Incorporating a property rental business
Over the last few years there have been a litany of changes to the UK tax rules around the taxation of residential property ownership for business purposes. Many of the changes have been such that those who previously operated “buy-to-let” businesses in their personal capacity (as a sole trader or through a partnership) will have considered whether it is more tax effective to incorporate their personally held businesses into a company structure.
This note looks at the headline tax issues relevant to incorporating a personally held property rental business.
The restriction on the deductibility of interest for individual buy-to-let landlords and the imposition of higher rates of capital gains tax on disposal of residential property (28%) which only apply to direct individual ownership (i.e. they do not apply to companies) make the option of owning residential investment properties through a company more attractive. For further discussion of this see our article
The advantages of operating through a company include:
- Relief is available for all interest paid.
- Corporation tax is at 17% on income and gains.
- Income can be accumulated in the company for distribution after retirement to avoid higher rates of tax.
- If ownership is to be passed or shared between family members, share capital offers greater flexibility than real property.
- The first £2,000 of dividend income for each recipient is taxable at 0%.
However, before you consider the tax rules in any detail you should consider first whether you need to be able to extract net profit from your property rental business on a frequent basis. You cannot forget that even though the rate of corporation tax is considerably lower, if you need to extract net profit from the business, where that business is operated through a company, you will encounter a second tax point on extracting those business profits.
The expected way to remove profit from a company is to declare a dividend. The current rate of tax on a dividend payment received by an individual is 32.5% for higher rate taxpayers. This means that you can either pay a higher rate income tax bill of 40% to get the profits from the business direct into your hands, or you can pay corporation tax at 17% followed by dividend tax at 32.5% (a total tax cost of 49.5%) to get into the same position.
It is for this reason that the first tax planning consideration when deciding how to structure a property rental business is often: do I need to extract the net profit immediately to cover my living expenses or can I leave the profit in the company and grow the business? Absent other practical considerations, we find that if a client needs to extract profit regularly to cover basic living costs, then they should be cautioned against using a company structure.
However, if your property rental business is focused on preserving profit for investment into further property, then on first principles, an incorporated property rental business may be a good option, subject to the following disadvantages being considered alongside the advantages listed above:
- Any private use of the property will give rise to a benefit-in-kind charge for the director/shareholder.
- All capital growth will occur within the company, resulting in a double charge to tax on gains when the property is sold and the company dissolved.
- There is a higher compliance burden in terms of filing accounts and annual returns.
- There is no annual exemption on realised capital gains (whereas individuals benefit from a £12,500 per tax year exempt amount for capital gains purposes)
- If the business comprises several rental properties and one is sold, the proceeds can only be extracted by way of income distribution.
- No relief will be available to the new company (following incorporation) for any losses or unused tax credit brought forward by the individual from earlier years.
Incorporating an existing directly held residential property business
If you are going to move from owning properties held in your personal name(s) to holding those properties in a company then you will need to transfer the properties. This is because a company is a separate legal person to you as an individual (or as individuals in a partnership). There will be legal costs associated with this; how onerous they are will depend upon whether the property is subject to a charge or mortgage to a lender.
There will also be tax implications, triggered by the fact that as an individual you are disposing of property and a separate legal entity is acquiring it. The presence of the disposal means that there is potentially a capital gains tax point for you as an individual, and the company may need to pay stamp duty land tax on its acquisition of the property. It is irrelevant that there may not have been any actual cash paid, because there are some tax rules that can operate to deem market value to have been paid.
There is a collection of tax reliefs, referred to very generally as incorporation reliefs, that can apply to mitigate these tax costs. The main reliefs are discussed further below.
Capital gains tax on incorporation
The biggest hurdle when incorporating a property business is usually the inherent capital gains tax liability on any gains that crystallise when a property is transferred. For tax purposes, the transfer of a property by an individual to a company will be a disposal for capital gains tax purposes and will be deemed to take place at market value. However, as long as 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 property. The added advantage is that the base costs of the property is uplifted tax free to market value on transfer into the company, thereby reducing any future capital gains tax on a later disposal of the property by the company.
In order to qualify for the relief, the properties rented out by the individual (or by the individual in partnership with others) must constitute a business. An individual owning a single rental property that undertakes little management activity is not sufficient to qualify as a business for these purposes (and so the relief would not be available). Ideally there should be at least three properties being regularly rented out that are actively managed, in circumstances where the landlord carries out a significant number of activities and generally spends at least 20 hours a week running them.
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 new company.
Unless the business being incorporated is a partnership, SDLT will be payable by the company on the market value of the property that is transferred to it on incorporation, using the market value at the date of transfer. The SDLT scale charges will include the supplemental 3% charge.
For SDLT purposes, the transfer of a property 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. 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. If the existing business is a partnership (as evidenced by a partnership agreement and the submission of partnership tax returns to HMRC) and all partners receive shares in the new company in identical proportions to that which their partnership share entitled them to, then relief from SDLT should be available. However, co-owners who seek to establish a partnership with the intention of claiming relief on subsequent incorporation may face a challenge from HMRC. 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.
It should also be noted that it is not possible to withdraw capital from a partnership within three years of land or property being added to it, otherwise there is a clawback of any SDLT relief that was claimed on incorporation.
In the event that the SDLT “incorporation” relief cannot be claimed, it is still possible that if at least two dwellings (excluding any with a value of £500,000 or more) are transferred in a single transaction or linked transactions, the company may elect for multiple dwellings relief, which will entitle it to calculate the SDLT charge on the average consideration of each property. If six or more dwellings are transferred in a single transaction, the non-residential rates of SDLT may apply. However, the non-residential rates of SDLT will not apply to any of those dwellings that are worth more than £500,000.
The summary above is only a brief canter through the multitude of issues that need to be carefully considered when deciding whether to incorporate a directly held property rental business. Before undertaking any sort of incorporation it is important to ensure that you have full visibility of all the tax triggers and issues. Equally so, it is important to understand the non-tax issues, such as those with bank financing and additional ongoing administrative costs and regulations that accompany running a business through a separate legal entity. These are all issues which we can advise you further on.