How to avoid paying tax on your rental income
Our resident landlord tax expert, Iain Rankin, has put together a great guide on how to reduce the amount of tax paid on income from your rental property
How can I avoid paying tax on my rental income?
He is very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit TaxKings Accountants for more information.
As a property tax adviser, perhaps the most common question I’m asked is 'How can I avoid paying tax on my rental income?'. The answer is, of course, that you can't. Or, at least, not without risking a hefty fine and a possible jail sentence, not to mention paying all the tax that you owed anyway plus interest and surcharges. Not a strategy then that I'd necessarily recommend.
If we alter the question slightly however and ask instead, 'How can I avoid paying ‘income’ tax on my rental income?', well, now we have grounds for discussion. We could even add, for good measure, 'How can I avoid paying capital gains tax and inheritance tax on my rental properties?'.
Holding properties within limited companies
Possibly the biggest trend that's occurred in my ten years as a property tax adviser is the ever-increasing shift to individuals holding properties within limited companies. Prior to 2016, this option was a niche one, solely for professional property investors. There was simply no need for most landlords to incorporate their rental businesses. In addition, 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
So what has sparked this trend? Step forward one George Osbourne and the changes to the tax treatment of mortgage interest, first outlined in the Summer 2015 budget. At one stroke, the company route became far more appealing even for smaller property investors. This trend continues and so the rates and mortgages available become yet more competitive.
Getting the ownership structure right
Now, this potential strategy is not for everyone. As things currently stand, it is only useful for higher and additional-rate taxpayers, as the changes to tax relief only affect them. It will become relevant to those basic rate taxpayers who have a combined (rental and other) income of over £40,000 and are looking to purchase a new Buy-To Let property, who will find themselves dragged into higher-rate tax. Getting the ownership structure right could thus make a massive difference to the amount of tax paid over your lifetime (and even beyond) from your rental income. So let's take a look at the potential advantages and disadvantages of holding property in a limited company.
Before we do though, as always, I would caution that there is no one size fits all solution to property taxation. I always recommend that you talk any potential strategy through with a property tax professional.
What are the Advantages of Using a Company to Invest in Property?
1. Lower Tax Rates
The main reason to 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 and capital gains tax rates. If you are a higher rate taxpayer, you pay 40% on your profit from your property rental. For a limited company, the corporation tax rate is currently 19%, set to fall to 17% by 2020 (we shall, of course, wait and see); a substantial saving.
As an individual taxpayer, you are taxed on all of your rental profit, no matter how you may distribute it. 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 fee allowance per individual. You can both time your dividend payouts for maximum tax-efficiency and choose to distribute them to family members who are basic rate taxpayers . Or you can simply leave the profits rolling up within the company to buy the next property.
2. Tax Treatment of Mortgage Interest
As of 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 is being phased in from April 2017 and you can read all the details in a previous blog post. [https://listentotaxman.com/uk-tax/tax-guides/landlord-tax-guide.html]
However, landlords structured as companies are exempt. 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 IHT purposes. If this 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
Imagine you own a buy-to-let property where 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 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. 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.
Sound good so far? There are, naturally, some downsides…..
Disadvantages of Using a Company to Invest in Property
1. Mortgage Availability
While you won't 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 dealbreaker than it used to be. It's true that the number of 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 need to take money out the company urgently
If you're leaving your rental profits in the company to re-invest, there is no issue. The company pays corporation tax 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
Compared to an individual filing a Self-Assessment tax return, companies have additional running costs as they require accounts to be formally filed and directors to approve 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 then you should be aware that companies do not pay Capital Gains Tax (CGT) on the profit, as an individual would. Hence there is no annual exempt tax free amount (currently £11,700). Instead companies pay corporation tax - 19% - 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.
Is a limited company right for you?
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?
Otherwise, 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?
Initially, of course, this will be you, but 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 company (if structured correctly) could result in huge Inheritance savings.
Before embarking on any property tax strategy, it is 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 a property tax expert.