Buy-to-let residential landlords: To incorporate or not incorporate?
The legislation which progressively disallows landlords’ finance costs is effective from 6 April 2017. The regime, which effectively punishes borrowing to finance the business, will undoubtedly act as a barrier to entry for prospective landlords, leaving mortgage-free and corporate landlords unaffected.
The new legislation giving effect to these changes is to be found in ITTOIA 2005, Part 3 Chapter 3, starting with new section 272A (s. 272, ironically, being the section that says the taxation of property businesses should follow trading principles).
The new rules will be phased in from April 2017, as follows:
- 2017/18 75% of finance costs allowable, and 25% gets only 20% tax reduction
- 2018/19 50% of finance costs allowable, and 50% gets only 20% tax reduction
- 2019/20 25% of finance costs allowable, and 75% gets only 20% tax reduction
- 2020/21 No finance costs allowed against rental profits; 100% gets 20% tax reduction.
There are several ways that landlords can mitigate their increased costs. Some may be effective during the introduction phase of the new regime; others offer more lasting benefits.
For the purposes of this article, we will examine incorporation.
It would probably be fair to say that most BTL landlords who are aware of the new interest restriction regime will be aware of incorporation as a possible solution. But it is not a panacea. It would be broadly accurate to point out that, from a tax perspective at least, most property investment businesses would not be more tax-efficient if run through a company, were it not for the new interest disallowance rules. Incorporation brings its own costs – notably the new, more expensive dividend regime that applies to income tax on dividends paid on or after 6 April 2016 – and its own regime and administration overheads.
In the following paragraphs, we will evaluate the potential benefit of incorporation from an ongoing tax efficiency perspective. Of course, new property investment ventures may benefit from incorporation from the outset, without the hurdles faced by long-established portfolio owners.
Example: Individual vs company
Rose is a ‘modest’ property investor who is already a 40% taxpayer thanks to other income sources, with net rent of £15,000 after mortgage interest of £4,000. Assuming she were to take all the residual funds from the corporate alternative in the form of dividends (given that she has no tax-free Personal Allowance left), the outcome would be:
This model assumes that 2016/17 rates and allowances apply throughout. Corporation tax rates are of course set to fall to 17% by 2020/21, which would in turn increase the residue left for dividends to be paid out to Rose, increasing the net saving through incorporation. However, there are also likely to be higher ‘running costs’ in the corporate route.
The saving through incorporation is relatively modest, given that the cost of the new regime is only small in this example; it is perhaps unlikely, looking solely at these numbers, that a BTL investor would want to go through the exercise of incorporating this business, given the potential tax costs, fees and effort involved.
Example: ‘Career’ property business
If we take the example of a typical ‘career’ landlord with more extensive property interests and with higher levels of debt gearing, the potential ongoing savings of the corporate route become more apparent.
Rupinder has three young children (for which she claims Child Benefit) and a residential property portfolio generating £36,000 of net rental income, but after £30,000 of mortgage interest. Assuming that the facts, personal tax rates and allowances stay the same from 2016/17 onwards (but observing the downward trend in corporation tax to 17% by 2020/21 as mentioned above) and that she takes a modest salary of £8,000 to utilise her Personal Allowance / Primary Earnings Threshold, Rupinder’s results would be:
While it is clear that there is potentially significant ongoing tax efficiency for Rupinder in incorporating her residential property business:
- the results for 2016/17 show that, in the absence of a significant interest-related tax adjustment, there is little benefit in incorporating a property business – in fact, there is a cost in doing so
- the inherent ‘double tax charge’ of paying corporation tax, then income tax on the residue in order to withdraw the funds for personal use, makes incorporation expensive (in the absence of the NIC saving normally associated with trading enterprises)
- incorporation might not be cost-effective in the first few years of the introduction of the new regime – the saving in 2018/19 may not be worthwhile
- but, ultimately, the ongoing additional costs of a business with significant dwelling related loan exposure are so substantial that incorporation offers some comparatively substantial savings
- very broadly, greater efficiencies will be achieved with higher incomes and higher interest costs. For example, a doubling of the above mortgage and interest costs results in a saving by 2020/21 of more than double Rupinder’s outcome
- the model assumes that Rupinder needs to withdraw all of the company’s funds to meet her lifestyle demands – which is reasonable, given that her net funds are not actually going to increase under incorporation; the worst of the double tax charge may be avoided if some of the funds can be kept within the company.
- while not the focus of the examples, companies remain eligible for Indexation Allowance on their capital gains, thereby avoiding ‘inflationary gains’ (TCGA 1992 s 52A et seq).
Obviously, the suggested measures will not be appropriate for all portfolios, nor in all circumstances.
The tax implications of incorporating a buy-to-let business are not discussed here, but must be considered carefully. This topic is discussed in detail in Chapter 13 of the Buy-to-let Property Tax Handbook (Bloomsbury Professional).
If your client is not ready to take the plunge to incorporation, there are several other methods that could also be investigated, such as transferring income-producing assets between family members, planning the timing of expenditure, paying off capital, reducing the term of mortgages and thus accelerating finance costs, or making pension or gift aid contributions. One could also look at the effect of rationalising or diversifying the business.
For further explanation, case studies and worked examples on all methods, please see Chapter 3 ‘Finance Cost Relief Restrictions’ by Lee Sharpe in Buy-to-let Property Tax Handbook: http://www.bloomsburyprofessional.com/uk/buy-to-let-property-tax-handbook-9781784510541/