Company owned rental property
Written by Ray Coman
Historically, company ownership has not been a popular option for landlords. Gains on disposal of property are potentially liable to both corporation and capital gains tax. However, given the rules that will be introduced for landlords on restricting mortgage interest tax relief, and on the taxation of dividends, new opportunities have arisen for tax saving in a few, limited situations.
Capital gains tax on transfer of property from private to company ownership
Capital loss on transfer of a property to a company
Initial purchase of property by a company
Eventual disposal of the property
Deduction of interest from taxable profits
Income tax on drawings of company profits
Annual tax on enveloped dwellings
Capital gains tax on transfer of property from private to company ownership
Landlords owning property with pregnant gains are likely to pay tax sooner, and pay more tax overall as a consequence of transferring property into a company.
The transfer of a property into a company gives rise to a disposal for capital gains tax purposes. The gain is based on the market value of the property on the date of transfer. Consequently, the transfer of existing property could give rise to substantial capital gains tax (CGT) liability. Because no money changes hands on transfer of the company, it is possible that the cash is not available with which to meet the CGT liability to HMRC when it falls due. An instalment option can be reached with HMRC, where the transfer of property is effectively treated as a gift to the company (following section S281 TCGA 1992.)
If the property falls in value after the transfer into the company, capital gains tax has effectively been calculated on the property with a higher value than the amount for which the property was eventually sold. In this situation a capital loss would arise. However, a capital loss in a company can only be used to reduce future capital gains. If there are no further capital gains, the loss is wasted. In summary, the above scenario could result in more tax payable through company ownership than if the property remained in the hands of its original owner.
Incorporation relief
Under Section 162 Taxation of Chargeable Gains Act 1992, it is possible to claim ‘incorporation relief’, and thereby defer capital gains tax on transfer of the property to a company. In order for the relief to apply it has to be demonstrated that a ‘business’ was transferred. In a recent leading case “Elizabeth Moyne Ramsay v HMRC [2013]” it was decided that the owner of a block of flats had transferred a business and therefore qualified for incorporation relief.
Following this case, HMRC have stated that there has to be some degree of activity in the rental business in order for incorporation relief to apply. However, HMRC have not been more specific. In the Ramsay case, the landlord spent more than 20 hours a week attending to her properties. Where a landlord has a single property or uses a letting agent, it is highly doubtful that HMRC would regard the company activity as other than investment.
Most landlords hold one or two investment properties, and therefore incorporation relief is rarely applicable on transfer of a residence to a company.
Capital loss on transfer of a property to a company
Where a property stands at a loss, transfer to a company presents an opportunity for the loss in value to become a ‘taxable loss’. For instance, if a person makes a gain in a tax year, but also has a property which is worth less than it was acquired for, then transfer to a company provides an opportunity to mitigate capital gains tax without having to dispose of a loss-making property.
Stamp duty
Where the property owner will be the shareholder of the company, transfer to a company will give rise to stamp duty land tax based on the market value of the property at the time of transfer. The tax applies regardless of any cash or other consideration received by the owner in return for the property.
Where property is owned by a partnership it is possible that no stamp due will arise on the transfer. However the partnership would need to be carrying on trade and not merely holding investment property.
Often the purpose of a transfer to a company is for the company to eventually sell the property. However if, for any reason, the company returns the property to its original owner, this event would potentially give rise to further stamp duty land tax.
Initial purchase of property by a company
Where a property is purchased directly by a company, rather than transferred by a shareholder, the stamp duty and capital gains tax implications discussed above would not be at issue. Stamp duty would be payable by the company, but it would not be effectively paid twice by the same owner.
Financing
In practice, mortgage providers will typically offer financing to a company on less favourable terms than to an individual. The decision to purchase a property via a company should include an assessment about the availability and cost of finance. Early redemption charges may apply on transfer of a property to a company.
Eventual disposal of the property
Entrepreneur’s relief is not available on disposal of shares in a company owning residential property. A property letting business does not meet the definition of a ‘trading’ company for the purposes of entrepreneur’s relief.
The main drawback of the company ownership is the ‘double tax charge.’ First, corporation tax would be payable on any gain in the property. Second, capital gains tax would be payable when the company is closed and the proceeds are withdrawn by its owner.
To take an example, say a director adds £400,000 to a company in mortgage and their own funds to purchase a property and later sells the property for £500,000. After the sale, the first £400,000 would be paid back to the director and mortgage provider with no tax implication. The increase in value of £100,000 would be subject to corporation tax, say at 20%. Let us say that the owner decides to liquate the company following the sale, because capital gains tax on disposal of the share results in less tax than income tax on dividends. The remaining £80,000 would then be subject to capital gains tax. If the shareholder has available annual exemption of about £11,000 and is subject to tax at 28%, there is further tax to pay of £19,320. The overall tax is about 40%. This compares to tax of less than 28% if the property is held personally.
Deduction of interest from taxable profits
Company ownership has received renewed interest in response to the rules introduced in the July 2015 Budget. The new system, which will be gradually introduced between 6 April 2017 and 5 April 2020 will not permit mortgage interest to be deducted from taxable rental profits. In its place a 20% tax reducer will be applied to the amount of mortgage interest. The effect is that, from 6 April 2020, a higher rate taxpayer will receive on 20% tax relief on mortgage interest where that same person received 40% or 45% previously.
Provided the mortgage is for the purpose of the business, there is no restriction on the deduction of mortgage interest from profits for corporation tax purposes. However, corporation tax rates are 20%, reducing to 19% by 2017 and 18% by 2020, which is the same or lower than the basic rate of income tax. As a consequence, the comparative tax advantage of company ownership rests on the tax efficiency of extracting profits for higher rate taxpayer.
Income tax on drawings of company profits
From 6 April 2016, the first £5,000 of dividends are tax free, and therefore tax savings can be achieved. The dividend rate will be 32.5% for a higher rate taxpayer and 38.1% for an additional rate taxpayer.
The tax savings are therefore only applicable on the first £5,000 of profits. For every extra pound of dividend paid over the £5,000 allowance, 46 pence in tax is paid for company rental profits where 40 pence is paid for non-company profits. When profits reach a certain level, it will become more expensive, rather than less expensive to receive rents from a company.
As a point of clarification, a landlord who is a higher rate taxpayer will pay 46% in corporation tax and income tax on dividends over the £5,000 threshold. This compares with 40% payable on rental profits for property owned privately. The difference is 45% and 50.5% for an additional rate taxpayer.
The comparison ignores the deduction of mortgage interest. If the property is mortgaged, a higher rate taxpayer will be better off receiving rents from a company well after dividend have exceeded £5,000.
In an example where a landlord has £5,000 of dividend from other investments, his tax position on £10,000 of rental profit would be £4,000 on property owned privately and £4,600 if owned via a company. This is if the landlord is a higher rate taxpayer and has taken all profits out of the company as dividend. In another example where gross rents are £14,000 but mortgage interest is £4,000, a landlord who is a higher rate taxpayer would pay the same £4,600 on company owned property, but now £4,800 on privately owned property.
It is not straightforward to summarise whether company owned property will save tax. However, if rental profits are less than the available dividend allowance, then there is a clear tax advantage for a higher rate taxpayer. If the property is mortgaged then the tax efficiency of company ownership improves.
For a basic rate taxpayer, there is less likely to be any tax to be saved by owning property through a company. However a company could be used to allocate profits to a lower earning spouse. For privately owned property the income sharing ratio and capital sharing ratio is the same for all owners. However, through the allocation of different classes of share, it is possible to allocate company dividends so as to produce the most tax efficient outcome.
Dividends paid to a shareholder’s child, in excess of £100 per year, would be assessed to the parent. This applies to a childe who is under 18 and unmaaried.
Inheritance tax implications
Disposal of a property, during a person’s lifetime carries a risk that the lifetime gain on the property will be subject to capital gains tax, and that the value of the property in the estate will give rise to death duties. This would occur in the situation where a person suffers capital gains tax on the transfer of a property into a company of which that person is a shareholder.
When a person dies, there is no capital gains tax on any increase in value of property held in the estate. Consequently, it is more tax efficient for a property with pregnant gains to form part of an estate, than for the after-tax proceeds from the sale of this property to form part of the estate. In the former case, capital gains tax has been avoided.
Given that the exposure to capital gains tax is higher for property owned in a company, the potential for tax saving is also greater.
Death creates a capital gains tax free uplift in value. Therefore probate value, rather than original cost, will determine the gain on which the beneficiaries would be liable, on eventual disposal of the property.
A company owned property could be a tax efficient method of passing wealth to family members. One arrangement could be the allocation of lifetime rental profits to a spouse, and the passing of this property to children on death.
The ownership structure of the company is best established at the outset. Once the company owns property, the stamp duty and capital gains tax implications of any share restructuring will be at issue.
Annual tax on enveloped dwellings
A residence which is owned by a company or partnership and valued at more than £1 million, or more than £500,000 from 1 April 2016 will be subject to the annual tax on enveloped dwellings or ATED. The annual charge is £7,000 for properties worth between £1 million and £2 million and rises in stages until the charge reaches £218,200 for properties worth more than £20 million.
From 1 April 2016, the annual charge will be £3,500 a year for properties worth between £500,000 and £1 million.
A landlord who lets property at a commercial rent, and where the tenant is not connected with the landlord will be entitled to full relief from the charge. The ATED charge was introduced as an anti-avoidance provision for non-UK domiciled individuals using companies to mitigate their exposure to UK inheritance tax.
Recommendations
In summary, where rental profits are comparatively low and there is no expectation of capital gain, a company can carry some tax advantage over personal ownership. By the same token, the additional accounting cost of a company structure is likely to be at issue where rental profits are lower. The cost of financing should also be considered. The transfer of an existing property into a company could give rise to stamp duty and capital gains tax.
Company owned property could form part of inheritance tax planning. Changes to the tax rules poses a particular risk to lifelong tax planning, particularly in view of the capital gains tax exposure on withdrawing property from the company during the owner’s lifetime.
For higher value residence the annual tax on enveloped dwellings should be considered if the property is not let.
