This is the first of a series of articles on the main issues that residential property landlords must evaluate when considering whether or not to incorporate their business.
We shall firstly look at whether or not running a buy-to-let (BTL) business through a company will actually prove beneficial in the years to come. In other words, ‘why incorporate?’.
Why should I incorporate?
At risk of stating the blindingly obvious, a BTL investor should only incorporate his or her business if there is good reason to do so. Before the new rules restricting tax relief for finance costs on residential property, many landlords would not have been better off by incorporating. Since April 2016 a new, more punitive regime for taxing dividend income means that incorporation is even less beneficial.
Example: Sole proprietor vs company
Boris owns several properties, but has no other sources of income. His net property profits are £40,000. In 2016/17, his personal tax position will be:
2016/17 £ £
Rental Income 40,000 40,000
Less: Personal Allowance ( 11,000)
29,000
Taxed at: 20%
Tax ( 5,800)
Net income 34,200
If he had instead put his properties into a company, the company would first have to pay corporation tax on its profits:
2016/17 £ £
Rental Income 40,000 40,000
Less: Boris' salary (say) ( 8,000) ( 8,000)
32,000
Taxed at: 20%
Tax ( 6,400)
Net company income 25,600
But this is only half the story; although it is Boris’ company, he has so far drawn out only £8,000 salary and the rest of the company’s profits are locked up in the company’s bank account – those funds are not yet his. He therefore pays a dividend out of the company to put the funds at his personal disposal:
2016/17 £ £
Company funds now payable as dividends: 25,600 25,600
Balance of Boris' Personal Allowance (3,000)
Taxable 22,600
Taxed at:
New Dividend "Allowance" 0% 5,000 -
Ordinary Dividend Rate 7.5% 17,600 1,320
22,600
Total Income Tax on dividends (1,320)
Boris' dividend income after tax: 24,280
Add: salary already taken (as above) 8,000
Boris' net income 32,280
Boris' net income if he'd never bothered
with a company (above): 34,200
Lost from running portfolio through a company: (1,920)
Of course the real problem is that, by 2020/21, Boris will be getting only 20% tax relief on his mortgage interest if he continues to hold the property personally, while the corporate alternative would not be caught. Let’s suppose that Boris’ net rental income of £40,000 is after having paid £32,000 in mortgage interest, and move forwards to 2020/21, where all of his mortgage interest will be subject to the new tax relief restriction:
2020/21 £ £
Rental Income 40,000 40,000
Disallow: interest 32,000
72,000
Less: Personal Allowance (12,500)
Deemed taxable: 59,500
Basic Rate 20% 37,500 7,500
Higher Rate 40% 22,000 8,800
59,500
Mortgage Interest
adjustment ( 6,400) ( 9,900)
Net income 30,100
Boris stands to lose £4,100 by 2020/21 if he continues to run his business personally, even though personal tax-free bands and allowances have risen significantly by then (the government has committed to increase the personal allowance to £12,500 and the higher rate threshold to £50,000).
We already have a rough idea of how Boris would fare with a corporate property portfolio, because companies will not be affected by the new BTL finance restrictions. On the basis that companies remain static, then Boris would still be £1,920 worse off in a company in 2020/21 than with a personal portfolio now in 2016/17, but that would nevertheless be £2,180 better than sticking with personal ownership all the way through to 2020/21.
In fact, companies will be more tax-efficient by 2020/21 because the main rate of corporation tax is set to fall to 17%, increasing Boris’s saving to more than £3,100.
Many career landlords are dealing with much larger numbers, and the savings will be much more substantial. The key consideration is how much the artificial tax cost of disallowing interest, etc., exceeds the compensating 20% tax relief. If we look instead at an alternative where Boris’ mortgage interest is only £12,000, the results are quite different:
2020/21 £ £
Rental Income 40,000 40,000
Disallow: interest 12,000
52,000
Less: Personal Allowance (12,500)
Deemed taxable: 39,500
Basic Rate 20% 37,500 7,500
Higher Rate 40% 2,000 800
39,500
Mortgage Interest
adjustment ( 2,400)
( 5,900)
Net income 34,100
In this scenario, the new mortgage interest regime will end up costing Boris only a very small amount annually, even when fully implemented in 2020/21. He would be much better off sticking with direct ownership, rather than incorporating his business.
Conclusion
For non-advisers, the calculations can be quite daunting – particularly if also having to consider the possible effects on student loans, child benefit, or even the forfeiture of personal allowance for those with larger portfolios, to name a few. But they are essential, in order to get a decent appreciation of how the new rules will affect someone’s annual income. If only someone had developed a model sophisticated enough to deal with all those variables…
