By Stephen Metcalf, Private Client Tax Senior Manager at Kreston Reeves
By now, most buy-to-let investors will have heard about the rules restricting tax relief on mortgage interest that are being gradually introduced from 6 April 2017.
For those with highly leveraged properties, the effect on tax liabilities can be quite dramatic.
Since the new rules were announced in the Summer 2015 Budget, people have been considering what options they have to mitigate the tax increases that they face.
According to certain buy to let lenders, there has been a recent upsurge in the amount of Limited companies applying for buy-to-let finance, which suggests that many landlords / investors are changing the way in which they purchase and hold property.
The headline advantages of owning property through a company are compelling:
• The mortgage relief restrictions are not applicable to companies.
• Profits in a company are taxable at only 19% (with plans for that rate to drop to 17% in the next few years), compared with income tax rates of 40% and 45% for many individuals.
• Capital gains in a company benefit from indexation relief and the same rate of 19%, compared with capital gains tax rate on residential property for individuals of 28% where they are higher rate income taxpayers.
No doubt for some, this would be enough for them to take action.
However, as with many things in life, there are potential downsides that need to be considered. To demonstrate, let us take two different scenarios.
New Property purchases
Arguably the purchase of new properties comes with a simpler tax position. Broadly speaking, on a purchase Stamp Duty Land Tax will be the same for a corporate purchase as it would be for an individual buying a second property, i.e. both would suffer the 3% surcharge on residential properties.
However, whilst the corporation tax rates on profits are lower than the income tax rates, you don’t escape income tax rates entirely unless you decide not to extract any cash from the company.
Therefore, an element of double taxation can occur, with corporate tax payable on the company profits and income tax payable again on the net profits extracted from the company.
The same applies with capital gains made on property sales. If you want to extract the profit from that sale, which has already suffered corporation tax, you will then have to pay income tax again on this, unless you take the option of winding the company up entirely when it may be possible for capital gains tax to be paid by the individual.
Where companies own residential property with a value of £500,000 plus, there is a potential increase in Stamp Duty Land Tax (“SDLT”) rates both on purchases (a 15% rate can apply) and through the Annual Tax on Enveloped Dwellings (ATED) - an annual charge based on the value of the property. Reliefs can be claimed for both of these where the rental properties are being let to unconnected persons, for full market rent, but whilst the higher charge may not apply, there is additional paperwork to be completed each year.
When taken together, these corporation tax and extraction tax costs could possibly exceed the total tax costs of a similar unincorporated property business.
Existing portfolios transferred into a company
The above double corporate tax / income tax implications apply equally to the ongoing operation of a company which has had property transferred into it from an existing individually owned property business.
However, before you get to that stage there are two very important hurdles to consider.
1. Stamp Duty Land Tax (SDLT):
A transfer of an investment property by an individual to a limited company is normally a chargeable transfer for SDLT purposes if the previous owner and the company are considered to be connected for tax purposes. SDLT would be payable based on the market value of the properties transferred. This could prove an expensive upfront tax cost, especially considering the 3% surcharge would be applicable here on residential property.
There has been much talk of the use of partnerships to help mitigate this charge. In certain circumstances, the transfer of property from a partnership to a limited company can be made free of SDLT considerations. However beware, if HMRC believe that you are simply using a partnership as a stepping stone into a company to avoid SDLT, they are likely to use the SDLT anti-avoidance provisions to charge you anyway.
2. Capital Gains Tax (CGT):
CGT is chargeable on a transfer of assets into a connected company, and this is done by calculating a capital gain based on market values in place of actual sale proceeds.
Whilst trading businesses have long been able to defer this tax hit using incorporation relief, this has not been available to investment assets.
We have however seen since the Ramsay case, HMRC now accept that property investment can be considered a business, as long as the involvement of the owner represents more than just a “modest” quantity of activity. If, therefore, an existing unincorporated property business meets this more than modest criteria, the potential CGT liability when property is transferred into a limited company can be rolled over into the base cost of the shares issued on transfer. If not, landlords may face a significant CGT bill when they transfer property to a company.
Given everything said above, it really is difficult to say whether a company will be advantageous for tax purposes. Therefore it is worth taking advice before you decide.
So, you’ve set up a company and purchased a property. What now?
It may be that the upsides of property ownership in a company outweigh the downsides in your circumstances, most likely when talking about the purchase of new properties. Therefore you go out and set up a company.
Firstly, you should understand that the company is an entirely separate legal entity to you.
As such the company has various responsibilities and additional administration requirements compared to an unincorporated business. It will be required to produce a set of annual statutory accounts which need to be filed at Companies House. Separately the company will also have to prepare a Corporation Tax Return annually, and pay over any corporation tax due to H M Revenue & Customs.
A company bank account should be set up to deal with any financial transactions for the company.
One important thing to remember is that property purchased in the company is not your own assets. The income generated is not your income. This applies until you make a decision to extract the profits from the company by dividend, or pay yourself a salary. These two separate decisions have tax consequences on you individually.
Dividends may only be paid to shareholders of the company, whereas a salary can be paid to anyone you choose to employ. It is worth noting however that taking on employees, whether in a company or in an unincorporated business adds another layer of things to consider, including operating a payroll and registering with HMRC for PAYE and pensions Auto-Enrolment.
The use of a corporate structure might bring with it additional admin costs, but typically can be more flexible than owing property businesses individually.
Timely planning in respect of who should be shareholders and / or receive salary from the company, could afford a family some reasonable tax advantages in respect of maximising use of tax free dividend allowances, personal allowances and basic rate tax bands to keep tax liabilities down.
In summary, if you have decided that a company does work for your situation (having hopefully considered all the factors mentioned in the first part of this article), then good advice early can help you maximise the flexibility and tax advantages that may be available, whilst ensuring that you don’t fall foul of the additional responsibilities that you have to consider.
For specialist tax advice please contact Kreston Reeves.