How to handle tax on residential lease extensions

Posted: 18/10/2024

The tax costs to a landlord of agreeing an extension of a residential lease with their tenant can be unexpectedly large if this is implemented as a surrender and regrant transaction. However, a more cost-effective route may be available. Granting a lease of the reversionary interest in the property using what is termed a ‘concurrent’ lease, leaves the existing lease unaltered for tax purposes but achieves the same rights to occupy for the tenant. Failing to identify this option for landlords might prove to be an expensive oversight for their advisers.

The taxation of lease extensions is an area that is often misunderstood and, as we will demonstrate below, can result in substantial unanticipated tax liabilities for the landlord. Leases can be extended through a number of legal processes, although for residential leases most lawyers will use a ‘surrender and regrant,’ ie the old lease is surrendered to the landlord as consideration (with payment of a premium) for the issue of a new longer lease.

However, if the lease was instead extended by granting a ‘lease of the reversion’, ‘concurrent lease’ or ‘overriding lease’, the taxation of the transaction changes completely and no surprise tax liabilities should arise.

Although property lawyers are familiar with the concept of concurrent or reversionary leases, in practice, in the authors’ experience, many have simply not considered their use for extending leases, hence very few leases are extended that way. This article seeks to raise awareness of them as an alternative, while also seeking to bust some of the misconceptions surrounding the tax treatment of surrenders and regrant.

Terminology

The ‘reversion’ is the landlord’s interest in the property when the property is subject to a lease. A lease of the reversion is a lease granted out of that interest. It is granted subject to, and with the benefit of, the existing lease.

For example, F (the freeholder) granted a lease to T and T occupies the property. The next day F grants a lease of the reversion to R. R becomes the immediate landlord of T. R’s lease sits above T’s lease. R’s lease is subject to the rights and obligations owed by F to T and has the benefit of the rights and obligations owed by T to F, including the right to receive rent from T.

A ‘concurrent lease’ is the same as a ‘lease of the reversion’. The name comes from the fact that the original lease and the lease of the reversion run concurrently.

An ‘overriding lease’ is also sometimes used to mean a ‘lease of the reversion’. However, it originates from Landlord and Tenant (Covenants) Act 1995 s 19 which applies to commercial tenancies.

A ‘reversionary lease’ is a lease that takes effect when an existing lease has expired and gets its name from the fact that it takes effect in reversion, that is, the tenant does not have an immediate right to possession of the property – the right to possession of the property is postponed to a future date. In practice, reversionary leases are usually only used for commercial property.

The legal process

To understand the tax treatment, it is first necessary to understand the legal process by which residential lease extensions are carried out. Normally, lease extensions are effected as an express surrender and regrant. This applies when the extension is voluntary – that is, agreed between the parties – or compulsory by virtue of the Leaseholder bringing a claim under s 42 of the Leasehold Reform, Housing and Urban Development Act 1993 (‘the 1993 Act’) – soon to be revised by the Leasehold and Freehold Reform Act 2024 (‘the 2024 Act’) when it comes into force. A lease extension usually consists of two distinct transactions:

• the surrender of the original lease by the tenant to the landlord; and
• the grant of the new lease in substitution by the landlord to the tenant.

Consideration for each transaction includes the surrender/grant of the other lease, so the overall value of the transaction, which includes the existing lease, is substantially larger than the cash paid for the extension.

Simply agreeing to a variation of lease terms by changing the length of the term or by enlarging the area demised is considered in law to be an implied surrender and regrant, and is therefore treated as such for tax purposes.

The tax implications

As noted above, for residential lease extensions, in practice the only options are:

• a surrender and regrant (whether express or implied); or
• a concurrent (overriding) lease, the tax analysis being quite different.

Surrender and regrant (whether express or implied)

These transactions consist of two separate disposals in consideration for each other.

For the tenant: There is technically a disposal of the old lease, followed by the acquisition of the new lease. In many residential cases, no gain will arise on the disposal, due to the availability of Principal Private Residence relief (PPR). Otherwise, Extra Statutory Concession D39 (ESC D39) may apply so that, for the tenant, and subject to conditions, the new lease acquired is not treated as consideration for the disposal of the old lease.

For the landlord: There is technically a purchase of the old lease, a merger of that lease into the freehold, followed by a part disposal of the new lease out of the enlarged freehold. Critically, the landlord’s tax must be calculated based on these legal steps – this is best demonstrated by the real-life example 1.

Example 1: Surrender and regrant
A flat management company acquired the freehold consisting of 100 flats in 1990.

Over 30 years later, a tenant wished to extend their lease from 85 to 999 years – this was the first time a tenant had requested an extension:

• the market value of the extension was agreed at £15,000;
• the indexed base cost of the freehold reversionary interest over the entire property was £200,000;
• the value of the leasehold flat before the extension was £1.2 million; and
• the value of the freehold asset over the entire property after granting the extension was £1.8 million (roughly £15,000 for 100 flats plus £300,000 NPV of ground rents).

The tax computation is as follows:

As can be seen, although the value of the old lease is subsumed into the base cost for the freehold (due to the operation of the part disposal rules), not all of that value is released back into the follow-up disposal on the grant of the new lease. In this example, a considerable element remains locked-up in the freehold base cost, resulting in a corporation tax liability that is over ten times the premium received for granting the extension.

In the authors’ experience, large gains as described above are more likely to occur where the landlord has held the freehold for a long period with no or few lease extensions having been carried out.

SDLT
Generally, where interests in land are exchanged for each other, SDLT applies to both land transactions. However, where there has been a surrender and regrant of leases, specific provisions ignore the leases as consideration (FA 2003 Sch 17A para 16), such that the only chargeable consideration received is the cash premium paid for granting the new lease.

Consequently, the landlord should have no SDLT due in respect of their acquisition of the old lease, because no premium was paid. Furthermore, for residential property, the premium paid by the tenant is often wholly within the SDLT nil rate band, so there is usually no SDLT to pay by the tenant either. For completeness, we note that whilst the market value rules for corporates acquiring property from related parties will prima facie quantify the chargeable consideration, the relief in Sch 17A para 16 will eliminate any element attributable to the lease itself, so the above will equally apply to corporate tenants and landlords regardless of the other contracting party.

Common errors when reporting the landlord’s gain
We have assisted a number of landlords to correct returns where gains from lease extensions (using surrender and regrant) were calculated incorrectly. Often these came to light when subsequent extensions were carried out, requiring disclosures over a number of years. 

Common errors include the following:

• Ignoring the two-stage transaction and treating the extension as a single disposal, with consideration being solely the cash premium paid.
• Electing under TCGA 1992 s 242 (small part disposals of land) to treat there being no gain and to deduct the cash premium received from the freehold’s base cost. Given that the actual value of the consideration includes the value of the old lease surrendered to the landlord, total consideration will almost certainly exceed the £20,000 cap for those provisions to apply.
• Wrongly believing that ESC D39 applies for the landlord – which HMRC are quite clear is not the case (see HMRC’s Capital Gains Manual at CG71240). ESC D39 allows the tenant to ignore the leases as consideration for each other but makes no mention of the landlord.
• Claiming rollover relief under the compulsory purchase provisions for extensions carried out under the tenant’s statutory rights (TCGA 1992 s 247). Strictly, the legislation requires any reinvestment of proceeds to be made into ‘acquiring other land,’ but for a single lease extension the reinvestment is the lease surrendered immediately before the grant and is in the same land.

Note: for commercial landlords, claims under s 247 might be possible where they have carried out lease extensions across a number of properties during the reinvestment period. In essence, the acquisition of a surrendered lease on a different property could be ‘acquiring other land’ (as required by s 247) – although strictly speaking they already hold an interest in that land, so have they acquired land or enhanced an existing land interest? Some comfort can, however, be taken from extra statutory concession D22 (ESC D22). Although ESC D22 strictly applies to business asset rollover relief (TCGA 1992 s 152), it does allow proceeds to be reinvested in land held by the taxpayer to be treated as if it was an acquisition of a new asset.

Concurrent lease

When a concurrent lease is used to facilitate an extension, there is only a single disposal and acquisition, being the granting of the new lease with no changes being made to the existing lease.

For the tenant: Tenants are simply acquiring a new asset for the cash premium paid. Technically, the tenant will now hold two separate lease assets, but nothing prevents them being subsumed into a single lease in due course as long as the leaseholders of both interests are the same. Where there is a mortgage on the existing lease, this will need to be swapped over to the concurrent lease, if it is to remain.

For the landlord: Landlords are making a part disposal out of their existing freehold when granting the concurrent lease. Example 2 illustrates the tax calculation.

Example 2: Lease of the reversion
The facts are identical as for example 1.

Advantages of using a concurrent lease

In the authors’ experience, concurrent leases are used where tax advice has been sought in advance and the drawbacks of using surrender and regrant have been identified. Concurrent leases have the following tax and non-tax advantages:

The tax is much simpler to understand and compute; in particular, it avoids the need for determining the market value of the old and new lease for the purposes of calculating the chargeable gain.

TCGA 1992 s 248, small part disposals of land, might be available if the premium is £20,000 or less such that no gain accrues.

Because the original lease remains untouched by the transaction, there is no requirement for the tenant to request permission from their mortgage lender before proceeding with the extension. The original secured asset is unaffected so strictly the lender only needs to be informed if it is subsequently subsumed into the new lease. This can simplify matters for the tenant.

As no tenant will be relying on ESC D39 (in the absence of PPR), they will no longer insist that the terms of the new lease being broadly the same as the terms of the old lease. This means that the new lease can be changed to include modern terms to reflect current best practice without the lawyers having to opine that the new modernised lease will meet the conditions of the concession. Modernising leases is often an objective for tenant-owned flat management companies looking to extend leases across the entire estate.

ESC D39 also requires the area over which the leases apply to be identical, so no longer requiring to meet the concession means that the footprint of the new lease can be varied. For example, if a tenant owns two flats and wishes to join them together the lease will need to be extended to cover the airspace between the flats, sufficient to install a door or staircase. Using a concurrent lease means this can now be achieved at the same time as a lease extension.

Nothing requires it to be the tenant who acquires the concurrent lease. For succession purposes, they might arrange for the new lease to be purchased by another person (for example, their adult child). Over time, the value of the old lease will reduce and that of the new lease will increase; however, given the usual length of leases at the time of extending (60 to 80 years), any value shifting will be modest unless a considerable period of time passes.

Under the 1993 Act, if the leaseholders bring a collective claim to acquire the freehold, they are obliged to buy in any lease which is superior to a lease hold by a qualifying tenant. This means that any concurrent lease must also be acquired which may have an adverse consequence if the tenant was depending on the concurrent lease to make his/her existing lease more marketable if the existing lease is short. The 2024 Act when enacted will avoid this difficulty as intermediate leasehold interests do not have to be acquired.

Final thoughts

With so many advantages to using a concurrent lease to extend residential leases, one might wonder why they are not used more. It appears that the biggest hurdle to using concurrent leases is the unfamiliarity with their operation across both the legal and tax professions which, in this litigious age, is perhaps a risk to unwary advisers dabbling in providing services to landlords.

This article was previously published in the Tax Journal, on 4 October 2024. It was written in collaboration with Chris Holmes, tax director at BDO LLP.

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