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Landlords - Should you incorporate or not?

Iain Rankin our Property Tax Expert, from TaxKings, takes a run through the decision making process to help you weigh up what the appropriate course of action is for you

This Guide was written by Iain Rankin, Landlord Tax Adviser at TaxKings Accountants. Iain now writes for Listentotaxman.com on matters relating to property tax and landlord tax. He is very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the TaxKings Accountants website for contact details.

This Guide was written by Iain Rankin, Landlord Tax Adviser at TaxKings Accountants. Iain now writes for Listentotaxman.com on matters relating to property tax and landlord tax. He is very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the TaxKings Accountants website for contact details.

First things first - you need to understand that incorporation isn’t just a magic wand that will save you thousands in tax. Of course, for some landlords it is, but it still takes very careful planning. If you want to do it right, it’s definitely not a next-day delivery service. I often get calls from landlords whose friends or colleagues have incorporated their portfolio, and they ask if I’m able to help them to do the same. They jump right in, guns blazing, asking how long it will take to form the company and get moving.

My answer is always that first, they need to figure out whether this is the right move to make.  Yes, it is possible to make big tax savings, but for many landlords it is absolutely not worth the hassle. So before we explain how you would incorporate, let’s take a few steps back and check that it’s actually going to benefit you.

Why would you incorporate?

There’s several reasons, but the most common reasons are:

  1. Your tax payable would be restricted to 19%; the current rate of corporation tax. This is a major advantage for those earning above £50,000 (and thus paying income tax at 40%)
  2. You avoid the notorious mortgage-interest restrictions which have been phased in since April 2017. These don’t affect companies at present.
  3. To ensure your loved ones are not hit with a large inheritance tax bill.
Are you affected by any or all of the above? If you are, read on! If not – why not read one of my other articles? I hear they’re outstanding.

First things to consider:

“All three apply to me! When can we get started?” I heard you exclaim. Not so fast, sir. We’ve got a few more considerations to make about before we dive in.

Now, a company is technically a separate legal entity from its owner (or owners). So when you transfer the property over to the company, it is essentially purchasing the property from you. This incurs two tax liabilities on each party. I’ll give you a clue on the first one – it starts with “S” and rhymes with “lamp duty land tax”.

Stamp Duty Land Tax

If the property is above £125,000 you pay SDLT at increasing rates on the value of the transfer. You can view the list of rates and their value benchmarks here. There is also an additional rate of 3% regardless of property value, or whether the property is the company’s first purchase. So whether you have a large property portfolio made up of properties below £125k, or just one very expensive property (we’re looking at you London landlords) the initial costs of transferring your properties over to a company can be quite high.

For some, SDLT alone can be a big barrier to incorporation. Let’s just say your property is valued at £300,000. Can you afford to loan your company £14,000 to cover the stamp duty it will incur when it “purchases” your property from you? In some cases, it’s worth it in the long run.

But then there’s the issue of capital gains tax (CGT).

Capital Gains Tax

Let’s say that 10 years ago, you purchased one of your properties for exactly £150k; a nice round number. Before you sell it on to the company, you’ll have to get it valued.

You sit down in your favourite café to read the valuation report. You’re surprised to see that the property value has doubled to £300k. Your area has become really trendy in the last 10 years - the entire street is full of beard barbers, craft beer shops and slickbacks and for some reason, people are willing to pay top dollar to be a part of it.

Sadly though, if you sell the property to your company, you’re going to have to pay tax on that £150k gain you’ve just made. In your case, you’re a higher-rate taxpayer, so that bill could be as much as 28% of the gain, which is £42k. I say “could” because CGT varies depending on you circumstances and whether you have other income. More on that later on, but I also covered it in this article.

You put down the report and start at your cold-brew coffee with a hint of disdain for a few minutes. You suspect that some of your other properties could incur similar tax liabilities. Although you can now bump up your rental fees, it isn’t going to make up for the CGT.

But, there’s hope.

For some of you, at least…

For some landlords, it might be possible to take advantage of incorporation relief. This enables a business to be transferred to a company without triggering a CGT charge, so long as the transfer of net assets is wholly in exchange for shares. There is, as you know, uncertainty as to whether simply owning rental properties amounts to a ‘business’. HMRC no longer provide clearance and, at some point, they may make the challenge. The property activities must provide the majority of your income, so you should have no other occupation or significant income source. The landlord must be actively managing the properties, spending around 20+ hours per week in doing so. The property business should be run to make a profit, with a ‘substantial’ turnover’. You need tenant management systems, banking arrangements and using ‘sound, recognised business principles’.

Interestingly, CGT can also be avoided if the property business is run as a partnership before incorporating. An added bonus is that if a property partnership incorporation exists, you are able to gain relief of up to 100% of the SDLT charge. Broadly, full relief from SDLT is given as long as the ownership of the new company matches the original partnership shares.

But the taxman isn’t just gonna let you off easy. We’re talking a genuine partnership here. Two individuals coming together to do business. You and your solicitor need to ensure that the partnership agreement and arrangement is watertight to ensure it does not fall into HMRC’s definition of a “fake partnership” with the sole object of avoiding tax.

Firstly, you’ll need a proper written partnership agreement, as well as separate bank account for the partnership. You’ll obviously need to have the partnership registered with HMRC, too. This alone is a fair bit of extra admin; it also means waiting a while before you can incorporate. You’ll first have to move your properties which you wish to incorporate into a partnership of at least two members.

As above, the partnership has to be a commercial business; you can’t just set up a partnership for a few days, incorporate it and expect to be clear of the taxman. This is a slow process. You will need to submit 3 years’ worth of self-assessments for the partners, as well as three years of partnership accounts. Once these have been produced, it is possible to incorporate the property business into a company.

This means that a genuine property partnership incorporation can be made with no immediate charge to tax, preventing the changes to the taxation of buy-to-let properties from making a significant impact, whilst enjoying the benefits of a limited company.

Hopefully you’re starting to understand why you can’t rush these things!

Luckily - for some of you - two spouses count as two partners. This of course makes things a bit more straightforward as your spouse goes on to become a company shareholder which widens your tax planning options in future. Although any two persons can form a partnership, in order to gain the SDLT relief, the partnership should comprise of family members or “otherwise connected persons”.

I know what you’re going to say next: “But Clare, my family avoid my calls, I’ve got no friends and zero sex appeal – who can I form a partnership with?”

My professional advice is to just pay the tax.

How do we actually incorporate?

The year is 2022. It’s been 3 years since we last spoke. In that time, you’ve convinced a family member (or otherwise connected person) to enter into a partnership with you. You’ve transferred all your properties and operated as an actual commercial business using “sound, recognised business principles”. Luckily for you, you also have “substantial” profits.

Nice one. Let’s incorporate.

SPV

We’re going to set you up with what we call an SPV, which is short for “Special Purpose Vehicle”. The SPV is basically just a flashy name for a company with a special purpose, usually property investment. We need to set up the SPV before we incorporate your partnership.

Market Value

The properties must be sold at a reasonable price i.e. market value. So first we need to find the market value for all properties. With this information you can arrange new mortgages for them in the company’s name.

Despite a far greater amount of mortgage products for companies year on year, you will still expect to pay a small premium on interest rates. Hopefully, in three years however, there will be yet more products available and rates will be nearer parity. Patience is indeed a virtue.

It may be possible to incorporate the property rental business in such a way that the legal interests in the properties, and the mortgages, would remain as they are. This is done by altering only where the beneficial interest in the properties lies. It's called a ‘Company Trust’ and you need highly specific legal and financial advice for this. It should be considered where finance has been obtained on particularly favourable terms, or on longer term deals which may incur early redemption charges.

Otherwise, at this point, you’re ready to transfer the title from your name to the company name on the mortgages. You’re ready, but... don’t do it just yet.

Just a final check

This bit is specifically aimed at anyone who has no experience in setting up a limited company before.

Let’s take a step back; have you made sure that every one of your tenants is ready for this transition? For example, all your tenants need to be paying into the company bank account now; do they have the right details? What about the deposit schemes, or AST’s? These people need to know that they’re dealing with a company now, not you personally.

This is simple stuff to anyone with experience of limited companies, but if you’re receiving company rental income into the wrong bank account, it can land you in a lot of trouble with the taxman. It’s worth making sure you’ve tied up all the loose ends.

This is why we recommend you start preparation for incorporation 9-months prior.

And lastly

Finally, you would draw up the final partnership accounts & tax return. If you’ve genuinely made it this far without an accountant (no chance) I’ll give you a tip; there’s a tiny box to tick which notifies HMRC that the partnership is ceasing to trade. Voila, you now have what we call “cessation accounts”.

When the time comes, we’ll then draw up the first year of company accounts & tax returns. As per usual, these accounts will detail the income, expenditure, assets and liabilities of the company at the end of its first year. But importantly, they’ll also detail all of the properties which the company has taken over, as well as the ‘base cost’ of the properties and company shares/shareholding.

The advantages here are that the base cost of all properties are now uplifted to market value and profit can now be distributed and split more favourably between shareholders.

So how much does it cost?

Six million dollars.

Not really. I suppose it could cost that much but if your portfolio really is that big, you might not want to rely on a free how-to-incorporate guide you found on the internet. It’s not that I’m not that good… I’m just not that charitable.

Obviously costs can vary wildly depending on the size of your portfolio. As usual, I’ll try and do a fair estimate for you.

When you take into account all the professionals involved (I’m talking accountants, solicitors, surveyors, financial advisors, mortgage advisors), the average landlord is probably looking at up front costs of about £4,500 as a ballpark figure.

This includes advice on operating the partnership as well as compliance stuff e.g. preparing and filing your tax return/accounts for the partnership. And then of course, there’s the cost of the incorporation process itself. This would also come to about £4,500 on average.

Let’s say you’ve got about 6 properties; that’s usually a good benchmark. Obviously it depends on the individual, but I wouldn’t scold the average landlord for thinking “hey, maybe I should incorporate” once their portfolio reached 6 or so properties.

So let’s at least try to estimate the rough costs of incorporating the average 6-property portfolio. I’ll be honest, the average property prices are surprisingly high, but let’s work with them anyway, and we can pretend you’re absolutely minted. I’m going to take a “best case scenario” approach here, and keep it as conservative as I can.

From the same index, we can see that the average property in the UK is valued at £228,147. For simplicity’s sake, let’s say your 6 properties are valued at £200,000 each; a nice round number, but just below average. That takes your total portfolio worth up to £1.2 million.

Congratulations, you’re loaded.

According to the UK House Price Index January 2019, home prices increased by 1.7% last year. That’s low, but 2013’s growth was lower, at 1.5%. Let’s say then that, you bought all of the properties in 2013 and (best case scenario) your portfolio value has only increased by 1.5% each year.

Stamp Duty Land Tax:

The stamp duty land tax on your 6 properties is calculated per property, rather than on the full value of your portfolio. You pay 0% on the first £125k of each property, and then 2% thereafter. There is also the higher rate of 3% on the full amount.

This works out at £7,500 per property, or £45,000 in total.

Capital Gains Tax:

I’ll leave out the math… Nobody likes working compound interest backwards.

So… an increase in value of 1.5% per year for the last 6 years means that each property would have been valued at £182,908 upon purchase. Therefore you’ve made a gain of £17,091 on each of your properties. Therefore your total taxable gain is about £102,549.

Congratulations, you’re being taxed.

You get a £12,000 tax-free allowance for capital gains. We can deduct that from your gains, bringing your total taxable gain down to £90,549.

I should note that I am simplifying things here; other variables may be involved. For more info, have a look at this article.

Is it safe to assume that someone with £1.2m in assets is a higher-rate taxpayer? I’d say so. Let’s say your income is exactly £50k (the higher-rate threshold).

Because you’re in the higher-rate tax band, you pay capital gains tax at 28%. That leaves you with a total CGT bill of £25,353.

So your tax liability is:

£45,000 in SDLT

£25,353 in CGT

A grand total of £70,353 just to transfer the properties over to a company. And don’t forget that your ongoing costs are increased too. Companies have greater compliance costs, as well as (generally) higher mortgage interest rates, and there are more tax issues to manage.

How much will I save?

Well, that’s the thing… it varies from person to person; I can’t give you an estimate, but the key is to think long-term. For a lucky young professional who might benefit from the company for another 30-40 years, the total savings would be huge. For those nearing retirement age, it won’t be as significant, although it may still be worthwhile for Inheritance Tax Purposes.

What I can tell you is that:

  1. This tax saving can make it easier to grow your property portfolio. If you’re paying higher-rate tax at 40%, on top of National Insurance Contributions, the 19% corporation tax rate increases the amount of profit which you are able to re-invest in your portfolio.
  2. You also get full tax relief on any mortgage interest costs. This can further reduce your tax liability, again helping you to grow your property portfolio in the long term.
  3. By gifting family members shares annually to use up allowances, you are able to begin the process of shielding your portfolio from inheritance tax. But that’s for another article.
  4. You gain the benefit of limited liability. In the event of a disaster, you are only liable for your initial share capital upon incorporation of the company. If a tenant were to take legal action, to claim compensation for whatever reason, this would limit your personal exposure to risk.

Summary

So… even if you do tick all the boxes, I’m sure you can see now that incorporation is something you have to take your time with. While it can be extremely beneficial, it will take a while to reap these benefits. It’s a slow process, best suited - though not exclusively - to those with high income, more than one or two properties, and (perhaps most importantly) the ability to think long-term. But each case is different and one should always consult with a professional tax adviser experienced in property incorporation. Incorporation is definitely not something I would recommend undertaking without the right team involved from the start. With so many variables and tax implications to consider, a poorly thought through strategy could end in a potentially ruinous tax bill and legal challenge from HMRC.

Hopefully, I’ve at least given you an insight into how the process works, and why you would (or wouldn’t) wish to go ahead with it.

This Guide was written by Iain Rankin, Landlord Tax Adviser at TaxKings Accountants. Iain now writes for Listentotaxman.com on matters relating to property tax and landlord tax. He is very happy to speak with Listentotaxman visitors to discuss any tax questions they might have – just visit the TaxKings Accountants website for contact details.

This article was published in our Guides section on 26/07/2019.

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