When Does Incorporation Stack Up For Landlords? Part 3

In the third in a series of articles, Lee Sharpe looks at some of the main issues for buy-to-let landlords contemplating the incorporation of their property business.

Last month, we looked at the problem caused by capital gains tax (CGT) when incorporating a buy-to-let (BTL) property business, and the idea of ‘latent gains’ that cannot be postponed when transferring your portfolio into your company.

In this article, we shall look at a potential fall-back option, being the opportunity to pay CGT by instalments, over up to ten years, which may help to draw some of the sting of a large CGT bill. There are numerous routes to pay CGT by instalments, but this section will deal only with the issues relevant to transferring BTL property into one’s own company.

Instalment options – requirements

If you have no choice but to pay CGT, then it is sometimes possible to pay it over up to ten years by instalments (TCGA 1992, s 281).

The main rules are:

the assets disposed of must be land (including property) – certain types of shareholding also qualify, but are not really relevant here;
the disposal must be by way of gift (i.e. transfer for nil consideration, or otherwise than as a bargain at arm’s length); and
that cannot have been ‘held over’ (i.e. postponed) – e.g. by incorporation relief

Partial relief is permitted – e.g. where incorporation relief is available for some of the gain, then payment by instalments is potentially available for the remainder. This is particularly relevant for those BTL investors contending with latent gains on their BTL portfolio that cannot be postponed (see last month’s article).

Instalment options – mechanism

The taxpayer must make an election to use payments by instalments within four years of the end of the tax year of the gain.
However, the first instalment is due on the normal date for payment – for individuals, this will currently be 31 January following the tax year of the gain (although this may be brought forward under plans announced in the 2015 autumn statement to shorten the ‘capital gains tax payment window’ in relation to residential property). It would be quite unlikely, therefore, for the taxpayer to wait four years until making the election, if the first instalment is generally due much earlier.
A further nine instalments fall due on the anniversary of the first.
Interest is charged on the payment as against the original due date, on each of those instalments.
A taxpayer may settle the instalment plan early, and have his or her interest re-calculated accordingly.
If the underlying asset is disposed of for valuable consideration (usually an onward sale for money) by the donee (or indeed any subsequent owner), any outstanding balance of CGT due is payable immediately. This applies where the donor and donee are ‘connected persons’ (as will be the case for the BTL investor and his own BTL company).

It follows that BTL investors should keep a watchful eye on the disposal by the company of any properties held pre-incorporation, to ensure that they do not inadvertently trigger an immediate charge to any postponed amounts.

Example: Incorporate and pay CGT by instalments?

Let’s work with the example in the previous article – Benito – who had a ‘latent gain’ that could not be postponed using incorporation relief because the overall gain was too large to be held over.

In that example, Benito had £550,000 worth of property that originally cost £200,000, so a gain on transfer to his company of £350,000.

However, Benito’s mortgages were £250,000, so the net value of his portfolio was only £300,000, (£550,000 - £250,000), and he could not therefore hold over the full gain as it exceeded the net value of the portfolio transferred in - £50,000 could not be held over, and was chargeable immediately.

Let’s assume that Benito does not want to (or cannot) borrow more money to pay off his immediate CGT bill straight away, but would prefer to pay it off by instalments, over the next ten years. From a cost/benefit perspective, Benito reckons that the additional CGT cost over the next ten years will be ‘worth it’ if they can be funded out of the income tax he stands to save, if he incorporates his BTL business and therefore avoids the impending restriction of income tax relief for dwelling-related loans.

Instalment payments

The gain that Benito could not postpone was £50,000. Assuming Benito is already a higher rate (40%) taxpayer (using 2016/17 rates, etc.):

£50,000 - £11,300 annual exemption = £38,700, taxable at 28% (residential property) = £10,836.

Each instalment payment will be £1,083 + the interest that will have accumulated to date on that repayment:

‘Capital’ Year Rate Interest Total

1,083 0 2.75% - 1,083

1,083 1 2.75% 30 1,111

1,083 2 2.75% 60 1,143

1,083 3 2.75% 89 1,172

1,083 4 2.75% 119 1,202

1,083 5 2.75% 149 1,232

1,083 6 2.75% 179 1,262

1,083 7 2.75% 208 1,291

1,083 8 2.75% 238 1,321

1,083 9 2.75% 268 1,351

10,830 1,340 12,170

This equates to an average extra cost of £1,217, annually (£12,170 ÷ 10)

This equates to an average extra cost of £1,224, annually (£12,240 ÷ 10)

Income tax saving

To work out whether or not the extra cost is worthwhile, Benito needs to consider what the alternative cost will be in ‘staying put’, and paying the extra tax on disallowed mortgage interest. For the purposes of this exercise, Benito thinks it is worthwhile if the additional income tax due, if he were not to incorporate, were to be at least as much as the additional CGT he would have to pay over the next ten years. It is important to emphasise, however, that Benito is only saving money through incorporation because the alternative is that much worse: he is unlikely to end up better off overall; rather he will not be as poorly off.

Benito’s mortgages total £250,000 and he is paying 2.5%, interest only – equivalent to £6,250 in interest each year. We have already established that Benito is a 40% taxpayer, so the cost of this disallowed interest (once it is 100% disallowed by 2020/21) will be:

£6,250 @ (40% - 20%) = £1,250

Benito will suffer the disallowance of his interest cost at 40%, but will ordinarily get a basic rate ‘credit’ to set against his income tax liability, so his net tax cost is only 20%.

In other words, he would be paying an extra £1,250 in income tax by not incorporating, and only an extra £1,217 CGT by incorporating and suffering CGT by instalments over the next ten years.

In this example, it is a close-run comparison, but Benito will be slightly better off by incorporating over the next ten years – in essence, the CGT instalments are mathematically self-funding – and significantly better off after ten years, when he can properly ‘enjoy’ the benefit of the relative income tax saving.

Other considerations

The exercise assumes that Benito is looking at incorporation only when BTL interest has been fully disallowed, so ignoring the 25% increments that apply from 2017/18 through to 2020/21.

The benefit of inflationary effects, etc., on paying something off over time has been ignored. It also assumes that the CGT annual exemption will be £11,300 when this happens. Perhaps most importantly, it assumes that the late payment interest rate will remain at 2.75% throughout.

Where the sums involved are significant, then it would be appropriate to consider discounting future payments to their ‘net present value’ (basically, that a commitment to pay £1,083 in nine years’ time is better than a commitment to pay £1,083 today, thanks to inflation or whatever better use one can put the money to in that interval), and to consider the effect of an increase in interest rate.

Conclusion

The option to pay by instalments means that, even where CGT is unavoidable on incorporation, it may be defrayed by up to a decade, and may therefore be significantly more manageable from a cashflow perspective. Depending on the amounts involved, the mathematical modelling may need to be much more precise than the simple illustration above – and there is always the risk, given the timeframe, that a new Chancellor – or a new government – will fundamentally change the relevant tax rules, for better or for worse.