is that it’s exempt. However, there are many exceptions where the zero, lower or standard rates of VAT can apply. In addition, where an non-residential property is exempt you can opt to tax it, that is you disapply the exemption. This is a useful move if you’re a landlord who would otherwise not be entitled to recover VAT paid on the costs of maintaining and improving your property.

Option to tax drawback

While often VAT efficient, opting to tax can limit your market for tenants. For example, a business which makes wholly or partly exempt supplies, e.g. charities, dentists or insurance brokers, won’t be allowed to recover some or all the VAT you charge. Conversely, there are situations where opting tax is clearly the right move. For example, if you let a factory the likelihood of an exempt or partly exempt tenant wanting to occupy it is a small and so their loss as potential tenants isn’t a major drawback.

Limited application of an option

The effect of an option to tax is often misunderstood. It only applies to your (and no one else’s) interest in the property. In other words, it doesn’t apply to the property in general, but only to the person/business that makes the option to tax it.

Example. Acom Ltd owns the freehold of a high street shop and offices above on which it has opted to tax. It lets it to a clothing retailer and charges VAT. The retailer, which makes you only VATable supplies, reclaims all the VAT. Your lease allows the tenant to sublet any part of the property subject to your approval. The retailer lets the offices above the shop under a sublease to an insurance broker. Acom’s option to tax as the freeholder doesn’t carry over to the sublease granted by the retailer. It can therefore let the offices without having to charge VAT.

Trap. The arrangement in the example above might seem to work to everyone’s advantage, but that isn’t necessarily so. The rent charged by the retailer is an exempt supply. It’s now a partially exempt business an so might not be entitled to reclaim some of the VAT you charge it on the rent.

Tip. In our example, the retailer might be able to rely on VAT de minimis rules which allow full recovery of VAT by a partially exempt business. The rules apply where VAT incurred in making an exempt supply, i.e. the rent it charges the insurance broker, doesn’t exceed £625 per month on average and half of the total VAT incurred.

Do your sums first

Before opting to tax a property you should consider the immediate and longer-term effect as once made the option can’t usually be revoked for 20 years.

Allowing a tenant to sublet a property doesn’t affect your VAT position adversely, even if you’ve opted to a tax the property, i.e. charge VAT on the rent. You can continue to recover VAT on your expenses relating to the property. Your tenant can opt to tax the sublease – it won’t affect your VAT position either way.