The Pros and Cons of Incorporation for Buy-to-Let Landlords
Tax changes announced during 2015 will increase costs for many buy-to-let landlords and may make some lettings unprofitable. But there may be ways of mitigating some of these costs.
The summer 2015 Budget ushered in the removal of higher and additional rate income tax relief on the costs of buying residential property for letting, a change that will be phased in over four years starting in 2017/18. At present, loan interest is deducted from rental income, together with other costs of letting, and tax is charged on the resulting profit. This means that owners receive tax relief for the interest at their highest rate or rates of tax.
For example, if rental income before interest is £30,000 and the owner pays interest of £20,000, the profit of £10,000 is currently subject to income tax. For a higher rate (40%) taxpayer that would result in tax of £4,000. From 2020/21 the same owner will pay tax of £8,000 – i.e. 40% of £30,000 less 20% basic rate tax relief on the £20,000 interest.
Owners of commercial property and furnished holiday lettings will still be able to get full tax relief for interest, so one way of avoiding the restriction will be to diversify into these types of properties. However it can be difficult to meet the qualifying conditions for furnished holiday lettings.
Holding properties in a company
Another possibility is to hold properties in a company. Companies will not be affected by the restriction on interest relief and by 2020/21, the corporation tax rate will have fallen to 18%. A company with rental income of £30,000 paying interest of £20,000, as in the example above, will therefore pay tax of £1,800.
Against this benefit must be set some costs. There will be more tax to pay if income is drawn from the company, although from April 2016 every individual will have a tax-free dividend allowance of £5,000. Dividends that an individual receives above that amount will be taxed at 7.5% basic rate, 32.5% higher rate or 38.1% additional rate. To reduce tax on distributions, you could spread ownership of the company’s shares among family members, especially those who do not pay more than basic rate tax.
The 18% corporation tax rate will normally also apply to a company’s profits on selling properties. Furthermore, companies benefit from an indexation allowance which reduces their chargeable gains. However an individual who withdraws the profits will have to pay further tax, so the low corporation tax rate is most valuable if the profits end up being reinvested within the company.
A major downside to incorporation could be the capital gains tax (CGT) and stamp duty land tax (SDLT) charges on transferring properties to a company because these taxes will be based on the market value of the properties. A corporate structure is therefore likely to be most useful for new investment in residential property. The administrative burden is likely to be heavier where a company is used , and banks may charge a higher interest rate. Further tax liabilities will arise in the case of a company holding residential properties worth over £2 million.
The Autumn Statement 2015 included two further changes that will affect buy-to-let investors. From 2019, payment of CGT on residential property will be brought forward to 30 days after completion, and by 2020 most landlords will have to keep track of their tax affairs digitally and update HMRC at least quarterly. These changes seem unlikely to apply to companies. However the 3% added to SDLT rates on purchases of buy-to-let property will be imposed on both companies and individuals, though the government is considering some exemptions.