Many individual landlords will need to restructure their lettings business over the next five years in order to avoid huge tax increases. The problem is caused by a change in the tax treatment of property financing costs; from a deduction to a restricted tax relief. This change only applies to landlords who hold residential properties in their own names or as a partnership; non-residential and furnished holiday lettings are not affected, neither are corporate landlords.
Currently landlords can deduct all of the financing costs related to lettings from their rental income before tax. This deduction is to be reduced to nil in steps from 2017/18 to 2020/21 (F(no 2)A 2015, s 24). A tax credit equivalent to approximately 20% of the denied finance deduction will be set against the tax payable, but that will not alleviate the tax position for most landlords.
In practice, landlords will be taxed on their turnover less running costs, instead of their true accounting profit. A highly-geared property business may return an accounting loss after tax and be left with insufficient income to cover the mortgage payments.
Solutions to this problem involve selling part of the property portfolio to reduce debt, or restructuring in one or more of the following directions:
- sell the residential properties and reinvest in commercial buildings;
- let the residential properties so that they qualify as furnished holiday lettings; or
- transfer the residential properties into a company.
The sale of the properties, or transfer into a company controlled by the individual, is likely to generate capital gains. CGT will be due unless the gains can be covered by a relief, or deferred by reinvesting the gains under the Enterprise Investment Scheme (EIS) or Social Investment Tax relief (SITR). The Seed EIS (SEIS) can also be used to exempt up to £50,000 of gains per tax year, where the maximum permitted (£100,000) is invested in SEIS shares.
Where gains are expected to be relatively low per property, the properties could be transferred into the company year by year, such that the gains arising are covered by the taxpayer’s annual exemptions. Where properties are held in joint names, the annual exemption of both owners can be set against their proportion of the gain.
Most CGT reliefs (entrepreneurs’, business asset roll-over, hold-over for gifts) can’t be used on the incorporation of a property letting businesses, as letting is not regarded as a ‘trading business’. However, incorporation relief (TCGA 1992, s 162) can be used to roll-over the gains into the value of the company’s shares, if all the conditions are met.
The key condition is that the letting activity must be seen to be a ‘business’ rather than a passive investment. The leading case in this area (E M Ramsay v HMRC  UKUT 226 (TCC)) held that lettings can be considered a business if the activity is:
- pursued with reasonable or recognisable continuity;
- has a certain amount of substance in terms of turnover;
- conducted in a regular manner and on sound and recognised business principles; and
- the activities are of a kind which are commonly made by those who seek to profit by them.
In other words the lettings business must be substantial, and pursued for annual profits rather than long-term gains.
If incorporation relief is used no claim is required on the individual’s tax return, but it would be advisable to make a full disclosure of the transfers on the return.
When advising on incorporation, the imposition of SDLT, or LBTT in Scotland, must be considered. The mortgage provider must also co-operate with the transfer of loans to the company, and it may require higher rates of interest on a corporate loan.
Rebecca Cave is the co-author of Capital Gains Tax Reliefs for SMEs and Entrepreneurs 2015/16 (Bloomsbury Professional) which publishes next month and the co-author of Capital Gains Tax 2015/16 (Bloomsbury Professional).