Sarah Bradford takes a look at the differing tax consequences of operating a property business as an unincorporated business and operating as a limited company.
When setting up a property company, one of the choices that needs to be made is the form that the business should take. While there are a number of different options that can be considered, the decision is often whether to incorporate or not.
From a tax perspective, the implications differ, and there are advantages and disadvantages to each.
1. Unincorporated property business
Where a property business is run as an unincorporated property business, the profits of that business will be taxed in accordance with the property income rules.
Under these rules, all properties owned by the same person or persons form a single property rental business, with the exception of properties let as furnished holiday lettings, which have their own rules and which are treated as a separate furnished holiday lettings business.
For an unincorporated property business, the profits are computed for the business as a whole, rather than on a property-by-property basis. This effectively means that a loss on one property is automatically offset against the profits on another property.
(a) Cash basis
The default basis where rental income for the tax year is £150,000 or less is the cash basis. Where this is the case, as long as the landlord is not otherwise excluded from the cash basis, profits are computed by reference to rental income actually received in the period and expenses actually paid. This has the benefit of simplicity, as there is no need to take account of debtors and creditors or prepayments or accruals.
However, if the landlord would prefer to use the accruals basis and is eligible for the cash basis this can be done, but the landlord needs to elect to do so.
(b) Availability of the personal allowance
A landlord’s profits (or share of profits) from an unincorporated property rental business are taxed as his or her income personally at the landlord’s marginal rate of tax.
Where the landlord has not used his or her personal allowance elsewhere, this is available to set against the profits from the property rental business.
(c) Relief for finance costs
If the landlord has taken out a mortgage or loan to fund the purchase of the let property, tax relief for the interest and any associated finance costs (but not any capital repayments which do not qualify for tax relief) is given in the form of a tax reduction at the basic rate of income tax, rather than deducting the costs as an expense in working out the profits of the property rental business. The effect of this is that relief is given only at the basic rate, rather than at the landlord’s marginal rate of tax, where tax is paid at the higher or the additional rate.
If the landlord’s tax liability is less than the tax reduction for interest, unrelieved interest can be carried forward and relief obtained in a future period. The tax reduction is capped at the amount that reduces the landlord’s tax liability to nil; it cannot generate a repayable amount.
(d) Property income allowance
Landlords with rental income of £1,000 or less benefit from the property income allowance and do not need to declare their rental income to HMRC. Where rental income is more than this, the landlord can choose to deduct actual expenses or the £1,000 allowance.
Where actual expenses are less than £1,000, deducting the allowance instead will be beneficial.
(e) Losses
Where the property rental business makes a loss, the loss can only be relieved by carrying it forward and setting against future profits of the same property rental business.
(f) Capital gains
When the property is sold, the landlord will be taxed personally on the gain (or on their share of the gain). The gain can be reduced by any available losses, and sheltered by the annual exempt amount, where available.
Gains are taxed at the residential rates of 18% and 28% (as applicable). Gains on residential properties must be reported to HMRC within 30 days of completion and the associated capital gains tax (CGT) paid within the same time period.
2. Limited company
A limited company is a separate legal entity. Where a property business is to be operated as a limited company, it is necessary to set up a company and register it with Companies House. The company must file annual accounts and complete a confirmation statement each year.
(a) Profits charged to corporation
Where a property business is operated through a limited company, the profits are charged to corporation tax. Currently at 19%, the rate of corporation tax is less than the basic rate of income tax. However, corporation tax rates are set to rise. From 1 April 2023, the main rate (applicable to companies with profits of more than £50,000) rises to 25%, with marginal relief reducing the effective rate where profits are between £50,000 and £250,000. A small company’s rate of 19% will generally apply where profits are less than £50,000.
Unlike individuals, companies do not have a tax-free allowance; hence corporation tax applies from the first pound of taxable profit.
(b) Deduction for finance costs
Unlike an unincorporated property rental business, a property limited company can deduct interest and other finance costs in computing its profits chargeable to corporation tax. This means relief is given at the corporation tax relief of 19%.
Further, there is no cap on the deductions, which can create or augment a loss.
(c) Annual tax on enveloped dwellings
Where a limited company holds residential properties valued at £500,000 or more, it is necessary to consider whether the annual tax on enveloped dwellings (ATED) arises.
In most cases, where the company operates as a rental business, the ATED charge will not apply, as long as the business is operated on a commercial basis with a view to profit. However, the company should check that it meets the conditions for exception.
(d) Chargeable gains
Any gains arising on the sale of a rental property are charged to corporation tax rather than to CGT. Consequently, gains are taxed at the corporation tax rate of 19%. However, there is no annual exempt amount to set against the gain.
Residential property gains made by companies do not need to be reported to HMRC within 30 days; the corporation tax is generally payable by the corporation tax due date of nine months and one day after the year end.
(e) Losses
Where a loss is made by a limited company, the loss can be carried back, generating a tax repayment. Normally, a loss can only be carried back to the previous accounting period; however, due to the Covid-19 pandemic, it is possible to carry back losses made in accounting periods ending between 1 April 2020 and 31 March 2022 up to three years.
Where a loss cannot be carried back, it can be carried forward and set against future profits from the same business.
(f) Extracting profits from the company
If the landlord wishes to make personal use of the profits generated by the property company, it will be necessary to extract those profits from the company, and this may incur tax and National Insurance contributions (NICs) liabilities.
Where the landlord does not have other income, a popular tax extraction strategy is to pay a salary equal to either the primary threshold for Class 1 NICs purposes (£9,568 for 2021/22) or, if the National Insurance employment allowance is available, equal to the personal allowance (£12,570 for 2021/22), and to extract any further profits as dividends (assuming the company has sufficient retained profits to declare a dividend).
There are other routes by which profits can be extracted from a company, too, including pension contributions, benefits-in-kind and rent.
Which is best?
There is no ‘one-size-fits-all’ and no substitute for doing the maths. At first sight, it may look like operating as a limited company is a winner as the rate of corporation tax is lower than the basic rate of income tax, and finance and interest costs can be deducted in calculating taxable profit.
However, a company does not have a personal allowance or a CGT annual exempt amount, and any profits made by the company must be extracted from the company, which may trigger further liabilities.
Practical tip
Do not assume that a lower corporation tax rate and unrestricted interest relief means that it is more tax-efficient to run a property business as a limited company. The best outcome will depend on individual circumstances and on the numbers. Look at the whole picture and do the sums.
