Taxing real property

Real estate is tangible. It consists of land, land improvements, buildings, and building improvements. It is highly durable, so its services may be consumed over a long period. In contrast, real property represents the individual legal rights associated with ownership of the tangible real estate. Since all legal rights are intangible, real property is intangible.

Services associated with real property include construction and renovations. All aspects of this complex set of goods and services need to be considered carefully in setting up a VAT.

In principle, there is no reason to treat durable consumption goods such as housing differently than non-durable consumption goods or services.

In practice, however, the appropriate and equitable treatment of housing and housing services remains one of the more difficult areas in VAT. The politically most difficult aspect one that, unsurprisingly, as yet no country in the world has dared to tackle €“ is the taxation of the imputed consumption services provided by owner-occupied housing.

How is real property treated under VAT?

OECD lists supply of land and buildings and letting of immovable property as standard’ VAT exemptions.

However, there are many exceptions to this rule:
–  Australia taxes supplies of land (except certain farmland), commercial property, and new residential property.

–  Austria imposes tax on letting (renting or leasing) of private housing.

–  Canada taxes both the supply and the leasing of commercial land and buildings.

–  Finland and Sweden have an optional system for taxing the letting of commercial building in certain cases.

–  France has a similar optional provision in some cases (letting land and buildings for agricultural use, and certain cases of letting of undeveloped immovable property for professional use), although its general rule is to tax the letting not only of immovable property but also of developed land for professional use.

– Hungary normally taxes the supply of buildings and land not used for housing purposes and taxes non- housing letting of immovable property.

–  Ireland, for variety, taxes only long-term letting of commercial property, along with the supply of land and buildings.

– Italy taxes the supply and letting of commercial property at the standard rate but only taxes residential housing when let by enterprises (and at a favorable rate of 10%).

–   Japan taxes only the supply of land.

–   Korea goes the other way and taxes only the rental and supply of commercial buildings.

–  Mexico, however, taxes only the letting of commercial buildings.

–  The Netherlands does the same, although it will tax the supply of immovable property if such taxation is requested by both buyer and seller.

– New Zealand taxes the letting of nonresidential immovable property as well as the supply of land and buildings (unless they have been used for residential accommodation for five years or more).
– Poland taxes the rental or tenancy of immovable property used for commercial purposes.
– Turkey appears to tax all letting but only the sale of commercial buildings.
– The United Kingdom taxes freehold sales of new commercial buildings beginning three years from completion date and, as do a number of other countries already mentioned, provides an option to tax other supplies of commercial buildings.

When 17 of 29 OECD countries follow another path, one wonders how standard the real property exemption really is.

But, with respect to tax issues the devil is in the details. As the preceding list makes clear, when it comes to VAT and real property, there are many details.
The dominant VAT treatment of real estate around the world is to exempt not only services from owner occupation but also commercial leasing or letting of residential property, presumably in order to prevent distorting the choice between house ownership and renting. Exemption of residential rentals may be justified on distributional grounds as home ownership is correlated with income.

More surprisingly, however, in much of the world even most nonresidential property escapes VAT. Under the Directive applicable in the European Union, although both sales and rentals of real estate are exempt, newly constructed buildings as well as improvements are taxable.

Applying tax to new buildings amounts to charging a prepaid VAT on future services (whether use or subsequent sale) at the time of purchase the treatment generally applied to durable goods.

The result of applying this treatment to commercial (as well as residential) property is obviously that increases in the value of and hence the services provided by such property are not included in the tax base, thus violating productive efficiency. In addition, if new buildings are taxed but land and old buildings are not, owners of the latter reap windfall gains. More complexity arises when, for example, an old building on a site is replaced by a new one, since the value of the property must then be divided into land value and building value.

The original exemption of all but new real property in France and other EU countries was probably due to the fact that existing property was already subject to special taxes such as the registration tax in France. Most countries around the world subject land and real property to many taxes other than VAT.

Property transfers in particular are subject to various taxes and charges land transfer taxes, stamp duties, notarial fees, registry charges, in some instances succession and gift taxes. Transfers of land and real property are treated quite differently under VAT in different countries.

In Japan, for example, new construction is taxed at the standard VAT rate, while in Canada such construction is taxed at a lower rate.

In Germany it is exempt but subject to an alternative tax and in the United Kingdom, while residential construction is zero-rated, commercial buildings are taxed at the standard rate.

Taxes on the transfer of land and real property discourage the development and formalization of land markets. The fact that such taxes exist often at surprisingly high rates in so many countries around the world is presumably attributable primarily to the administrative ease of imposing them. The taxable event (the recorded exchange of title) is readily visible, even if the true value of the transaction usually is not.

Nonetheless, countries that wish to develop efficient markets would be well advised to consider lowering specific taxes on land transfers and perhaps making up revenue losses by, for instance, strengthening basic property taxes.

In contrast to the EU approach, Canada and New Zealand treat both the sale and the rental of real estate as taxable under VAT and, in addition to owner-occupation, exempt only residential rents and rental values.

Construction, alteration, and maintenance of all buildings are taxable, as is the rental of business accommodation. The sale of existing nonresidential buildings is also taxable. This approach has the virtue of keeping the VAT chain intact for more transactions.

When property rights are not clearly established, it is difficult to impose a sensible real property tax even though the immovable nature of the tax base in principle makes it easier to enforce payment. Given the weak fiscal administration in most developing
countries, in practice the only way to tax real property is likely to be some form of tax on sales, for example, on nonresidential sales. Some consider even this approach to be either unworkable or undesirable because of the inadequate financial market and the liquidity problems buyers would face in meeting large up-front tax demands.

Of course, if VAT is applied to (some) property transfers, presumably the other special taxes so often imposed on such transfers should be correspondingly reduced; however, we are not aware that this has actually been done in many countries. As a minimum, countries should subject the value of such intermediation services as real estate commissions to VAT.