Is incorporation always the best option for landlords?
Landlords of unincorporated property lettings businesses have had a rough time of it lately. Having only recently got to grips with losing the ‘wear and tear’ allowance and with mortgage interest now only being deductible at basic rates, the Covid-19 pandemic has hit; and with it an immediate loss of earnings, particularly with commercial lettings due to lockdowns; and loss relief only being available to carried forward.
But there is a stamp duty land tax (SDLT) holiday, and property prices might fall. Is the answer to incorporate?
Benefits of incorporation
(a) Corporation tax is lower Although the capital gains tax (CGT) annual exempt amount and inheritance tax (IHT) reliefs are not available to properties held in a corporate wrapper, the rate of tax for property income in the company is low at 19%. This means that if the profits from the rental properties are not required to be distributed, retained profits in the company can build up at a relatively low rate of tax. Furthermore, a distribution to the landlord through dividends, up to the £2,000 annual dividend allowance, is great way of extracting small amounts of annual profits out of the company with no additional tax to pay.
(b) All the mortgage interest can be offset As unincorporated residential landlords are now unable to offset mortgage interest on let properties at their highest rate of income tax, it may also be tempting for a higher or additional rate taxpaying landlord to incorporate their business in order to have all the interest offset at the same tax rate the rental income received is taxed.
(c) Corporation tax on gains is lower than CGT Higher rate taxpayers will also face a CGT charge at 28% on any gain on the disposal of the property (albeit subject to an annual exempt amount). In the company, on the other hand, any gain will be charged to corporation tax at 19%.
(d) Shares are a fungible investment and easy to split Spreading the income and associated tax burden is easier within families by owning shares rather than properties and dividends are especially good methods of income for basic rate taxpayers. Furthermore, planning for IHT on death may be easier with a property business inside a company rather than owned directly as shares are easy to leave to several legatees, whereas it is difficult to break up a property.
(e) Making tax digital and the 30-day CGT deadline Individuals selling residential property in the UK now need to declare and pay CGT due within 30 days after the completion date. This is not required for companies; unless they are large, they pay their corporation tax nine months and one day after the end of the accounting period.
Making tax digital is also due to come in for individuals’ annual business or property income above £10,000 from their next accounting period starting on or after 6 April 2023. The government has promised not to make this mandatory for companies before 2026.
Drawbacks of incorporation
(a) A property business is not trading One or more rental properties held by an individual is an investment not a ‘trading’ business. ‘Trading’ requires a far more intensive degree of activity and individual effort and time. In the context of a let property it is virtually impossible for such a business to be considered as a trade. This means that if the business is incorporated it will not become a trading company. The temptation to incorporate may be led by carrots such as business asset disposal relief (BADR), giving CGT on eligible shares at 10% and business property relief (BPR), allowing lifetime and death transfers free of IHT, but both of these reliefs are only available for ‘trading’ businesses.
(b) There may be CGT on incorporation Generally, any residential property brought within the last 40 years will be standing at a gain. As the landlord and the company will be ‘connected persons’ for CGT purposes, the proceeds for the calculation of the gain will be at market value, irrespective of the value of the shares received. Incorporation relief may be an option. Incorporation relief works as a deferral of the gain, whereby the gain reduces the cost of the shares that the landlord receives in exchange for the property on incorporation. Once these shares are sold in the future, the gain becomes chargeable. Incorporation relief requires ‘the sort of activities that are indicative of a business’ and HMRC state that the landlord personally spending 20 hours a week or more on such activities would obtain relief. Without this kind of commitment (although every case must be determined on its own facts) a simple buy-to let property business is unlikely to be eligible.
(c) Stamp Duty Land tax (SDLT) on incorporation As with the calculation of the capital gain, the calculation of SDLT (in England and Northern Ireland) will be made on the market value despite no cash proceeds having changed hands. In addition, there will generally be a higher rate of SDLT on the rental property business due to the additional supplement of 3% levied on the purchasing company. However, in July 2020 the Chancellor, Rishi Sunak, elevated the SDLT threshold from £125,000 to £500,000 in England and Northern Ireland, and this will continue until March 2021. The 3% supplement on purchasing as a corporate will still apply, but on a £500,000 property the duty will halve from £30,000 to £15,000, a saving of £15,000.
(d) Extracting profits is more expensive If the intention is to extract all the profits from the rental portfolio rather than keeping them in the company, the income tax rate will end up being higher despite the £2,000 dividend allowance. For example, if £20,000 property income is earned by a higher rate taxpayer, they would pay £8,000 in tax. If the entire rent was distributed the taxpayer would receive a dividend of £16,200 (i.e. £20,000 less 19% corporation tax of £3,800). They would be taxed in the company £3,800 and personally £4,615 (i.e. £2,000 @ 0% (dividend allowance) and £14,200 @ 32.5%), totalling £8,415.
(e) CGT Double charges In times of rising prices, there may be a double CGT charge if the property business is in a company. If a buy-to-let property is sold at a gain by an individual, the taxpayer will be charged to CGT on the gain. However, if the property is owned by a company, the gain will be calculated in arriving at the taxable total profits for the year. Furthermore, as the value of the company has increased, the share price will have increased. Therefore, if the shareholder sells their shares, which have gone up as a result of the sale of the buy-to-let, both the company and the shareholder will have capital gains on the same asset.
On balance… With the SDLT holiday in full swing, incorporation may currently be a good idea for those that have the intention to leave the profits inside the company, exploiting the 19% corporation tax rate as long as they have a property portfolio standing at either no gain, or a gain covered by their annual exempt amount.
Practical tip Tax is but a small part of a decision to incorporate a business. The personal preference of property income versus dividends or salary, the ability to raise loan finance inside a company, accounting considerations and other ad hoc ongoing expenses associated with a company should all be considered alongside the tax.