On 6 April 2017 there was a major change to the income tax rules for landlords. Instead of interest and other costs on loans taken out to purchase residential property being deductible from rental income, tax relief will now be restricted to basic rate only, with the changes phased in over four years. Individual circumstances can mean that the restriction produces eye-wateringly high effective tax rates.
This restriction does not apply to companies, prompting many landlords to wonder whether it might be better to incorporate their property business.
As with most things in tax, there is no straightforward answer to this question. As highlighted during lively debate at recent ATT conferences, there are a number of different issues which need to be considered.
Will there be any tax to pay on incorporation?
The answer to this is often yes. If existing residential properties are transferred into a company:
- This will be treated as a market value disposal for CGT purposes.
- CGT will be charged at the higher rates of 18%/28%
- HMRC are unlikely to accept that any of the usual reliefs (gift relief, incorporation relief, Entrepreneurs’ Relief) apply, as they view property letting as investment, and not a trade or business.
- There may also be an SDLT charge.
It is therefore important to look closely at the property portfolio before deciding whether to incorporate – it may be that the tax charges arising on transferring properties into the company cancel out any potential advantages.
If this is the case, then it may be worth considering making future property purchases through a company, but keeping existing properties in personal ownership.
Are there tax savings from operating through a company?
Although the new mortgage interest restrictions do not apply to companies, and corporation tax rates are lower than income tax rates, the following need to be considered:
- Even with the new restrictions, individuals will get tax relief at 20% on their interest payments versus 19% (falling to 17%) for companies.
- Although corporation tax rates are low, there will also be taxation in the hands of the shareholders when profits are extracted.
- It has been proposed that the dividend allowance, which currently charges tax at 0% on an individual’s first £5,000 of dividend income each year, will be reduced to £2,000 in a future year (potentially from April 2018).
The level of any tax savings will largely depend on the level of income the individual needs to draw from their business – the additional income tax payable on large dividends may cancel out any other savings. If on the other hand profits can be retained in the business, then operating as a company might be more efficient.
What about exit plans?
One key point not to be overlooked is the long term plan for the property business, especially any future exit:
- Individuals receive an annual exemption for CGT purposes (currently £11,300 per annum) whereas companies only receive indexation allowance.
- If the company sells properties there are potentially two tax charges – one on the gain and another when profits are extracted.
- If the company is liquidated or sold the lower 10% / 20% CGT rates will apply to any gain on the shares (as opposed to the higher 18% / 28% rates if the properties are sold directly).
- CGT Entrepreneurs’ Relief and IHT Business Property Relief are unlikely to be available whether the business is incorporated or not.
- Anti-avoidance measures such as the Transactions in Securities rules and the new company distribution Targeted Anti-Avoidance Rule can require distributions on winding up to be treated as income instead of capital if there is a tax motive.
Are there practical issues that need to be considered?
As well as looking at tax implications, it is important to consider wider legal implications (outside the scope of this article). The practical implications of incorporation also require attention, including:
- The additional administrative costs of running a company (e.g. preparing and filing accounts, corporation tax returns and confirmation statements).
- Will a newly formed company be able to borrow at the same interest rates?
- Does the mortgage lender need to approve any transfer of properties into a company?
Overall, the pros and cons of incorporation have to be considered on a case by case basis – there is no one size fits all answer.
When making this decision, it is important that landlords and advisers do not focus on a single issue, but look at the bigger picture including (but not limited to) the areas highlighted above. What is the best answer will often depend on the facts and circumstances of the individual landlord including their personal tax position, age and health, the make-up of their portfolio and their long term investment aims.