Several tax changes announced over the last year or so have left residential landlords reeling from the Government’s concerted attack on the private rented sector. One key question keeps emerging: ‘Should I be using a property company?’
Carl Bayley, author of ‘How to Save Property Tax’ and ‘Using a Property Company to Save Tax’, takes a detailed look at this issue:
Let’s start by looking at the main advantages and disadvantages of using a property company.
From a tax perspective, a company has two main advantages: lower rates of tax and better relief for interest and finance costs.
Companies currently pay Corporation Tax at 20% on all of their profits, income and gains, and this will reduce to 17% by 2020. There are no restrictions on interest relief for companies investing in residential property – they can even roll up excess interest costs and set them against future capital gains – something that individual landlords cannot do.
Companies have other advantages too. Limited liability status may provide protection against unforeseen losses or liabilities – something which is especially useful for those refurbishing or developing properties.
A company is a separate legal entity. This means that the profits and capital gains that it makes don’t belong to you, the company owner. To get these funds into your own hands usually means paying yourself a salary or dividends. There are, in fact, a number of ways to extract profits from your company: dividends are usually best, but all of them are taxable one way or another – except repaying a loan from you to the company.
In short though, getting the profits out of your company will usually create a second layer of tax. Until now, this has undone some or all of the advantage obtained by having the company. But the proposed restrictions on interest relief for individual landlords have tipped the balance somewhat. By 2020, a property investment company is likely to save tax on residential rental income in most cases, even when the owner is extracting all of the profits as dividends. Assuming that companies continue to enjoy full tax relief for their interest costs that is.
Companies have a few other minor disadvantages: like the need to produce annual accounts in a fixed, statutory, format and file an abbreviated version at Companies House where it goes on the public record for everyone to see. Having said that, under current Government proposals (known as ‘Making Tax Digital’), individual landlords with total annual rental income in excess of £10,000 will soon be required to make quarterly returns to HMRC, so the additional administrative burdens currently faced by companies will cease to look like a disadvantage!
Another issue is the question of finance. Many lenders will lend to property investment companies and some of the rates are quite competitive, but there is still no doubt that it is generally more expensive to obtain finance through a company than as an individual. Nonetheless, in the vast majority of cases where the company owner is a higher rate taxpayer (or would be if they had not used the company), the tax savings will far outweigh the additional finance costs.
Another way to finance your property company is to borrow funds personally and lend them to your company. In most cases, you will get full tax relief for the interest you pay on your borrowed funds and, at present, there is no proposal to restrict this form of interest relief. Additional costs, such as loan arrangement fees, are not allowable under this method but it does mean that your company could be paying as little as 17% tax on its rental profits in the future whilst you obtain tax relief at 40% or more on your interest costs: a neat reversal of the Government’s proposals for individual landlords!
As with rental income, a company only pays Corporation Tax at 20% on its capital gains, and this will also reduce to 17% by 2020. Furthermore, companies are entitled to indexation relief, which exempts the purely inflationary element of their capital gains, based on the retail prices index. Hence, for example, if property prices grow at exactly twice the rate of inflation, the effective tax rate paid by companies on their long-term gains after 2020 will be just 8.5%.
If, after paying its Corporation Tax, the company reinvests the rest of its gains into its portfolio, then this is the end of the story and a considerable tax saving will have been achieved.
But the big problem, as with rental income, arises when the company owner wants to extract the remaining sales proceeds from the company. Paying dividends will generally turn an effective tax rate of 8.5% into something more like 38%: considerably more in some cases.
Alternatively, the owner might decide that it’s time to wind up the company. This will generate additional costs, and the amount of these will vary from one case to another but, even ignoring these, there is the issue of that second layer of tax. Let’s say the company has made £1m of capital gains and that it is left with £915,000 after Corporation Tax. When the owner winds up the company, they will pay Capital Gains Tax on this sum, which, at 20%, amounts to £183,000. This leaves the owner with a net sum of £732,000, compared with at least £720,000 if they had held their property portfolio personally. Once the extra costs are brought into the equation, there is likely to be no advantage to the company owner at this stage.
Worse still, new legislation applying from 6th April 2016 means that the gain arising on the winding up will sometimes be treated as a dividend. This might happen whenever the company owner or a person closely connected with them (e.g. their spouse or adult child), continues to invest in property after the company is wound up. This would reduce the final proceeds in the above example to somewhere between £566,385 and £584,535, depending on the owner’s other income for the relevant year. At present it is hard to say how often this new legislation will actually be applied in practice.
Do The Exit Costs Mean That A Company Is A Bad Idea?
Not usually. What you have to remember is that the company will have enjoyed considerably larger profits after tax, year on year, than an individual investor would. The company owner will either have been able to enjoy these additional profits by extracting them as dividends, or will have reinvested them in the company and thus built up a larger property portfolio: or perhaps some mixture of both.
For example, by 2020, a portfolio yielding profits before interest of £200,000 with interest costs of £100,000 would lead to an Income Tax liability of £55,000 if held by an individual with no other income (more for an individual living in Scotland); leaving them with net income of just £45,000. A company owning the same portfolio would pay Corporation Tax of just £17,000 and, even if the entire £83,000 profit after tax is paid out to the owner (who has no other income) as a dividend, their net income after tax would be £69,838. Hence, they are almost £25,000 better off every year.
If this is the same portfolio that produces the £1m of capital gains discussed above then, even in the worst case scenario, it would only take six years of this improved net income to more than compensate for the extra tax when the company is wound up.
Does Reinvesting Profits Within the Company Improve the Position?
Yes, absolutely. Before the new interest relief restrictions for individual landlords were announced, it was generally only worth using a company if some or all of the annual profits were reinvested within the company. That is no longer the case, but reinvesting profits within the company does still increase the annual tax savings quite considerably.
Let’s say that, in our previous example, the company owner decides that they are happy with net income of £45,000. This means they only need to pay themselves a dividend of £47,230, leaving profits of £35,770 in the company. This £35,770 represents an annual tax saving which is available to the company to reinvest; whilst the owner still has the same net income after tax that they would have had: £45,000.
Let’s say that this additional £35,770 is reinvested every year and the company enjoys capital growth on its investments at a compound rate of 5%. After ten years, the company has additional investments worth around £472,000. If it sells those investments and pays an effective rate of Corporation Tax at 8.5% (after indexation relief) on the gains arising, it will still be left with an additional net sum of around £463,000. Even in the worst case scenario where the owner is taxed as if this sum is a dividend when the company is wound up, there is still an extra net sum of over £304,000 left in their hands.
Companies generally pay exactly the same rates of Stamp Duty Land Tax (‘SDLT’) as individuals: including the new additional 3% charge for residential investment property. The same applies to Land and Buildings Transaction Tax (‘LBTT’) on properties in Scotland.
Can I Transfer My Existing Portfolio Into A Company?
Yes, this can be achieved in a number of ways. A piecemeal transfer of one or two properties at a time will result in Capital Gains Tax (‘CGT’) being payable as if the properties had been sold for their market value. Often, however, it is possible to ‘cherry pick’ the properties being transferred so that the gains arising are largely covered by the transferor’s annual CGT exemption. Where a couple own property jointly, they can generally transfer properties with capital gains totalling up to £22,200 in each tax year free from CGT. Properties which were the owner’s former main residence can also often be transferred free from CGT.
A reasonable sized portfolio will often constitute a ‘business’ for tax purposes and can be transferred to a company with no CGT arising by claiming ‘incorporation relief’. Determining which portfolios qualify as a ‘business’ is a complex matter, so it is essential to seek professional advice before following this strategy. Where incorporation relief is available, it carries the additional advantage that the taxable gains on future disposals of the properties transferred will be limited to the increase in value after the date of transfer.
The major fly in the ointment, however, is SDLT (or LBTT for properties in Scotland). SDLT or LBTT will generally be payable on the total market value of any properties transferred to the company (subject to a potential exemption for properties transferred from a partnership). This will include the additional 3% charge for residential investment properties. There are two reliefs available to reduce the amount of SDLT payable. Multiple dwellings relief allows the company to pay SDLT based on the average value of the properties transferred (times the number of properties). Alternatively, where six or more residential dwellings are transferred simultaneously, the company may pay SDLT at the non-residential rates on the total value of the properties transferred. The two reliefs operate slightly differently for properties in Scotland. The LBTT payable under multiple dwellings relief is subject to a minimum charge of 25% of the amount which would have been payable without the relief; non-residential rates must be used for a transfer of six or more residential dwellings.
Another major problem is the question of how to deal with the mortgages over the properties which are being transferred. A number of potential solutions have been suggested, but most people agree that the lenders must be kept informed of any proposed transfer of legal or beneficial ownership. Legal advice is essential.
Can I Make Any Personal Use of Properties Held by A Company?
This should generally be avoided, as it gives rise to a great many tax problems. The only exception is where a foreign company is used exclusively to hold an overseas holiday home in the same country.
More Changes Ahead?
Changes in draft legislation published towards the end of August 2016 have led many to fear that the Government intends to treat gains arising on the sale of many investment properties as trading income rather than capital gains. At the time of writing, the position is far from clear but, if the new proposals are enacted and then enforced in their broadest possible sense, many gains arising on investment properties after 4th July 2016 could be subject to Income Tax instead of CGT. For most higher rate taxpayers this would mean paying tax at 40% instead of 28%, even more in some cases, plus losing out on the £11,100 annual CGT exemption.
What has this got to do with using a company? Well, there are similar proposals for companies selling investment properties but the only difference this would make to the tax arising is the loss of indexation relief. The effective tax rate on long-term gains arising after April 2020 would then be 17% rather than the 8.5% discussed above but this is still far better than 40% or more. These proposals therefore only lend further weight to the idea that using a company is now generally preferable.
As usual there is a downside. The same proposals may also mean that the gain arising on the winding up, or sale, of a property company might also be treated as trading income. However, the long-term advantages of using a property company as a vehicle in which to build a property portfolio over many years would still remain.
Is There Any Risk of Further Tax Changes Which May Affect Companies?
There is always a risk that the tax system will change in the future. In fact, it is almost a certainty! Apart from the issue of turning capital gains into trading income, the other major concerns at the time of writing are that interest relief restrictions may be imposed on companies investing in residential property, and their owners, at some point in the future; and that incorporation relief may be abolished for property businesses. Whilst nothing concrete has yet emerged regarding these possible changes, we cannot rule them out!
The RLA offers Property Tax training with special discounts for members, please have a look at our training for the latest offers and course dates near you.
NOTE: The views expressed in this article are Carl’s own personal views and are not necessarily shared by any organisation which Carl may represent.
Carl Bayley is the author of several plain English tax guides available from www.carlbayley.co.uk, including “How to Save Property Tax” and “Using a Property Company to Save Tax”. Carl frequently speaks on property taxation and has spoken on the subject on BBC radio and television.