First of all, we need to look at this concept, which is a little bit odd if you think about it, of a ‘property partnership’. By this, we don’t mean so much a partnership which owns property, but a ‘partnership’ whose raison d'être is letting out property as an investment.
Is there a ‘partnership’?
The reason for putting the word ‘partnership’ in inverted commas is because there is some doubt, on a true meaning of the word, as to whether a property portfolio managed in a business-like way can actually be a partnership, in the absence of any trade.
This isn’t just of interest or importance for pedantic choppers of logic; certain tax rules, in particular, rules relating to capital gains tax and stamp duty land tax, apply differently to partnerships from simple joint ownership situations. I’ll come on to give some examples of this shortly; but one important and very interesting point to make is that this uncertainty (as to whether your property business is a ‘partnership’ or not) can be eliminated at a stroke, by transferring your property ‘partnership’ into a limited liability partnership (LLP).
Under specific legislation, LLPs are treated as if they were partnerships in all circumstances, including circumstances where the business is of a pure investment type. So, if you’re running your property portfolio through an LLP (and there are a number of advantages in doing so), you can assume that all the tax rules relating to partnerships apply safely to you.
Accidental CGT charges
It’s perilously easy, in fact, to incur capital gains tax (CGT) when running a portfolio of properties in which a number of people are involved as joint owners. To understand why, I need to set out as simply as possible the way CGT works with partnerships.
The law itself (Taxation of Chargeable Gains Act 1992) has very little to say about partnerships, and almost all the rules are contained in an HMRC statement of practice, number D12 published in 1975 (as subsequently amended). You may think that this is no way to run a tax system, putting virtually none of the rules in the law and leaving it up to the Inland Revenue (as they then were) to make up the rules, so to speak; but actually, statement of practice D12 is something of a masterpiece in its own way. It is clearly written by somebody who understood not just the way CGT works, but also the way partnerships work and are accounted for – a very rare combination!
The basic issue facing the author of this statement was the fact that a partnership is an unusual beast legally. In English law, it isn’t a ‘person’ at all, and effectively doesn’t exist. Nevertheless, assets can be held as ‘partnership property’. So, how do you deal with the situation whereby partners in one sense own property (the partnership property) but in another sense their asset is actually, legally, their rights as against the other partners?
The D12 solution is that the rights that a partner holds in a partnership are actually completely ignored for CGT purposes, and partners are instead taxed as if they owned an individual fractional share in each of the partnership assets. So, you might conclude that in a partnership of A, B, and C, each of the three partners is treated as owning one-third of each of the partnership assets (property in our situation).
However, you would be wrong in concluding this. Partnerships are not necessarily equal, and ownership of partnership property isn’t the same as joint ownership. Instead, the interests of the partners in the underlying partnership assets are measured, by D12, according to the proportions in which partners share capital profits. At first sight, this may seem counterintuitive, or even arbitrary. In fact, when you follow the logic through rigorously (and I haven’t the space to do so here) it does seem that this is the only way the rules could actually have been sensibly written.
Changes of capital profit sharing ratio
It follows logically, from the fact that partners are treated as owning assets in the same proportion as they share capital profits, that a change in the capital profit sharing ratio (CPSR) results in a disposal of those assets by the person who is reducing his CPSR, and an acquisition by the person who is increasing his share. Let’s see how this works out in practice.
Example: Introducing offspring as partners
Mother and father own a property-based partnership and are the only partners. The properties in the portfolio (based in the Midlands) originally cost them a total of £1 million, but, with property price inflation over many years, this value has now increased to £5 million.
As they want to involve their three adult children in the business, they introduce Annabel, Bobby, and Charlotte as members of the partnership.
Result: They have CGT to pay of nearly £700,000! Why is this?
The reason is because, in default of any specific agreement, the three children are treated as being equal partners, which means that they now have rights to profits (including capital profits, i.e. CPSR) of 60% between them. This triggers a disposal of 60% of the portfolio, and the gain which mother and father are deemed to have made is £2.4 million. Ouch!
How could mother and father have avoided this punitive tax charge? Well, they could have considered, amongst other possible solutions, the following three ideas:
- They could have put the children’s interest in the partnership on trust, rather than bringing them in as ‘absolute’ partners. Transfers of assets to a trust are eligible for CGT ‘holdover relief’, meaning that the trustees effectively take over ownership of the interest in the properties at cost rather than market value – so no taxable gain is treated as crystallised;
- If some of the properties in the portfolio were standing at a low or no gain, they could have given the children effective interests (under the D12 regime) in those assets only; or
- Probably most sensibly, they could have retained all, or almost all, of the capital profit sharing rights themselves and introduced the children on terms such that they were entitled to shares of income only, rather than of capital profits as well.
The last ‘get out’ is an example of how flexible the rules relating to partnerships are. If you have a partnership, you can decide to allocate the three main rights, which are capital profits, income profits, and rights to control, differently between the various partners and the various rights.
Stamp duty land tax
As with CGT, partnerships have their own separate set of rules for stamp duty land tax (SDLT) and its Scottish and Welsh equivalents; although in this case they are actually written down in the statute law. Unfortunately, the law, whilst it is much more definite than simple HMRC practice can ever be, is also very much harder to understand!
To paraphrase, though, SDLT charges can arise where property is put into a partnership; or where the interests in a partnership are changed, in a way that is not wholly dissimilar to the CGT rules. As a rough general rule, the SDLT provisions are more favourable than the CGT ones, though, because it is possible to bestow interests in properties (effectively) owned by a partnership on connected persons without triggering an SDLT charge. So, in our example of a mother, father, and three children, bringing in the three children would not give rise to SDLT because they are connected with the existing partners. The one exception to this, which comes up quite often, is limited companies. If a limited company is a partner then, if it is controlled by the other partners, it is not treated as being connected.
So, introducing a property into a partnership which includes a company can be expensive in SDLT terms because the company is treated as receiving an interest in the property at its market value, and chargeable to the tax. The way to avoid this is to minimise the company’s entitlement to income profits (SDLT goes by income profits, rather than capital profits). This does not necessarily prevent you from allocating more profits to the company on occasion, it seems, so long as this is not a fixed ‘entitlement’, but it does seem to work to minimise the value on which SDLT is charged.
