Few people buy investment property without borrowing part of the purchase price. As a result, getting tax relief for interest costs is an important part of the fiscal arithmetic in most cases. So, when legislation was introduced in 2017 to limit tax relief on interest paid on loans taken out by individuals to acquire residential property, it caused some rethinking in the market.
We won’t go into the detail of the new rules here: it’s enough to know that the increased tax payable can make lettings of residential property a lot less attractive and can in some cases even turn a profitable letting into a loss-making one. The rules have been phased in over a period and will have full effect from 6 April 2020.
There are a number of possible solutions. These include consolidating into a smaller, less highly geared portfolio or refocussing away from residential into commercial property, where the restrictions don’t apply. But since the restrictions apply only to individuals and partnerships and not to companies, one of the solutions being suggested is to transfer the letting activity to a company. That can indeed be the right answer: but it is nowhere near as simple as some advisers would have you believe. In this note we aim to explain why.
As well as ensuring full relief for interest costs, holding investment property in a company offers a lower rate of tax on retained profits. On the other hand, if all profits are distributed, the aggregate tax rate (corporate and personal) is higher than if you hold property directly; and capital gains in particular may be much more highly taxed. If low taxed profits are reinvested for long enough, faster growth in the company can outweigh tax on extracting it. The time to this tipping point depends on your personal assumptions for yields and growth and future taxes. Doing the comparative numbers is key to the decision to incorporate: but in this note we shall assume that the numbers are favourable, and we shall look only at the issues arising on the incorporation itself.
Transferring the letting business to a company will involve transferring the ownership of the property to it. That has two important tax consequences:
- Unless the property is of very low value, the company will need to pay Stamp Duty Land Tax (“SDLT”) on the value of the property transferred;
- To the extent that the property has increased in value since you acquired it, the transfer to the company will give rise to a gain chargeable to Capital Gains Tax (“CGT”).
It may be that even after accounting for SDLT, CGT and the professional costs of transfer, the tax advantages of operating the lettings through a company will nonetheless make incorporation worthwhile. But more often they won’t.
So, how to avoid CGT, SDLT or both?
There is a very useful relief that applies if you transfer a business to a company in exchange for the company issuing shares to you. It’s very often used to incorporate a trading activity, but it isn’t limited to trades: it applies to businesses of any kind. “Business” isn’t defined in tax law. In fact, it may mean slightly different things for different taxes. The problem is that in the context of this CGT relief it doesn’t (at least in the eyes of HMRC – and, unfortunately, the case law in on their side) automatically extend to property letting activity. And if what you are carrying on isn’t regarded as a “business”, there is no clear way to avoid or defer CGT when you transfer the activity to a company.
At the one extreme, simply owning and letting a property and appointing a managing agent to find tenants, carry out inspections and deal with all day-to-day problems will not be accepted as a “business” for these purposes. At the other extreme, owning a significant portfolio of properties, personally advertising for and selecting tenants, carrying out necessary maintenance or arranging for it to be done, and generally dealing with matters on a day-to-day basis will very likely be treated as a “business”. In between there is a wide grey area.
HMRC accept that incorporation relief will be available if you spend 20 hours or more a week personally undertaking “the sort of activities that are indicative of a business”. But that may lead back to the question of what sort of activities HMRC consider to be indicative of a business. Although HMRC may be persuaded to give their view in advance in a particular case, this may not always be possible.
There is also a relief from SDLT that can, in the right circumstances, reduce to nil the SDLT payable on transfer of property to a company. The relief applies if property is transferred from a partnership to a company that is, broadly speaking, controlled by the partners: which will usually be the case where a property investment business is incorporated.
However, there are a couple of flies in the tax relief ointment. The first is that it applies only to property transferred from a partnership. HMRC differentiate between (a) a partnership and (b) a number of people who jointly own and let property. The same criteria as we have discussed above in relation to CGT will apply here: if the co-owners are spending enough time actively carrying on “the sort of activities that are indicative of a business”, it’s likely that there will be a partnership and that the SDLT relief will be available. If not, it’s mere joint ownership, not a partnership, and SDLT will be payable in the usual way. Unhelpfully, HMRC say that in their view, partnership will be the exception rather than the rule – “Usually, there won’t be a partnership and the customer’s share from the jointly owned property will be included as part of their personal rental business profits.”
Where a letting is carried on in sole ownership, the SDLT relief will not be due. You might think that this can easily be overcome – first transfer the activity into a partnership (if you choose your partners carefully, such as a spouse or civil partner, this can be done without any tax or SDLT costs) and then have the partnership transfer the activity to a company so as to qualify for the SDLT relief.
The problem here is that there is wide-spectrum SDLT anti-avoidance legislation. Although it was originally enacted to counter specific complex and artificial arrangements, it is drafted in such a way as to catch much less arcane planning. Essentially, if as a result of transferring property from A to B via X the SDLT payable is less than it would be on a straightforward sale of the same property from A to B direct, the anti-avoidance legislation may kick in. So, transferring a property business (always assuming that HMRC accept it is a business—see above) into a partnership, with the clear intention and understanding that the business will thereafter be transferred to a company, will very possibly fall foul of the rule.
None of this is to say that there is nothing to be done to deal with the effects of the loan interest relief restriction as it increasingly comes to bite. But let no-one sell you incorporation as a “get out of jail free” card.
For more information, please get in touch with your usual BKL contact or use our enquiry form.