Over the last few years the government has introduced various tax measures targeting residential landlords in an attempt to support home ownership. The measures endeavour to deter landlords from purchasing additional properties, with the intention of making it easier for first-time buyers to compete in the market place.
Most notably, the changes include a 3% Stamp Duty Land Tax (SDLT) surcharge on the purchase of additional residential properties, introduced from 1 April 2016. This measure applies to both companies and individuals.
The second major change is the loan interest relief restrictions which came into force on 6 April 2017, which will increase landlords’ income tax liabilities over the next four years as the legislation takes effect. These measures only apply to individuals owning residential property and could therefore potentially make a corporate vehicle attractive, particularly where a property portfolio is highly geared.
Advantages of incorporation
Holding residential property within a corporate structure can enable debt to be repaid more quickly and provide a higher yield (net of tax) on the property portfolio due to lower corporation tax rates (currently 19% and reducing to 17% in April 2020, compared to income tax rates of up to 45%). If not all of the income generated is required by the shareholder then it can be accumulated to enable faster repayment of debt or for future investment.
Within a company, finance costs are not deductible as an expense in calculating property income, but instead fall within the corporation tax loan relationship regime. These rules are complex and have to be considered with the corporate interest restriction rules, which may limit the finance cost deductible.
There is also the opportunity to pay a tax efficient salary and dividends, though tax benefits diminish on distribution of profits (payment of dividends) from a company, as the dividends are subject to a further tax charge on the shareholder. There may still be some tax benefits for highly geared portfolios, however, even where all of the profits are required to be distributed.
The biggest hurdle when incorporating a property business is usually the inherent capital gains tax (CGT) liability on any gains that crystallise when the properties are transferred. For tax purposes, the transfer of properties by an individual to a company will be a disposal for CGT purposes and will be deemed to take place at market value. However, provided the relevant criteria are met, there is a relief available on incorporation that enables the gain to be deferred and rolled into the base cost of the shares issued in exchange for the properties. The added advantage is that the base costs of the properties themselves are uplifted tax free to market value on transfer into the company, thereby reducing any future CGT charge on a later disposal of those properties by the company.
A property investment company can also be a useful tool for inheritance tax (IHT) planning, as different classes of shares could be issued to the younger generation entitling them to any future increase in the capital value of the company. Although this doesn’t reduce the IHT position for the original shareholders, it does limit their IHT exposure so that the value of any future growth falls outside their estates.
Disadvantages of incorporation
It is a requirement of the incorporation relief that all properties of the rental business owned by the landlord will need to be transferred. This can present difficulties where the landlord wishes to retain certain properties privately or where a property is occupied by the owner or members of their family, as this can result in other adverse tax consequences.
In addition, there will be some loss of privacy, as accounts must be filed at Companies House. This can be mitigated by the use of minimum disclosure or an unlimited company, although there will still be some filing requirements in relation to the register of People with Significant Control (PSC).
There are a number of tax considerations that need to be taken into account when incorporating a property business and these are discussed in more detail below.
In order to qualify for the relief the property portfolio must constitute a business in the first instance. A landlord owning a single rental property that undertakes little management activity is not sufficient to qualify as a business for the purposes of the relief. It is the quantity rather than the quality that is important. Consequently, larger portfolios that are actively managed, where the landlord carries out a significant number of activities and generally spends at least 20 hours a week running the portfolio is more likely to qualify.
If the activity is sufficient to qualify as a business, incorporation relief permits the capital gain to be deferred until such time as the shares in the company are sold or the company is wound up. In order to utilise this relief certain criteria need to be met, namely that all of the assets of the business, excluding cash, must be transferred and the consideration paid is by way of the issue of shares in the company.
One administrative issue that is often overlooked is the re-negotiation of third party debt, which will need to be considered and managed carefully as it is a requirement of the relief that any debt is novated to the company rather than repaid and new loans taken out, as this will impact the CGT position.
A further complication arises where the net value of the business is less than the gain being rolled into the shares. In this instance, a portion of the gain will be chargeable immediately (ie crystallising a tax liability), so it is essential to carry out a financial modelling exercise prior to incorporation to ensure there are no nasty surprises.
Stamp Duty Land Tax
Another important consideration when incorporating a property portfolio is SDLT. For SDLT purposes, the transfer of the portfolio to a company will be deemed to take place at market value and a tax charge will arise on that value regardless of whether any actual consideration is received. This can represent a significant cost, particularly where a number of properties are transferred, although there is some relief where six or more dwellings are transferred at the same time. Companies will also be subject to the 3% surcharge. Nevertheless, this cost may be acceptable when compared with the overall tax savings the corporate vehicle may achieve.
Where the properties are held in a partnership it may be possible to transfer them without giving rise to an SDLT charge at all. This is due to the way the rules work when calculating the SDLT on transfers of land to a company where all parties to the transaction are connected. However, there are strict anti-avoidance provisions to deal with any abuse and so it is not possible to notionally create a partnership prior to incorporation to avoid the SDLT charge.
Incorporating a property partnership in itself presents further traps and pitfalls which will need to be carefully managed. For example, it is not possible to withdraw capital from a partnership within three years of land or property being added to it, otherwise there is an SDLT clawback.
Annual Tax on Enveloped Dwellings
Companies are subject to the Annual Tax on Enveloped Dwellings (ATED) charge where residential property is held within a corporate structure and the value of the property is more than £500,000. However, providing the property is let to a third party and is not let to the shareholder, or anyone connected with them, then relief may be available to reduce the charge to nil. An annual return is still required though.
Where the incorporation is of a solely residential property portfolio there should be no VAT considerations, as residential property is generally exempt from VAT. However, if the portfolio includes commercial property it is worth considering if there are any VAT issues on properties that have been opted to tax.
In addition, there are other practical considerations to be taken into account, such as opening new bank accounts in the company’s name, changing tenant deposit accounts, notifying tenants and altering any tenancy agreements. Insurance will also need to be rearranged and the formal transfer of the properties will need to be dealt with. Once the company is up and running, there will be administrative expenses in dealing with the preparation and filing of company accounts and tax returns, as well as other annual filing requirements which may represent an additional cost.
Incorporating a property rental business is complex but there can be clear tax and commercial benefits in particular circumstances. Once incorporated it is virtually irreversible, or certainly very costly to unwind the structure, so it is a decision not to be made lightly. Professional advice is recommended to ensure the implications and associated costs are fully understood prior to making a final decision.
This factsheet is based on law and HMRC practice at 1 June 2019.