Head of London Business Tax - Partner London +44 (0)20 7131 4331
Sarah Callanan, manager, and Mark Webb, partner, at Smith & Williamson advise a fictional client on changes to buy-to-lets and what they need to consider in the future.
Gary, a finance professional, bought some London property in 2014. He bought four buy-to-let properties at £500,000 each and has a loan of £1.6m on which he pays £75,000 mortgage interest a year. He has recently had someone value the property portfolio at £2.2 million. Gary receives £100,000 a year in rent from the property portfolio which he uses to pay mortgage interest, other costs, tax and loan repayments etc. He intends to maintain the portfolio for his and his wife Sharon’s retirement and to support their children.
Gary is growing concerned about the effect of the withdrawal of mortgage interest relief will have on his portfolio. As a 40% tax payer he had previously been able to set off the £75,000 mortgage interest against the rental income and only pay tax on the difference. He would like to know whether he will have enough money coming in from his rents to start paying off the loan, to give him a better equity stake in the properties or if he will have to raise the rents on his tenants.
Gary holds the property personally and manages them himself. A friend has suggested there may be some financial benefit in creating a company to manage his property portfolio. He would like to know if this is sensible advice.
Prior to this summer’s budget, Gary, as a private individual landlord, could use the interest paid on his mortgage each year to reduce the taxable profits on his let property. Gary had the potential of saving of up to 40% through mortgage interest tax relief.
With the Chancellor curtailing this popular relief, all of Gary’s rental profits before deducting interest will be taxable. Although the scheme will be gradually withdrawn from 2017 onwards, the regime is expected to be fully implemented by 2020. Following this, a tax credit equivalent to the standard rate of tax on the mortgage interest incurred can be deducted from this tax bill (reducing the tax allowance in Gary’s case from 40% to 20% of the interest). Although the final deadline is five years away it is important to begin planning for this eventuality now to avoid being left in a difficult situation.
The changes are likely to force higher rate taxpayers to pay substantially more tax. Standard rate taxpayers could also be affected by the increase in taxable profits potentially pushing them into a higher rate tax bracket.
Many commentators subscribe to the view that an individual should transfer their residential letting property business to a company. The benefit is that mortgage interest currently remains fully deductible against corporate profits (with net profits liable to corporation tax at only 20%, although this is expected to decrease to 18% by 2020). There are further benefits in potentially being able to retain some of the profits and recycle them to buy further property. However, there are a number of factors to consider before automatically using a company.
Cash Extraction - If Gary was to draw a salary from the company, the combination of two salaries, from Gary’s job as a finance professional and from the property company, could potentially move Gary in to the additional rate income tax band of 45%. A dividend is therefore a more advisable way to extract income from the company. From April 2016, dividend income in excess of £5,000 will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate and 38.1% for the additional rate.
Stamp Duty Land Tax (“SDLT”) – Gary paid £60,000 in SDLT in 2014 to purchase these residential properties originally. However, when moving the property in to a company, the company will have to pay SDLT again. When considering the increase in value of the properties, the company will have to pay an additional £70,000. Therefore, Gary will have had to pay £130,000 in SDLT plus legal costs in a little over a year.
Additional compliance costs – Annual Tax on Enveloped Dwellings (“ATED”) will need to be dealt with from 1 April 2016 (given the property values). While no annual levy should apply, given the relief available to let properties, this continues to add complication and cost.
The company will need to complete a tax return including supporting accounts, annual filings and financial statements with Companies House. The tax returns and supporting documents need to be in an electronic format that HMRC will accept.
Costs for financial statements, ATED, tax return filings and yearly Companies House filings will usually exceed at least £2,000 - £3,000 annually.
Capital Gains Tax - The transfer of residential let properties from an individual to a company will not trigger capital gains tax charges when “incorporation relief” is available. In summary, if a taxpayer transfers their sole trader business or partnership into a company in return for shares in that company, capital gains tax can be delayed until those shares are sold. Based on historic UK caselaw, which remains untried in a similar scenario to Gary’s, the relief is not automatic and activity has to be sufficient enough to amount to a business. Relief is dependent on the facts and, in the absence of the relief, CGT would apply to 28% of the gain incurred on a transfer to the company.
Therefore, the costs of CGT at £56,000 (gain of £200,000 x 28%)) and SDLT at £70,000 (4x((£125,000 x 0%) +(£125,000 x 2%)+(£300,000 x 5%)) are considerable. If CGT is payable up front, as with SDLT, then Gary will be left with a tax bill of £126,000, all of which will need to be paid within a short timeframe of the transfer of property.
Example: See below a basic calculation to illustrate the points above:
Annual rent: £100,000
Annual mortgage interest: £75,000
|Sole trader (prior to changes)||Sole trader (after changes)||Company (18% tax rate)|
|Tax @ 40% on NET profit||Tax @ 40% on Rents||Tax @18% on NET profit|
|Mortgage interest relief||(15,000)|
|NET tax payment||10,000||25,000||4,500|
|NET after tax (available for distribution)||15,000||0||20,500|
|Dividend distribution tax (DDT) on distributable profits (@32.5% with the first £5k tax free)||5,037.50|
|NET after DDT before secondary costs|
While the following advice applies to an established buy-to let investor, it can be contrasted with a new investor with similar types and values of properties. A new investor could set up a company from the outset and be liable for some of the expense.
What should Gary do?
A first impression might imply that it’s attractive for Gary to transfer his letting business to a company but the decision is not automatic. Without extensive savings, the large initial tax outlay on incorporation may require Gary to re-mortgage his family home or sell one of his properties. Professional advice should be sought in this situation as it is not obvious how to proceed as, based on the calculations, it will take between five to eight years for Gary to receive a return on his considerable investment, assuming there are no further changes to taxation!
This article has previously appeared in Citywire New Model Adviser
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
The tax treatment depends on the individual circumstances of each client and may be subject to change in future.
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