Recent changes in regulations, and in particular the March 2016 Budget announcements have changed the tax position of landlords significantly.
Shelter from the income tax implications of these rulings has increased the appeal of a company as a structure for ownership of residential property. Moreover, changes in corporation and capital gains tax have lessened some of the former drawbacks to company ownership.
Tax on gains made through property held in a company.
The, so called, double tax charge is a reason that companies have not historically been a popular with UK landlords. However, the reduction in both the main rate of both corporation tax and capital gains tax have reduced this classic drawback of the double tax charge.
When a property is disposed of, usually either sold or transferred as a gift, the company realises a gain or loss. If there has been any overall increase in value this gain will be subject to corporation tax. The rate of corporation tax for 2016/17 is 20%, however it is due to reduce to 19% in 2017 and again to 17% in 2020. On withdrawal of the proceeds by the owners any increase in value of the property is also subject to tax. Income tax would apply if the funds are withdrawn as dividend, but given the tax implications, it would be more prudent to wind the company up and treat the distribution as a capital gain. The rate of capital gains tax is currently 20%. Since, this gain will be on proceeds after deduction of corporation tax the overall gain could be said to be 36% (i.e. 20%, plus 80% of 20%.) This combined rate will reduce to approximately 33.6% by 2020. This compares to a rate of 28% for gains on residential property held privately.
The percentages above are broad estimates to show a comparison between the two forms of ownership. The actual rate would be lower for a company due to indexation allowance and lower for an individual due to the annual allowance.
In general, capital gains tax will be greater for property held in a company. However, careful planning could reduce this tax. This planning could include:
- Disposal of the property while not UK resident;
- Appointment of shares to family members taxed at lower rate; and
- Investment of proceeds in a pension.
Residential property cannot be owned by a pension. Therefore, company ownership can be used to achieve market exposure and subsequent pension contributions to secure tax advantage.
Tax on rental profits achieved through company owned property
Until 6 April 2017, it will still be possible to deduct mortgage interest from rental profits subject to income tax. However, from 2017/18, the percentage interest that can be deducted from taxable profits will taper, so that by 6 April 2020 no interest will be tax deductible. In its place, a tax reducer equal to 20% will provide a form of relief. However, a higher rate taxpayer currently finding 40% tax relief on interest payment will by 2020 obtain only 20% relief.
There is currently no restriction on the amount of interest that can be deducted from profits chargeable to corporation tax. For a higher rate taxpayer, tax payable on profits for a mortgaged property could be considerably lower if owned through a company.
A taxpayer can obtain relief from general income on a loan made to a close company. This will provide:
- Full tax relief for mortgage interest irrespective of the profitability of the property. For private landlords, rental losses can only be used to reduce future rental profits.
- Greater profits can accumulate in the company, either to be paid to shareholders taxed at a lower rate, or to be accumulated and withdrawn as capital on winding up. The ‘capitalisation’ of rental profits could confer considerable tax saving as explained later in this article.
- More favourable loan terms. Companies are inherently riskier to a creditor, and in practice corporate loans cannot be secured at all or for the same value.
For individuals earning over £200,000 a cap may apply to the amount of tax relief available on interest.
From 2016/17, each person is entitled to a dividend allowance of £5,000. This allowance is valuable to higher rate, and additional rate, taxpayers. In effect, a husband and wife could withdraw company rental profits of up to £12,500 per year, and pay only £2,500 in tax. This compares to tax of £5,000 on the same income if both spouses are taxed at the higher rate.
A higher rate taxpayer would suffer tax at 32.5% on dividends withdrawn over the £5,000 allowance. Therefore, there could be a benefit to retaining funds in the company, and withdrawing the funds as capital gains when the property is eventually sold and the company is dissolved thereafter. The combined rate of corporation tax in this case would be 36% (or lower if a tax year after 2016/17.) This rate of tax is explained above. By comparison, landlords subject to higher rate tax and with the property in their own name would suffer a rate of 40%.
Moreover, the capital gains tax element would not be payable until the company is eventually dissolved. Therefore, retained funds could be used, for instance, to repay a company mortgage or to invest in further property.
Since 6 April 2015, all non-residents have become potentially liable to capital gains tax on their UK rental property. Depending on the prevailing tax regime in the country of residence, tax savings can be achieved through company ownership. This is because a non-resident is not subject to UK tax on the disposal of a share. Dividends are disregarded income for an individual who is not UK resident. It is therefore only the corporation tax element of the gain which would be subject to UK tax. The timing of disposal of rental property could form a key part of retirement planning where the landlord’s intention is to emigrate in the future.
Inheritance tax is charged on the value of a person’s estate, which includes any gifts made in the seven years prior to death. Therefore, the transfer of property in seven years prior to death could be subject to both inheritance tax and capital gains tax.
Probate value determines the gain or loss made by the beneficiary on disposal of the inherited property. Thus, death creates a ‘capital gains tax free’ uplift in value for property. Given that the proceeds from a property sale could form part of the estate, a plan to simply hold property until death can be tax efficient.
Property owned in a company will not enjoy the same tax benefit. On a future disposal of the shares by the beneficiary any capital gains tax would be calculated by reference to the market value of the property when inherited. To the extent, capital gains tax is avoided in the same way as for property held privately. However, the overall gain on company property has two elements. The value of the property for determining gain subject to corporation tax will still be its original cost, regardless of any changes to the shareholders.
Company ownership is likely to be more tax efficient where it is not the intention to hold the property for a lifetime.
By the same token, if structured carefully a company can become a useful mechanism in inheritance tax planning.
Rental property can form a significant part of a person’s wealth. A company can facilitate the transfer of a property, and the income which it generates, to various children, grandchildren and other beneficiaries over time. This way the family wealth can be imparted in a controlled and gradual manner. This is the kind of arrangement that would previously have been performed by a trust. However, it is probable that the rates of tax on a trust will not be as favourable.
The tax advantage gained from the use of a company is more likely to be realised on properties that produce high yields rather than capital growth. The higher the mortgage cost the more suited the investment to corporate ownership.
For couples, a company could allow for double the dividend allowance. The use of an alphabet structure could facilitate transfer of income to the spouse taxed at the lower marginal rate. By contrast, a married couple are taxed on rental income in the same proportion as they own the property, regardless of the way this income is paid.
It will rarely be prudent to transfer an existing rental property into a company. The purchase of additional residential property is subject to a further stamp duty of 3%. The transfer would be treated as a disposal for capital gains tax purposes. Therefore, an increase in value from the date the property was acquired to the date that it is transferred into a company would be subject to capital gains tax. The rate of tax is currently 28%.
The government could legislate to block any means of avoiding tax through company ownership. An entire disruption is unlikely given the various areas of tax law that would have to be simultaneously changed. Nonetheless, any arrangements to save tax should be regularly reviewed in response to changes in regulation, and a clear exit strategy put in place.
Ray Coman, FCCA, CTA
Watch our one minute video here: https://www.youtube.com/watch?v=Haxo2pzDRfs