Meg Saksida outlines some pitfalls to avoid where investment property is jointly owned.
For more tips on this important area of business taxation and plenty more business tax tips too, please see our recently released guide, Taxation Of Property Partnerships and Joint Ownership.
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Andrew Carnegie once said, “The wise young [person] or wage earner of today invests his money in real estate”. He was also quoted as saying, “Ninety per cent of all millionaires become so through owning real estate”. Carnegie died in 1919, but what he said must be true, as property ownership remains one of the best investments a savvy investor can make.
However, unlike shareholdings where the fruits of the investments are dividends with their £2,000 nil tax rate and generously lower tax rates per tax band, rental income is taxed at either 20%, 40% or 45%, depending on the individual’s level of income. One can, therefore, understand the pressure on taxpayers to try and lessen this load in any way they can.
Share the burden
One option for potentially lessening the burden is to hold the property jointly with another investor.
Firstly, pooled wealth sources allow for a more valuable property to be bought initially, and secondly, the profits will then benefit from two personal allowances for income tax purposes, the capital gains from two annual exempt amounts and, if gifting in later years is desired, the transfers from two inheritance tax nil rate bands. In addition, if the other joint owner has a lower income tax band or a lower tax rate, the profits can be split such that they are taxed in the most efficient way. Or can they?
It will depend on who the other joint owner is and whether there is a partnership as to precisely how the split of the income is made and, subsequently, how it is taxed.
Two individuals not married nor in a civil partnership
Assume there is no partnership. If two or more taxpayers own property together and there is no formal partnership, by default they will be taxed on the income according to their share in the capital.
For example, Milly, Molly and Mandy are three sisters who own a commercial property in the proportions 50%, 30% and 20% respectively. The property earns £60,000 in 2022/23. Milly is taxed on £30,000. Molly on £20,000 and Mandy on £10,000.
If the sisters wish to share the profits in another way, they can do this, but they would be well advised to have a formal contract or agreement setting out the split, just in case HMRC ask for verification of the apportionment at a later date. They will also need to ensure that the parties actually receive the same proportion that they declare to HMRC.
For example, say Milly and Molly have substantial income from employment, but Mandy is unemployed. They may wish to change the percentage to 10%, 10%, and 80%, so Milly and Molly receive £6,000 each and Mandy receives £48,000, ensuring that she has enough to live on and is not in the higher rate band.
Two individuals in a marriage or civil partnership
However, if the property is owned by a couple who are bound legally into a marriage or a civil partnership, it is not possible to opt for a profit split different from the actual ownership percentage.
HMRC will make the initial presumption that the couple is entitled to 50% each of all income and will tax them accordingly. This may be beneficial for the couple. For example, say Mork and Mindy are married, and Mork is a stay-at-home Dad earning no income and Mindy is employed and an additional rate taxpayer. If their jointly owned property was owned 90% Mindy and 10% Mork, this would be initially ignored by HMRC and both would be taxed on 50%. In this case, the split would be beneficial as Mindy would be taxed on 50% rather than her true holding of 90%, and Mork, 50% instead of 10%.
If this 50:50 situation is not beneficial to the couple (e.g., it was the other way around and Mork legally owned 90% of the property), the couple may inform HMRC of the true ownership. HMRC will only split the income between the couple if they are both entitled to a part of the income and they have an unequal entitlement. Proof must be given of the unequal entitlement.
Now let’s assume there is a partnership.
Where there is a partnership, the profit allocation can be made by the partners themselves. They do not have to be linked to the capital share invested (although they often are). This gives substantial freedom to split profits however they may wish, but it is not always the case that two or more individuals who join together to exploit an asset for profit are in partnership. To have a partnership, the joint owners must be carrying on a business.
The definition of a ‘business’ is much wider than a ‘trade’ and although it does sometimes encompass investment activities, holding land simply to generate rental income on it would not be enough to be a business. There are two categories of partnership to be considered.
An existing trading partnership
This is the situation where the two (or more) owners of the property already have a trade or business.
For example, two lawyer friends may be in business as a legal partnership. Perhaps they have a spare floor in the building they are trading out of and decide to rent this out. As they are already in business trading as a partnership, the rental income can be declared as partnership income. The share given to each of the partners will be in relation to their profit-sharing agreement in the partnership agreement.
An investment partnership business
Only found in the rarest of cases, here a partnership holding property is being run as an investment business. Usually, simply holding property is extremely unlikely to be a business when the only activity of the partners is passively jointly holding a property for profit.
However, if there are significant additional services in return for additional payment over and above the rent received for the letting of the building or land, this is a possible partnership scenario. HMRC covers this in its Property Income manual at PIM1030, where it states: “Much depends on the amount of business activity involved. The existence of a partnership depends on a degree of organisation similar to that required in an ordinary commercial business.” HMRC’s guidance goes on to state: “Merely holding property jointly does not constitute a partnership.”
Possible solutions?
The higher-earning spouse or civil partner may be keen to even up the income between the couple and gift the property to the lower-earning partner. This is quite a big (and risky) gift, and the donor spouse may instead consider gifting only the income by gifting the property to a life interest trust. However, a trust with a spouse or civil partner as a beneficiary is a ‘settlor-interested’ trust, and as such, any income arising to the trust is taxable on the settlor.
If instead, the properties are held through shares in a company, it could be considered a good idea to simply issue some non-voting shares to the spouse. However, as the shares would be wholly or substantially a right to income, the dividends would again, under the ‘settlement’ rules, be taxable on the donor spouse.
Practical tip
Andrew Carnegie was right, but Warren Buffett was even more right when he said, “Risk comes from not knowing what you‘re doing”. Letting the tax tail wag the property investment dog could end up causing a lot more admin for the donor spouse and end up not saving the couple anything at all.
