Lee Sharpe looks at the use of corporate structures to avoid the developing restriction of income tax relief for finance costs for residential lettings.
The new restriction on income tax relief for dwelling-related finance costs (see Sarah Bradford’s article in this edition of Property Tax Insider) is set to cost buy-to-let (BTL) landlords hundreds of millions of pounds in extra tax each year, by the time it is fully implemented in 2020/21 (according to the Treasury’s own projections in the Summer 2015 Budget analysis).
The relevant legislation starts at ITTOIA 2005, s 272A. Critically, there is no corporation tax equivalent to ITTOIA 2005, s 272A and, unsurprisingly, converting your BTL business into a company is now very much en vogue. But it will not always work for all landlords.
Comparing personal ownership to running through a company
Set out below is a comparison of the expected net personal income with a BTL portfolio in 2020/21, when the new restriction will have fully ‘bedded in‘, based on the following assumptions:
- paying 1/3rd of its gross income in mortgage interest (and assuming no other rental costs);
- with no other personal income, so the tax-free personal allowance and full 20% basic rate bands are available;
- assuming that the company pays its owner/director a salary of £700 a month first, and then distributes all of its annual letting profits remaining after corporation tax, as a dividend; and
- assuming no additional costs to running a company.
Rental After Net Income Net Saving /
Profit Mortage as Personal (Cost)
Interest Individual Income of
of Investor Through Incorporation
Company
-
10,000 5,000 10,000 9,728 ( 272)
20,000 10,000 18,500 17,763 ( 737)
30,000 15,000 26,500 25,441 (1,059)
40,000 20,000 32,500 33,118 618
50,000 25,000 37,500 40,796 3,296
60,000 30,000 42,500 48,166 5,666
70,000 35,000 46,500 53,769 7,269
80,000 40,000 48,500 59,371 10,871
90,000 45,000 52,500 64,974 12,474
100,000 50,000 57,500 70,576 13,076
110,000 55,000 61,750 76,179 14,429
120,000 60,000 66,000 81,614 15,614
130,000 65,000 70,250 85,798 15,548
140,000 70,000 74,500 89,533 15,033
150,000 75,000 78,750 93,476 14,726
The table indicates that the benefit of running the portfolio through a company really applies only when the landlord becomes exposed to more punitive 40% tax due to the interest restriction. By the time net rental profits reach £80,000, however, the corporate route is saving almost 15% of the net rent. The results would be slightly different for landlords subject to Scottish rates of income tax.
It stands to reason that the more interest a landlord is paying, the greater the potential benefit of running the business through a company. Of course, the converse also applies; a landlord with rental profits of £80,000 but no interest cost is worse off by a little more than £1,000 through a company – and that is before counting any of the additional administrative costs of operating a company that would likely apply.
Other possible benefits of the corporate alternative
Aside from the interest relief restriction, there are some drivers towards incorporation, such as:
- limited liability protection – particularly useful for serious construction projects;
- ease of administration of large property portfolios rather than direct ownership in property;
- ease of administration of large property portfolios rather than direct ownership in property;
- inheritance tax planning is facilitated in a corporate wrapper by moving wealth in the form of shares, rather than splitting ownership in bricks and mortar;
- where the owner can afford to leave the profits to accumulate in the business rather than needing to withdraw them for personal use, the low-tax corporate environment (without triggering additional income tax by withdrawing the funds for personal use) means that profits can be recycled into growth much more tax-efficiently; and
- taking a salary from the company means ‘relevant earnings’ which can support more substantial private pension savings (the company can also contribute, as the employer).
Hurdles to incorporation – capital gains tax
Incorporating an existing BTL business means disposing of the portfolio at full market value, which can trigger a substantial capital gain. Many readers will be aware that the landlord can potentially claim incorporation relief (under TCGA 1992, s 162), which acts to postpone the gain into future disposals of the company shares, but three important conditions are:
- the portfolio must count as a business – it cannot be the mere passive receipt of rent, but must involve active participation by the landlord, to a substantive degree. Those with small portfolios or who delegate the estate management function to third parties may well fall foul of this requirement;
- the whole business must be incorporated – one cannot normally pick and choose which properties to incorporate while keeping some in personal ownership; and
- ‘excessive’ gearing may result in an unavoidable or even prohibitive capital gains tax charge. Simply put, the key test is whether or not the portfolio’s debts exceed the capital gain on incorporation, as per the following example.
Example: Incorporation relief restriction
Francine has accumulated a property portfolio that originally cost £1 million but is now worth £3 million (before considering mortgages, etc.). It is therefore standing at a gain of £2 million. However, the portfolio mortgages are standing at £1.5 million, basically because Francine used the increasing portfolio value to leverage further acquisitions.
If Francine incorporates the business, and transfers over all of the mortgage debt as well, (as would be the norm), then the gain will be £2 million but the portfolio’s net value is only £1.5 million, once debts are considered. The incorporation relief mechanism will postpone gains only up to the net value of the business, so £500,000 of gain cannot be held over (and would be chargeable in the tax year of transfer).
Alternatively, Francine could restrict the amount of mortgage debt transferred into the new company (although she would need significant other personal wealth against which to secure such liabilities – and the lenders’ permission).
Hurdles to incorporation – stamp duty land tax
Note - By the time you read this, Wales will have its own version of stamp duty land tax (SDLT) – land transaction tax – alongside Scotland’s land and buildings transaction tax. The rules are, of course, similar to the original SDLT, but specific advice is recommended, where either jurisdiction applies.
Just as with capital gains tax, incorporating a property business will trigger a charge to SDLT based on the properties’ market value (whether the properties are subject to mortgage is irrelevant for SDLT in this category of transfer). The 3% additional SDLT rate is automatically chargeable, because companies cannot have a ‘main residence’. The starting point is that SDLT will be chargeable on the whole amount as one transaction. But the transferor can usually claim either:
- multiple dwellings relief (FA 2003, Sch 6B) which uses the rate applicable for the average property value against the total consideration; or
- commercial/mixed use rates (FA 2003, s 116(7)) if there are six or more dwellings, to apply the lower ‘commercial property’ rates to the transaction value.
Assuming one has the choice, which is preferable will largely depend on how low the average property value is. It may be possible to avoid an SDLT charge completely where incorporating a partnership business, but the rules are complex, and many property businesses may not qualify as partnerships.
Conclusion
Hopefully, this article has helped to illustrate the point that, while companies may offer a valuable option to some BTL landlords, it is primarily a function of how bad the new interest relief restriction regime will be, rather than how good companies are for landlords more generally.
Furthermore, there are significant hurdles to transferring a BTL or similar business into a company. Tailored advice is essential to ensure the process runs as expected.
