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Should Landlords Incorporate their Property Rental Business?

Lee Sharpe from TaxInsider.co.uk looks at the implications for property businesses considering incorporation into a limited company, particularly in light of the tax changes announced in the summer 2015 Budget.

The summer 2015 Budget saw some important tax developments for property businesses and, as a result, there has been significant interest in the potential benefits of incorporating one’s rental business into a limited company.

It must be emphasised that:

some of these tax ‘reforms’ have not yet been set in law, and may change; and
‘unpicking’ an incorporation can be a messy affair. It is essential to get competent, tailored advice from a suitably qualified professional.

Key changes

While there were several announcements that potentially affect property investors, two are particularly relevant in the context of changing to a limited company:

Perhaps the most important development is that tax relief for mortgage interest (and other finance costs) is to be progressively restricted, from the 2017/18 tax year onwards. This applies only to unincorporated residential property businesses, and makes conversion to a limited company potentially very attractive.

But the tax efficiency of limited companies, in terms of profit extraction, will also be curtailed because of forthcoming changes to dividend taxation, which is set to become significantly more expensive.

Tax relief for mortgage interest

Mortgage interest (and similar/related finance costs) will be disallowed in rental income and expenditure accounts so that, for tax purposes, rental profits will be increased and taxed accordingly. There is a corresponding tax credit against the person’s income tax bill – but only at the basic rate of 20%. This means that those who pay tax at 40% (or more) stand to be significantly worse off under these new rules. Worse, disallowing substantial interest costs may well force many landlords into the 40% tax bracket even though they might generate only relatively modest net accounting profits. In other words, landlords may be caught out by this change even though they are currently only basic rate taxpayers (see example below).

This change basically applies only to persons subject to income tax – individuals, partnerships and potentially trusts. It also applies only to residential properties (with a specific exception for furnished holiday lettings, which are spared). The legislation also protects corporate landlords from the add-back, in most cases, although companies generally pay tax at only 20% anyway (and this tax rate will also fall a little in the coming years).

The restriction will be introduced in stages from April 2017 – the 2017/18 tax year – through to 2020/21:

2017/18 25% of interest costs, etc., disallowed; corresponding 20% tax credit
2018/19 50% interest cost disallowance; replaced by 20% tax credit
2019/20 75% interest cost disallowance; replaced by 20% tax credit
2020/21 100% interest cost disallowance; replaced by 20% tax credit

This will give residential property landlords a little over a year to prepare, before the effective cost of mortgage interest starts to rise significantly.

Dividends

The Chancellor also announced a ‘reform’ of the tax regime for dividend income. This is likely to be of particular interest to those who are already in ‘shareholder/director’ companies, or are contemplating the moving of their property business into a limited company, where they intend to take substantial dividends on their shareholdings

The changes, which will take effect from April 2016 (2016/17), are as follows:

the introduction of a new ‘dividends allowance’ which means that the first £5,000 of dividend income in a tax year is effectively taxed at 0%;
a 7.5% increase in the tax rate applicable to dividends across all bands; and
the abolition of the 10% notional tax credit which attaches to dividend income.

Example: Effect of interest relief restriction

Belinda has six residential properties. Each is let for £900 a month, and has an interest-only mortgage of £600 a month, leaving her with £300 a month net rental profit – £21,600 a year in total.

In 2016/17, (i.e. next tax year), her income tax bill for the year on her £21,600 rental profit will be £2,120. Let’s see what happens in the following years, with the Chancellor’s intended adjustments to mortgage interest:

Tax Year: 2016/17 2017/18 2018/19 2019/20 2020/21
£ £ £ £ £
Rental Income 64,800 64,800 64,800 64,800 64,800
Mortgage interest 43,200 43,200 43,200 43,200 43,200
‘Real’ profits 21,600 21,600 21,600 21,600 21,600
Add back: interest 0 10,800 21,600 32,400 43,200
Overall tax-adjusted position 21,600 32,400 43,200 54,000 64,800
Tax Liability
Initial 2,120 4,240 6,400 10,640 14,960
Replacement 20% Tax
Credit
0 -2,160 -4,320 -6,480 -8,640
Overall Tax 2,120 2,080 2,080 4,160 6,320
Net income to Belinda 19,480 19,520 19,520 17,440 15,280
Tax increase on 2016/17 -40 -40 +2,040 +4,200

For the first couple of tax years, Belinda is basically unaffected: while her tax-adjusted income stays in the basic rate band of around £43,000, the replacement tax credit keeps pace with the additional tax on her disallowed mortgage interest (in fact, she is slightly better off because of expected increases in tax-free personal allowance, etc.) However, the phased-in disallowance pushes her into the 40% higher rate tax band in 2019/20, and by 2020/21, her net tax bill has almost trebled from around £2,000 to over £6,000. Remember, Belinda’s actual profit – a modest £21,600 – has not changed throughout.

In a limited company

Let’s assume that Belinda instead incorporates her rental business at the beginning of 2016/17, to avoid the mortgage interest restriction applicable to non-corporates. She draws a modest salary and takes the rest in dividends, leaving nothing in the company.

Tax Year: 2016/17 2017/18 2018/19 2019/20 2020/21
£ £ £ £ £
Rental Income 64,800 64,800 64,800 64,800 64,800
Mortgage interest -43,200 -43,200 -43,200 -43,200 -43,200
Belinda’s Salary -8,000 -8,000 -8,000 -8,000 -8,000
Net taxable company profit 13,600 13,600 13,600 13,600 13,600
Corporation tax -2,720 -2,584 -2,584 -2,584 -2,448
Available to pay as dividends 10,880 11,016 11,016 11,016 11,152
Income Tax on dividends -216 -211 -211 -211 -221
Net dividend income 10,664 10,805 10,805 10,805 10,931
Add Belinda’s salary 8,000 8,000 8,000 8,000 8,000
Belinda’s net income 18,664 18,805 18,805 18,805 18,931
Belinda’s original income (previous example) 19,480 19,520 19,520 17,440 15,280
(Cost)/saving as a company: -816 -715 -715 1,365 3,651

While it starts off being more expensive to run the property business in a company, by 2019/20 (when the mortgage restriction serves to ‘push’ Belinda into 40% higher rate tax in the original unincorporated business), the potential savings quickly mount up. Deciding to incorporate in 2019/20 could optimise Belinda’s position.

Conclusion

It was clear from the Chancellor’s Budget speech and supporting documentation in July 2015 that he sought to deter ‘tax-motivated incorporations’ – i.e., where a business has converted into a limited company in order to benefit from a more favourable tax regime. The increase in the effective rate of income tax on dividends was part of this approach. And yet, in the same Budget, he has put a very substantial proportion of residential property landlords in such an invidious position that, for some, incorporation may be the only route to avoiding a significant increase in tax costs and perhaps even insolvency.

Practical Tip:

The changes to dividend taxation from April 2016 restrict the tax-efficiency of dividends. A company scenario may still be advantageous overall, however, for those with substantial mortgage gearing in their portfolios; those affected would do well to consult with their adviser, to see if a limited company offers the best way to avoid a substantial tax rise on mortgage interest costs.

FREE Report – Key Changes To Property Taxation Over The next Few Years
Lee Sharpe has produced a 5,000 plus word detailing the key changes to property taxation over the coming years. You can download a free copy here:

>> Key Changes To Property Taxation Over The next Few Years

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