Is it more advantageous to use a limited company to buy and hold your property investments or should you hold them direct? On the face of it, incorporation looks the better route. However, there are many other factors to consider, not least your personal circumstances and financial objectives, so professional advice will always be needed. In this article, we look at some of the issues you and your tax adviser will need to consider.
A quick update
Before we look at the core questions, here’s a quick summary of recent developments that may affect any decision you make:
- The Government has announced that corporation tax rates will fall. Before you get too excited, however, there is a sting in the tail: income tax on dividends is to be raised.
- A new 3% stamp duty land tax (SDLT) surcharge will apply to purchases of buy-to-let properties from this coming April. At the time of writing, it is not yet clear how the surcharge will be applied. However, the Financial Times quotes Jennet Siebrits, head of residential research at CBRE, the global estate agency, as saying: “The new surcharge could add between £3,500 and £7,500 to the cost of a £250,000 property, depending on how it is implemented.”
- Higher-rate tax relief for individuals on mortgage interest payments is to be removed. Now, instead of getting relief of up to 45% on mortgage interest costs, private landlords will be restricted to the basic 20% rate of income tax. True, this measure will be introduced over three years starting in 2017 but nevertheless when fully implemented it will be a major burden for many landlords. Companies will still be able to claim all interest as a business expense.
A couple of practical examples
At the beginning of this article, I point out that much depends on personal circumstances and financial objectives. What do I mean by this? Let me offer you a couple of examples.
Mr and Mrs Osborne buy one property a year at auction, redecorate it and then sell it on through an estate agent. They generally make around £30,000 profit on each transaction. As they are basic-rate taxpayers and they each have a CGT allowance of £11,000, their tax bill this year on a £30,000 profit is 18% of £8,000, or £1,440. Clearly, incorporating a business like this would be unlikely to bring them any benefit.
On the other hand, the situation could be very different for Mr Brown. Mr Brown is interested in taking advantage of low interest rates to build a sizeable property portfolio. He borrows as much money as he can in order to leverage his holdings. His long-term objective involves reinvesting all profits and income for an indefinite period. For him, incorporation makes more sense.
The three key factors to consider
So, let us now consider the three key factors that affect whether you will be better off incorporating or not.
- Mortgage interest relief
As it currently stands, there are no limits restricting interest relief for a company. In other words, if a company borrows money it can set all the interest it pays against its profits. Moreover, measures that have been introduced to restrict interest relief for individual landlords after 2017 do not apply to companies. It is not impossible that the Government restricts interest relief claims in companies going forward, but for the time being if you are bridging a property portfolio a limited company makes greater fiscal sense.
- Rental profits
A company that owns rental property will pay 20% corporation tax on its rental profits compared to an individual landlord, who will pay at his or her highest rate. If you are a higher-rate taxpayer, you will pay 40% and if you are an additional-rate taxpayer you will pay 45%. Moreover, as an individual landlord, there may be other tax disincentives to private ownership, including loss of your personal allowance and the child benefit charge. It also has to be borne in mind that the 20% corporation tax will fall to 19% in 2017 and 18% in 2020. Of course, if you need to extract profit from the company the situation is different. In the short term, extracting profits by way of dividends may give you a favourable outcome. In the medium to long term, this is less certain. There are, of course, other ways of extracting profits from a business in a tax-efficient way, and this subject is frequently covered in this newsletter.
- Capital gains tax (CGT)
Capital gains are taxed at a lower rate than income. So, if you own a property as an individual (rather than through a company) any taxable gain will be charged at 18% as a basic-rate taxpayer or 28% if you are a higher-rate taxpayer. On the other hand, a company that sells a rental property will pay corporation tax on its capital gains at 20%, falling to 18% by 2020. If you are an individual, you will be able to take advantage of your annual exemption, currently £11,100 for an individual and £22,200 for a married couple. Companies, on the other hand, enjoy indexation relief. This means they do not have to pay tax on any rise in the value of the property caused by inflation as measured by the retail prices index. There are several variables, then. If you are planning to hold on to a property for a long time then the indexation relief offered to companies can be of great benefit. On the other hand, a company cannot benefit from the ‘principal private residence’ exemption.
Extracting capital gains from a company
It is one thing to take profits out of a company you plan to keep running for an indefinite period, and quite another to extract capital gains. If your company is involved purely and simply in property and you want to cash in, you will have three core options. The first is to sell the shares in the company itself, the second is for the company to sell the properties and for you to extract profits via dividends or salary as and when available or convenient and the third is for the company to sell the properties and for you to then wind the company up. You will need an accountant to work out the figures for you under each scenario.
Transferring existing property into a company
It is easy to use a company for any new property purchase; what is harder is getting properties you already own into a company. The reason for this is that any transfer of an asset between you and a company you own will be deemed to take place at market value for CGT purposes. For this reason, you could be faced with a substantial tax bill if you transfer existing properties into a limited company. Moreover, you could also have to pay SDLT.
There is, however, some good news. Many tax experts believe it is feasible to transfer properties that are part of a property business run by a partnership into a company and thus avoid SDLT. More than this, thanks to incorporation relief, in many cases it will be possible to avoid CGT when transferring properties into a company. How? Incorporation relief is available when any business is transferred to a company wholly or partly in exchange for shares. This is a complicated area and specialist advice needs to be taken. The problem lies in that many property businesses are regarded as passive investments. HMRC believes that the mere holding of investment property and the collection of rent does not constitute a business for incorporation relief purposes.
Do remember that Alan (Pink), our editor, is always happy to offer advice on the question of whether incorporation or some other option (such as the use of an LLP) would be favourable.