• Residential property businesses: to incorporate or not?
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Residential property businesses: to incorporate or not?

06 January 2020

Back in the summer of 2015, George Osborne delivered his penultimate Budget as Chancellor of the Exchequer. This included the introduction of the mortgage interest restriction for individuals with residential property businesses. This restriction has affected many landlords and has led to a lot of questions, the main one being “Should I incorporate?”

Mortgage interest restriction – how does it work?

Before the restriction was put in place, mortgage interest was often a fully deductible expense against a landlord’s rental income for income tax purposes.


Once fully in place, the restriction will effectively only allow a deduction for mortgage interest at the basic rate of tax. Therefore, higher and additional rate taxpayers will be taxed on the rental income at 40% and 45% respectively, but only being able to claim relief for mortgage interest at the basic rate of 20%. The restriction will not affect the tax liabilities of landlords who are basic rate taxpayers.


These rules are being tapered in, with the restriction taking full effect for the tax year 2020/21 and thereafter:  

Tax Year % of cost of deducted from profits ("old rules") % of costs available as basic rate tax reducer ("new rules")
2017/18 75% 25%
2018/19 50% 50%
2019/20 25% 75%
2020/21 - 100%

Example
An additional rate taxpayer also has rental income of £100,000 per annum, £10,000 allowable expenses and £30,000 mortgage interest would be affected by the mortgage interest restriction as follows: 

 

2016/17 (£)

2020/21 (£)

Gross rental income

100,000

100,000

Allowable expenses

(10,000)

(10,000)

 

90,000

90,000

Less mortgage interest paid

(30,000)

-

Taxable profit

60,000

90,000

 

 

 

Income tax @ 45%

27,000

40,500

Income tax reducer (20% x £30,000)

-

(6,000)

Net income tax

27,000

34,500

Effective tax rate on net income

45%

57.5%

Aside from the increase in the effective tax rate, a key risk here can be cash flow, where client’s mortgage payments (which may include capital repayment) can leave them in a cash negative position.


Potential solution: Property business incorporation

As a result of this change, many landlords are considering incorporating their property business. For landlords who reinvest their profits within a company, the effective rate of tax is just 19% (possibly 17% for 2020/21), however, even for those additional rate taxpayers who extract their profits through dividends, the effective rate should be 48.6% for 2020/21.


There are two immediate tax considerations for the incorporation of an existing property business: whether the incorporation will trigger Capital Gains Tax (CGT) and what Stamp Duty Land Tax (SDLT) there will be on the transfer of the properties from the landlord to the landlord’s company.


CGT


The current rates of CGT on UK residential property are 18% (basic rate taxpayers) and 28% (higher and additional rate taxpayers). Incorporation will normally trigger a CGT charge based on the market value of the properties less their base cost (usually historic cost), unless incorporation relief is available.
Incorporation relief could potentially be available when transferring the activities to the company in exchange for shares, however, this is only available where HMRC accepts that the letting is already being run as a business. Since May 2018, HMRC will no longer give clearance on this issue and, therefore, it is crucial that tax advice is sought on the CGT position before incorporating.


Alternatively, the properties could be sold to the company. While this may trigger CGT, it would create a loan account, which could subsequently be drawn down free of tax.


SDLT

The usual SDLT rates on residential property should apply on the transfer of the property, including the additional 3%.
There are various SDLT reliefs potentially available to reduce (or in some cases, mitigate completely) these tax charges and eligibility for these reliefs depends on each landlord’s circumstances. 

Financing arrangements

Another non-tax related point to consider is the financing. Any mortgage on the properties will need to either transfer or be refinanced, and the interest rates available to a company borrower may be different to those which were afforded individually. A mortgage adviser should be consulted.

Long term plans

It is also important to take your long term plans for the property into account. If the properties are to be retained as a long term investment, then reducing the year to year tax on profits by incorporating the letting business is likely to be beneficial.

If the capital tied up in the properties will be needed in the foreseeable future or the properties put to other uses, incorporating and then extracting the properties after just a few years may not be cost effective. This is because frequently there will be two layers of tax on realising capital from a property held in a company (corporate capital gains tax on the disposal by the company and tax on distributing the proceeds to the shareholders). If the proceeds are distributed by dividend then the shareholders would suffer income tax on them. Alternatively, if the company was wound up after the property was sold and all corporation tax paid, it may be possible to obtain capital treatment on the funds passed to the shareholders so they would be liable to capital gains tax (usually lower than income tax).

Another option is a direct transfer of the property to shareholders. This would be subject to SDLT if there is any assumption of debt by the shareholder as a result of the transfer. This would be the case, for example, if there is a mortgage on the property which is being transferred. The effect on the financing arrangements would also need to be considered if this is the case.

What is the first step?

Discuss your current position with a real estate tax advisor and establish whether a property business incorporation would be beneficial for you.