Meg Saksida considers whether the incorporation of a property rental business is worth it from a tax perspective.
Holding a property rental business personally can have several drawbacks, not least of which being the comparably high tax rate.
Unlimited liability is quite a scary prospect in these litigious days, and with the inability to offset mortgage interest at higher and additional rates coupled with income tax payable at up to 45%, is it any wonder that many landlords are considering the possibility of a corporate wrapper for their property businesses? At 19% corporation tax, a letting company should surely decrease your tax bill? However, as Shakespeare said, “all that glitters is not [always] gold”.
Corporate comforts and complications
(a) 19% corporation tax
The main reason incorporation is considered for tax purposes is the significantly lower tax rate of a company charged to corporation tax over an individual charged to income tax.
Even at basic rates, a taxpayer will pay 1% less with corporation tax at 19% than the income tax basic rate of 20% and the corporation tax rate is set to remain at this level for the foreseeable future for companies that do not have turnover above £50,000.
This rate is the same for corporate gains, which can be compared to the 28% rate a personal taxpayer would incur in capital gains tax (CGT) if the rental property sold was residential. Even for a commercial let, corporation tax is 1% lower than the higher CGT rate for individuals at 20%.
However, despite the headline incentives, holding property in a company means that the individual will no longer have a CGT allowance of £12,300 to offset against any gain. The gain will therefore be chargeable in full. Furthermore, a company does not get an income tax personal allowance, so all profits in the company are charged from the first £1 earned.
Another issue to consider when the temptation of the lower corporation tax rates is strong, is that unless the landlord shareholder wishes to retain the profits inside the company and use them to grow the corporate letting business, the profits will need to be extracted out of the company to be enjoyed. This will increase the overall tax of the owner by the income tax on the profits distributed.
If this distribution is made through dividends and for no more than £2,000 a tax year, no further income tax is payable due to the dividend allowance (currently at £2,000). However, depending on the income tax band of the landlord, they may be paying 8.75% (basic), 33.75% (higher) or 39.35% (additional) on any amounts over £2,000, in addition to the 19% paid in the company. If this distribution is made by other methods (e.g., interest payments or salary to the landlord) the income tax cost could be up to 45%.
(b) Mortgage interest can be offset
The limitation on personal landlords offsetting their interest payments was finally completely implemented in 2020/21. All interest charges will only be allowable at basic rates if the property business is held as a sole trader. However, this is not restricted in companies and all interest payments can be deducted in calculating total taxable profit.
Although this does look like a tempting prospect, the benefit of the interest offset is limited to 19%, so even less than the basic rate of 20% in a personal business. Once the interest has been offset at 19%, the balance will (as explained above) probably need to be distributed, and if the landlord is a higher or additional rate taxpayer, they will be paying the higher rates on the receipt of the profits anyway.
For example, using simple figures, suppose a property business earns £1,000 rental income and incurs a £100 interest payment. A higher rate taxpayer holding the business personally would receive net from the property: £520 (£900 less £380 income tax (i.e., (£1,000 x 40%) less a tax reducer of £20 (£100 x 20%)). The same amount in a company would yield a net corporate profit of £729 (£900 - £171 (i.e., £900 x 19%) but this profit would then be taxed on distribution to the landlord at either 40% or 33.75% (depending on whether it was distributed as non-savings, savings or dividend income) giving a net receipt of either £437 (£729 x 60%) or £483 (£729 x 66.25%). The advantage of being able to offset the interest no longer seems so advantageous.
(c) Shares are easy to split
As shares are fungible assets, this means they can firstly be owned by several different people and secondly be sold in a piecemeal fashion. Splitting the ownership of the property company might be a good idea inside families, to benefit from other family members’ lower income tax rates or unused personal allowances.
Dividends are also often a more tax-efficient way to receive income from the property business than trading income, as the rental business is often operated in addition to the landlord’s main source of income, which would have already used the personal allowance. Also, from an inheritance tax perspective, owning shares rather than having a sole trade in the estate means it is easier to bequeath shares to many different legatees.
Despite these benefits, the shares in a property company will always be from a business which is not defined as ‘trading’ but, rather, ‘investing’ (unless it is a furnished holiday lettings business). This means that many of the advantages given to trading businesses for both CGT (such as business asset disposal relief (BADR) and holdover relief) and inheritance tax (business property relief (BPR) will not be available to a rental property business).
When selling the properties, if they are held in a company, the shareholdings owned by the landlord will not be disposed of; it will be only the property inside the company, the gain on which will be charged to corporation tax inside the company, rather than CGT. The advantage here is that the rate is lower (though, again, if gains are to be distributed, this needs to be factored in) but jointly owning the properties through a company has the disadvantage that if the properties were held jointly personally, the disposal could have utilised more than one annual exempt amount.
Furthermore, if there has been a gain on the disposal of the property, the value of the shares could increase, leading to a double charge of the gain: once inside the company to corporation tax, and once on the increase in the value of the shares to CGT.
Cost of incorporation
Finally, when considering a company for the rental business, it is imperative to consider the costs of forming the company. There are, of course, the ongoing costs, such as drawing up the company accounts and such, but there are also the not insignificant initial one-off costs. The main cost to consider here is stamp duty land tax (SDLT) (NB Scotland and Wales have their own regimes). This will be calculated with the additional 3% supplement (due to a company purchasing the asset) on the market value of the property at the date of the incorporation. Remember, no cash will have changed hands so this will be a ‘dry’ tax charge. There may also be CGT on the incorporation of both the rental properties and other assets. Incorporation relief is unlikely to be available for a ‘small’ landlord.
Practical tip
Whether to incorporate or not is a very situational decision, contributed to by the personal tax position and income needs of the taxpayer, the inherent gains in the assets and the structure of the financing. For some, rather than glittery, a company structure might end up being fool’s gold.
