Sarah Bradford considers when a family may want to use a property company and when they may want to use a property trust, and the associated tax considerations.
There are different vehicles that a family can use to hold an investment property such as a residential buy-to-let or furnished holiday letting.
Where it is preferred not to hold the property personally, two options that can be considered are a property company or a property trust. Here, it is really a case of ‘horses for courses’ and the preferred options will depend on what the family are trying to achieve.
Property company
Tax changes in recent years have made operating as an unincorporated property business less attractive than it once was, particularly where the business involves the letting of one or more residential properties. Unincorporated property businesses can no longer deduct interest and finance costs as an expense incurred in relation to residential lets; instead, relief is given in the form of a tax deduction at the basic rate of 20%. There have been capital gains tax (CGT) changes, too – residential property gains must be reported to HMRC within 60 days of completion and the associated tax paid within the same window.
These restrictions do not apply to companies. Further, the current rate of corporation tax at 19% is lower than the basic rate of income tax, which is currently 20%. Together, these factors have resulted in many landlords deciding it may be more tax-efficient to operate via a property company. However, there are downsides, too.
If the landlord already has a property or properties and wishes to transfer them to a newly created property company, there will be tax implications. For CGT purposes, the transfer is to a ‘connected person’ and will be deemed a disposal at market value. However, if shares are received in exchange on the incorporation of the business, incorporation relief may be available. This relief is given automatically and defers the gain until the shares are sold by reducing the base cost of the shares. If incorporation relief is not beneficial (e.g., where any gain is sheltered by losses or the CGT annual exempt amount), it must be disclaimed.
There is also stamp duty land tax (SDLT) to pay on the acquisition by the company (in England and Northern Ireland). Where the property is a residential property, an additional 3% charge applies, even if the company only owns one residential property. SDLT will also be payable if the company purchases the property in its name. Where the property is in Scotland or Wales, the charge is to land and buildings transaction tax or land transaction tax, respectively.
A company pays corporation tax on its profits. The current rate of 19% is lower than the basic rate of income tax, and much lower than the higher and additional rates. Further, the company can normally deduct residential interest and finance costs in full in computing its taxable profit. However, unlike an individual, a company has no personal allowance and corporation tax is payable from the first £1 of profit.
Also, corporation tax rates are due to rise from 1 April 2023, where profits exceed £50,000. The rate will be 25% where profits are more than £250,000 and between 19% and 25% where profits fall between £50,000 and £250,000. These limits are proportionately reduced if the company has associated companies.
In deciding whether to incorporate, the forthcoming rise in corporation tax should be factored in, although where the landlord pays tax at the higher or additional rates, the corporation tax rates remain lower. For a basic rate taxpayer, it will depend on the company’s profits.
When the company comes to sell the property, any gain will be charged to corporation tax rather than CGT. Currently, this is at 19% compared to the 18% or 28% payable on residential property gains made by an individual. As corporation tax is payable nine months and one day after the year end, the window between completion and payment of the tax is much longer. However, unlike an individual, a company does not benefit from a CGT annual exempt amount.
One of the major disadvantages of operating as a property company is the need to extract profits if these are to be used personally outside the company. Profits can be extracted in a variety of ways, including as a salary or bonus or by declaring a dividend. Extracting profits may trigger tax liabilities on the recipient and, depending on the extraction method, National Insurance contributions liabilities for both the recipient and the company.
While there are definite advantages to operating as a property company, the family should consider the whole picture, including the tax cost of extracting profits, to ascertain whether this is the preferred option for them.
Property trust
The reasons that a family may consider putting an investment property (e.g., a buy-to-let property) into trust are different from the reasons for operating through a property company. Trusts are a popular way of mitigating inheritance tax (IHT), and where a family is considering a property trust, the likely driver is a wish to save IHT rather than to reduce tax on rental profits.
The tax consequences of putting a property in trust will depend on the type of trust that is used.
A transfer by the settlor of a property to a trust is a disposal for CGT purposes, and a CGT liability (at 18% or 28% where the property is a residential property) may arise on the settlor personally. Where the property is transferred to a discretionary trust, IHT is charged at the lifetime rate of 20% to the extent that the value of the property exceeds the settlor’s available nil rate band (£325,000 for 2022/23). However, this existence of an IHT liability (even if no IHT is actually payable) means that any CGT on the transfer of the property to the discretionary trust can be held over. There is no IHT on a transfer to a qualifying interest in possession (QIIP), and consequently, the gain cannot be held over.
If the property is gifted to the trust, there will be no SDLT to pay (as there is no consideration). However, SDLT will be payable where the trust purchases a property.
Where a rental property is held within a discretionary trust, income tax is payable on any rental profits. There are two different income tax rates for trusts. Income that falls within the first £1,000 is taxed at the standard rate of 20%. Income in excess of this is taxed at the trust rate of 45%. Unlike an individual, a trust does not have a personal allowance. If the rental property is held in an interest in possession trust, such as a qualifying interest in possession (QIIP), the trustees must pay tax on the rental profit at the basic rate of 20%.
When the income is distributed to the beneficiaries, they receive a credit for the tax paid by the trust.
The restriction on deducting residential interest and finance costs applies to trusts, so these costs cannot be deducted in computing taxable rental profits. Relief is given to a discretionary trust in the form of a basic rate tax reduction. Where the trust is a QIIP trust, the tax reduction is available to the beneficiaries.
While trusts are often used to mitigate IHT, if a discretionary trust is used, IHT may be payable by the trust. The transfer of the property to the trust takes it outside the settlor’s estate. However, as noted above, a charge at the lifetime rate applies where the property is put into trust to the extent that its value exceeds the settlor’s available nil rate band. The trust must also pay an IHT charge on each 10-year anniversary. An IHT charge may also arise when the property comes out of the trust (e.g., on the transfer to a beneficiary).
If the property is sold for a gain, CGT may be payable by the trust. Trustees have an annual exempt amount for CGT purposes. This is 50% of the annual exempt amount available to an individual. If the settlor has more than one trust, this amount may be reduced. CGT is payable by trusts on residential property gains at 28%.
Practical tip
Before deciding which route to take, the family members should determine what it is that they are trying to achieve. They can then ascertain how this can be achieved in a tax-efficient manner. As always, the tax tail should not wag the commercial dog.
