Sarah Bradford looks at the advantages and disadvantages of possible structures for rental property businesses.
When setting up a property business, one of the first decisions that has to be made is how the business should be structured. There are various options to consider, including an unincorporated business, a property partnership, a limited company or a limited liability partnership (LLP). As with most things, there are advantages and disadvantages to each. The trick is to find the structure that works best for your particular circumstances.
While this article focuses on the tax implications of each, the non-tax considerations should also be borne in mind. As ever, it is important to not let the tax tail wag the proverbial commercial dog.
Unincorporated property business
Most property business are unincorporated property businesses, with the properties in question being owned by individuals, either alone or jointly with others (such as with a spouse or civil partner).
Under the property income rules, all UK properties in the same ownership (other than those which qualify as furnished holiday lettings) are treated as part of the same property income business. The profits and losses are computed for the business as a whole, rather than by reference to each individual property, taking account of the income from all properties and the expenses from all properties to arrive at the profit or loss for the property income business. Properties which count as furnished holiday lettings form their own property business.
Each individual is taxed personally on their share of the profit from the property income business. Consequently, they will pay tax at their marginal rate of income tax. If the individual is a higher or an additional rate taxpayer, this will mean that the profits are taxed at 40% or 45% (as applicable). Letting property is normally regarded as an investment, and as such, National Insurance contributions are not usually charged.
Where the annual rental income is £150,000 or less, accounts should be prepared on the cash basis, which is the default basis. However, the landlord can elect for it not to apply if they prefer to use the accruals basis to prepare their accounts.
In recent years, tax relief for interest and other finance costs has been restricted. For 2020/21 and later tax years, relief for all finance costs is given as a tax reduction at the rate of 20%, rather than as a deduction giving relief at the landlord’s marginal rate.
When a rental property is sold, landlords will pay capital gains tax (CGT) on any chargeable gain at the residential rates (18% where income and gains do not exceed the basic rate band and 28% thereafter). Residential gains realised on or after 6 April 2020 must be reported to HMRC within 30 days and a payment on account of the CGT due made within the same time frame. Recent tax changes have removed lettings relief other than where the landlord lives in the property with the tenant, and reduced the final period exemption for properties which have been the main residence at some point from 18 months to nine months. These changes came into effect from 6 April 2020.
Property partnership
The fact that property is owned jointly is not of itself sufficient to create a property partnership. In most cases, joint owners will be assessed on their share of the profits. For spouses and civil partners, the default position is a 50:50 split regardless of actual beneficial ownership, unless an election is made on Form 17 for income to be taxed in accordance with underlying beneficial ownership. For other joint owners, profits and losses normally follow ownership shares, but the joint owners can agree a different split.
However, in a property context, a partnership might occur where the joint owners are in a trading or professional partnership, which also lets out some of its land and buildings. More rarely, the joint owners may run an investment business in partnership, which comprises the letting of property.
Where a partnership exists, each partner is taxed personally on their share of the partnership profits, allocated in accordance with the profit sharing arrangement. Varying the profit sharing ratios will change the allocation of profits and losses between the partners.
Limited company
Running a business through a property company has become more popular following a number of tax changes adversely affecting unincorporated property businesses. In addition to the benefit of limited liability, there are a number of perceived tax benefits to operating as a company.
Profits are charged to corporation tax rather than income tax. As the corporation tax rate (currently 19%) is lower than the income tax rate, there may be tax savings to be had. However, unlike an individual, a company has no personal allowance. The interest restrictions applying to unincorporated landlords do not apply to property companies, which are able to deduct interest and finance costs in full when computing profits. However, relief for those costs is at the corporation tax rate of 19% rather than at the basic rate of 20%.
While the rates of corporation tax may be lower than the income tax rates, it is likely that the shareholders will wish to extract the profits from the company and this may incur further tax charges. These must also be taken into account.
Where a property is sold at a gain, the gain is chargeable to corporation tax rather than to income tax. Consequently, gains are taxed at 19%, rather than at 18% or 28%. However, companies do not benefit from the annual exempt amount, which allows an individual to realise gains of £12,300 tax-free (for 2020/21).
Where the property portfolio comprises residential properties, a potential downside of operating through a company is the annual tax on enveloped dwellings, which applies where UK residential properties with a value of £500,000 or more are held in a company. The annual charge (for 1 April 2020 to 31 March 2021) ranges from £3,700 for a property with a value of £500,000 up to £1 million, to £236,000 for a property with a value in excess of £20 million. Holding high value residential property in a company can be expensive.
If the company is created after the properties have been acquired, there is also the issue of transferring the properties into the company, which may trigger both a SDLT liability (or its equivalent in Scotland or Wales), and also a CGT bill (based on the market value of the property). This will not be an issue if the company acquires the properties itself; and on the plus side, it may be easier for the company to raise the necessary finance than for an individual landlord.
Property LLP
A property LLP is something of a halfway house, providing the comfort of limited liability with flexibility as to how profits are shared. Like a company, it must be registered at Companies House.
The use of a property LLP can be particularly useful in a family situation where the individuals each hold property in their own name, but a different income split would be beneficial from a tax perspective.
An LLP can hold property in its own right. The LLP can acquire property or the partners can transfer property that they already own into the LLP.
Transferring property into the LLP can be advantageous from a tax perspective. The property is held on trust in the LLP, but the underlying legal ownership is unchanged, meaning there is no SDLT or CGT to pay. Where a member transfers property into the LLP, the value of that property at the time of transfer forms the opening balance on their equity account.
From a tax perspective, the individual partners are treated as being self-employed and must pay income tax on their share of the profits, and also Class 2 and Class 4 NICs, where relevant.
One of the key benefits of the LLP is the flexibility to share profits and losses. This provides the potential for a tax-efficient distribution. Profits and losses are shared in accordance with the ratios on the members’ capital accounts. However, the ability to pay salaries in a different ratio provides the flexibility to tailor the distribution in a tax-efficient manner. Providing or withdrawing capital will also change the default profit sharing ratio.
Where a property is sold realising a gain, the individual partners pay CGT on their share of the gain.
Practical tip
When planning the set-up of a rental property business, consider the different possible structures, choosing the one that best meets your needs.
