The default position is that the activity of renting out a building is considered an 'exempt supply' for VAT purposes. This means that VAT doesn't have to be charged on rents but conversely, VAT cannot be reclaimed on expenses incurred.
As far as residential lettings are concerned, they are always considered exempt from VAT and you will never see VAT added to residential rents. That means you can also never reclaim VAT on expenses incurred in conducting your property rental 'business'.
When does VAT become an issue?
With commercial property however you have the option to 'disapply the exemption to tax'. This is also known as 'opting to tax' the property.
When this is done it means that the supplies i.e rents charged from the property become subject to VAT i.e VAT is charged on the rents. Given that 'taxable supplies' are now being made, you can therefore claim VAT back on relevant expenses.
Why would you 'opt to tax' a commercial property?
Well given that you can claim VAT back on expenses, it can be quite beneficial. On the flipside if your tenant is VAT registered then there is no loss to them as they can reclaim the VAT paid on rents from HMRC.
However if you have (or could have) a tenant that cannot reclaim VAT i.e a smaller business that isn't registered or a business that cannot register for VAT e.g anyone carrying out exempt healthcare services e.g Dentists then for those businesses it would be an actual cost and make your property less appealing.
What about buying or selling a property with VAT?
If the property has been opted to tax, the seller would need to charge VAT on the purchase. The buyer can recover the VAT if they are VAT registered and going to be using the property in their business. It does however pose a cash flow problem to raise the VAT amount however, most banks can offer a bridging loan to cover this as the VAT paid on purchase can be recovered from HMRC in the next VAT return.
When VAT is added to the purchase price it does also mean that more stamp duty is payable as the stamp duty is worked out on the VAT inclusive cost.
How to avoid paying VAT when buying a commercial property with an existing tenant
If you are purchasing a commercial property which is opted to tax as an investment i.e there is a tenant within, then you can structure the purchase to avoid paying any VAT.
This is done via the Transfer of Going Concern (TOGC) provisions. A purchase of a commercial property with a tenant is seen as a purchase of a 'rental business' from a VAT perspective and is therefore treated as being 'outside the scope of VAT'.
Providing the buyer is also registered for VAT and chooses to opt to tax the property too, a joint election can be made for the purchase to be treated as a TOGC and then no VAT need be charged.
Not only does this save having to raise the cash for the VAT element but it also saves an actual amount of stamp duty too.
Hope that was helpful.