Should I incorporate my property portfolio?
There is much discussion at present about whether an individual should incorporate a property portfolio, ie move it to a limited company. This article explores the pros and cons.
The key driver from clients is the reduction in relief for mortgage interest against individuals’ property income. For a 40% taxpayer, the tax bill will increase by 5% of the amount of the interest each year from 2017/18 to 2020/21. After that time, relief for the interest will only be at the basic rate of 20%.
Incorporation gives other benefits as well
- In the company which acquires the portfolio, the base cost of the properties in computing capital gains is the market value at the time of incorporation. Therefore, the gain from original cost to current market value is wiped out and not taxed.
- The tax rate on net rents, after full mortgage interest relief, is only 20% reducing over the next few years to 17%.
There are three main obstacles in the way of incorporation:
- Possible Capital Gains Tax on all the properties on the transfer to the company based on current market values.
- Stamp Duty Land Tax on the transfers of the properties.
- Dealing with any mortgages on the properties.
To avoid Capital Gains Tax, Incorporation Relief can be claimed, the effect of which is to hold over any gains arising. However, this requires the portfolio to be classed as a business and, for many years, the view of HMRC was that this was never the case. This view was challenged by a Mrs Ramsay who claimed Incorporation Relief and was challenged by HMRC, who won their case when it was heard by the First Tier Tribunal.
Mrs Ramsay’s husband, then appealed on her behalf in the Upper Tax Tribunal and the previous decision was overturned. This has set a benchmark whereby Incorporation Relief should be available if there are more than 8 properties and the time involved in running them is 20 hours or more a week. It might be possible to claim the relief with less activity than this, but that has not been tested.
Stamp Duty Land Tax is more difficult to avoid. Many people who incorporate their portfolios agree to pay this tax, although this is less attractive now that each transfer will attract the 3% surcharge for multiple ownership, but that is one option which should be quantified before embarking on any alternative.
A way of avoiding the Stamp Duty Land Tax involves firstly transferring the properties to a partnership. In some cases, a partnership will already exist although we have found that to be a rarity – even if clients think they have a partnership, what they actually have is joint ownership of the properties. Normally, the decider will be whether they have declared the income from the portfolio on a partnership tax return each year or, the norm, they have declared their respective shares directly on their personal returns.
When the properties are in a partnership, the income is divided between the partners and they are taxed on their shares. This will be no different from tax on income where the properties are jointly-owned. However, losses on the partnership portfolio cannot be offset against profits from any properties held personally and vice versa. The restrictions on mortgage interest relief will continue to apply as will the personal rates of Income Tax.
After a partnership has owned properties for 3 years or more, they can be transferred out to a limited company, the shares in which are owned by the partners, without a charge to Stamp Duty Land Tax. This is a strange result of the partnership rules for Stamp Duty Land Tax which contrasts to where properties are transferred to a company by the individuals directly, where the tax applies in full.
The final obstacle concerns mortgage lenders. Probably, there is little or no difficulty if the initial transfer is to a partnership (not a LLP) between the individual owners because the Land Registry title will not change. However, on a transfer to a company, the lenders’ agreement will be needed or the portfolio remortgaged.
To avoid seeking the lenders’ agreement, many incorporations are implemented using Declarations of Trust. This means that beneficial ownership of the properties is changed to the company, which will agree to take over the mortgage obligations of the individuals and that works fine for tax purposes. It is a private agreement between the individuals and the company which, often, is not notified to the lenders. Legal advice should be obtained on how the mortgage agreement might impact and whether the lenders have any recourse to the borrowers if they find out that they have been kept in the dark. No change to the Land Registry title is needed because the individuals state that they continue to be registered as the owners of the properties but on behalf of the company.
There are other factors which become relevant after incorporation. The first is the rate of interest charged by lenders to company portfolio owners, which is generally 1% to 2% higher than charged to individuals, sometimes more. This will apply as and when any property is remortgaged after incorporation, perhaps if an existing mortgage is for a fixed term. The higher rate of interest might wipe out the benefit of the lower rates of tax in a company than for individuals and the sums have to be done to ensure there is no overall increase.
Another factor is the availability of income to the individuals after incorporation. A company is absolutely fine if the profits from the portfolio are reinvested into it by acquiring new properties or paying down the mortgages. However, any net income which is withdrawn for personal use will be taken as dividends and taxed on the shareholders. The overall rate of tax on withdrawn income is 20% Corporation Tax in the company plus (for a 40% taxpayer) 32.5% of the 80% which remains, which is a total of 46%. This is obviously more than the 40% rate charged on individuals who own property direct. This might be worthwhile, but only if the drawings are significantly less than 100% of the profit on the portfolio or are occasional.
Inheritance Tax planning changes with shares in a company as compared to individually-owned properties:
- With shares, they can probably only be given away in lifetime by transfers into trust. These will be subject to Inheritance Tax at 20% on the value, but no Capital Gains Tax or Stamp Duty Land Tax.
- With properties, they can be given away to other family members without any immediate Inheritance Tax, but they will be subject to Capital Gains Tax on the donor based on current market value and any mortgage liability assumed by the donee will be subject to Stamp Duty Land Tax.
The sums should be done if Inheritance Tax planning is desirable to see which is the better option. Consideration might be given to making any gifts before incorporation happens, perhaps by giving away shares of income during a period when the portfolio is owned by a partnership.
Incorporation is not for everyone, but there can be significant advantages, particularly if significant capital gains are foreseen on sales of properties in the near future.