How to avoid paying tax on your rental income

*Please note the information in this article may be out of date

As property tax advisers, one of the most common questions we get asked is how you can avoid paying tax on my rental income.

Mon, 04 Nov 2019

'How can I avoid paying tax on my rental income?' Good question. The answer is of course, that you can't. Well, not without risking a hefty fine and some jail time, as well as having to pay all the tax that you owed anyway plus interest and penalties. So that is not a strategy we recommend.

However, if we change the question slightly and ask: 'How can I avoid paying “income” tax on my rental income?', well, now we have grounds for a discussion.

Holding property within a limited company

The introduction of Section 24 and the restriction of interest and finance costs has seen a huge change in how many landlords operate their rental activities.  Prior to these changes, operating your rental business through a company was rare, and utilised by landlords with much larger portfolios. There was simply no need for most landlords to incorporate their rental businesses. Also prior to the changes, mortgages available for property companies - often called SPVs (Special Purpose Vehicles) in banker/financial adviser jargon) - were scarce and not very competitive.

Changes to the tax treatment of mortgage interest

Why is the limited company route more popular now? Well, since George Osbourne first outlined the interest and finance cost changes at the Summer 2015 budget, the company route became far more appealing, even for smaller property investors. With more and more landlords operating via a limited company, the rates and mortgages available are becoming more and more competitive.

Getting the ownership structure right

This potential strategy is not for every landlord. As things currently stand, it is more useful for higher and additional-rate taxpayers, and those who were previously basic-rate taxpayers, who have become higher-rate due to these changes. Getting the ownership structure right could therefore make a huge difference to the amount of tax paid over your lifetime from your rental income. So let's take a look at the potential advantages and disadvantages of holding property in a limited company.

However, before we do, as always, we would caution that there is no one size fits all tax solution for landlords. We always recommend that you talk any potential strategy through with a property tax professional such as ourselves.

Advantages of using a company to invest in property

1. Lower tax rates

Let’s start with the main attraction.  The main reason landlords use a company to invest in property is the benefit of taking advantage of corporation tax rates and dividend tax rates, which are lower than income tax. If you are a higher rate taxpayer, you pay 40% on your rental profits; additional rate taxpayers even more. For a limited company however, the corporation tax rate is currently 19%, set to fall to 17% by 2020, which is a substantial saving.

If you own and rent a property held outside of a limited company, you are taxed on all of your rental profit, no matter how you distribute it.  On the other hand, a limited company can choose to distribute its profit in the form of dividends to shareholders. As a company director, you determine the income you receive in a particular year; some years you may take a sizeable dividend when other income is low.  Other years, when the opposite is true, you may not. Although dividends are still taxable, there is currently a £2,000 tax free allowance per individual. Or you can simply leave the profits, essentially reinvesting them within the company to buy the next property.

2. Tax treatment of mortgage interest

From 6 April 2020, mortgage interest will no longer be an allowable expense for individual property investors. Instead they will claim a basic rate allowance. For higher rate taxpayers, effectively 50% of the interest amount will no longer be deductible against tax. This change began to be phased in gradually over 4 years from April 2017.  You can read all the details in our previous blog post.

However, landlords with rental property within a limited company are unaffected by these changes. Instead, limited company landlords can subtract mortgage interest costs in full from their rental income before calculating their corporation tax. This means limited company borrowers will have a significantly reduced tax bill.

3. Transferring ownership to avoid inheritance tax

Outside of a company structure, if you wish to gift a property to your child, then this will incur a capital gains tax liability. However, if you hold the property inside a limited company, gifts of shares to family members will be Potentially Exempt Transfers (assuming they are bona fide) and therefore could reduce your taxable estate for Inheritance Tax (IHT) purposes. If it is done correctly, then the ownership can pass to your children tax-free, as the value of the transfer can be held over for capital gains tax purposes.

A property investment company can also be used as a means to provide an income to other family members, in addition to providing an IHT planning structure. Family members can be encouraged to take an active part in the running of the company and control can gradually be passed down.

4. Limited liability

Let’s say you own a buy-to-let property, and your tenant has an accident, falling down the stairs of your property as one of the steps was not properly maintained. He successfully sues you. You have no insurance, and you cannot afford to settle the bill. The word 'limited' refers to the 'limited liability' of the company’s shareholders. If the company goes bust in this scenario, then the worst that can happen is that the company ceases trading as it is insolvent. However, for an individual or a partner in a partnership, you could be forced to sell your own possessions – including your home - to meet the outstanding debt.

This all sounds great doesn’t it?  However, hold fire,  There are, naturally, some downsides…..

Disadvantages of using a company to invest in property

1. Mortgage availability

It is true that whilst you may not find quite as many options, and the rates and fees are likely to be higher than for a personal buy to let mortgage, it's far less of a deal-breaker than it used to be. It is true that the number of mortgage products on offer for limited companies is still much lower than for individuals, however, this situation is rapidly changing as ever more property investors hold properties in a company structure.

You will still need to give a personal guarantee and your own finances will be scrutinised so think of the company more as a 'tax wrapper'.

2. Personal tax issues

If you intend to leave your rental profits within the company to re-invest, there is no issue. The company pays corporation tax on your rental profits, and the post-tax income is left to roll up to buy more properties or maybe invest in a pension.

However, while we discussed dividend tax planning above, there may be an occasion where you need to take out a large one-off sum from the company. Removing large amounts of profits from a company as a dividend can incur personal tax charges of up to 38.1%.

3. Additional costs of compliance

Companies have additional running costs as they require accounts to be filed with both Companies House and HMRC, and directors to approve annual confirmation statements. This creates an added layer of responsibility for landlords choosing the limited company route. This will be handled by your accountant, but it will naturally come at some additional cost. Of course, a good tax adviser should still save you more than their fee so this should not be a major concern.

4. Loss of some tax reliefs

If you ever need to sell a property held in a limited company, then you should be aware that companies do not pay Capital Gains Tax (CGT) on the profit, like an individual would.  As such, there is no annual exempt tax free amount (currently £12,000). Instead companies pay corporation tax on the profit. Of course, for higher rate taxpayers this compares favourably to the 28% CGT rate after the annual exemption.

If you are ever planning to occupy a rental property as a main residence then using a company structure would not be beneficial. The company would not be able to claim PPR (Principal Private Residence) relief on a future disposal.  It is worth pointing out that there can also be quite negative tax consequences if a Director lives in a property owned by their own limited company. 

Is a limited company right for you?

As we mentioned before, every landlord has differing circumstances. There is no one size fits all solution.  The decision as to whether a company should be used to hold new investment property will essentially depend on your future intentions. Ask yourself the following key questions:

Do I have a lower-earning spouse whose name the property income could be put into?

If not, for higher rate taxpayers, the lure of paying the much lower rate of Corporation Tax is very strong.

Do I need property profits to cover my living costs?

If not then leaving profits rolling up in the company - for future purchases, or just until your non-property income falls - will leave you better off than if you need to take it out to spend.

Do I need mortgages to grow my property portfolio?

The ability to claim the entire cost of your mortgage interest as a deduction against corporation tax is a major argument in favour of using a company for higher-rate taxpayers.

Ultimately, who am I buying property for?

In the early days, this will be you, but you should consider your exit strategy – do you plan to sell off your property portfolio to pay for your retirement or is it important that you pass on your portfolio to your children or grandchildren? If passing on your properties is important to you, holding them within a limited company (if structured correctly) could result in huge Inheritance Tax savings.

And finally….get advice!

This is certainly not a decision you should rush into.  Before embarking on any property tax strategy, it’s crucial that you speak to an accountant who understands property tax. So rather than this post being the end of your research, consider it to be a brief overview of the main facts in advance of your detailed consultation with property tax experts such as ourselves.  Ultimately, you must make sure you are making the right decisions for the right reasons.  Tax is just one consideration, and the key is to achieve the fine line between minimising your tax and maximising your future wealth.