…given the new rules on tax relief of mortgage interest?
In a recent post we outlined the new rules which will restrict tax relief of mortgage interest for those with buy to let properties. Just to be clear that the tax relief will not be fully restricted to the basic rate of 20% until 2020-21. Until 2017-18, individual landlords will still be able to deduct all finance costs from their rental income to arrive at the amount of on which they have to pay tax. For a 40% taxpayer with yearly rental income of £9,600 and annual finance costs of £6,000 this would mean a tax bill on the rental income of £1,440. The gradual reduction of tax relief starts in the 2017-18 tax year. Then the amount of finance costs landlords are able to deduct from rental income goes down to 75%. But in addition, they will be able to subtract tax relief at 20% on the remaining 25% of finance costs from the amount of tax payable which, given the same scenario as before would mean a tax bill of £1,740. In 2018-19, the finance cost deduction goes down to 50% with 50% given as a basic-rate tax reduction resulting in a tax bill of £2,040. In 2019-20 the figures are 25% deduction, basic-rate relief on 75% of finance costs and a tax bill of £2,340. When fully basic-rate restricted tax relief comes into force, the equivalent tax bill would be £2,640, which is £1,200 more than under the current system.
Given this restriction to tax relief on mortgage interest some landlords have looked at the possibility of operating through a company separating the property rental income from their regular PAYE and other personal income. Instead rental income would be considered business income and once the property or properties are within a corporate vehicle they benefit from full relief for loan interest. If you own a property in your own name, the profits you make from renting it out are added to your other earnings and taxed as income tax at your marginal rate. If instead you hold it within a company, the profits will be liable for corporation tax currently at 20% (if profits are below £300,000), which means your tax liability is halved compared to if you are paying income tax at a rate of 40% or higher.
If you do go ahead and decide to operate through a company you should be aware of the following:
- You must be careful to do it correctly otherwise you could trigger a large capital gains tax liability on the property if you need to sell. The property would then end up being treated as a disposal by the company.
- There are additional costs for legal set-up, and the ongoing compliance and administration fees of operating though a company – including filing annual company accounts.
- One of the biggest issues you will face is your access to finance will be more limited. Many buy-to-let lenders will not lend to limited companies at all. Some may do so if they are given a personal guarantee by the directors, but for the most part the only option for a company is to use commercial lenders. Commercial finance is harder to come by with the interest rates tending to be higher (and often on repayment rather than interest-only terms), and at lower loan-to-value ratios.
- To draw any money out of the company you will have to do so by way of a dividend and that will be taxable after the new standard of £5,000 allowance comes into force next year. Basic rate taxpayers will pay 7.5 per cent tax on any additional dividend income, higher rate taxpayers will pay 32.5 per cent and additional rate taxpayers 38.1 per cent.
- Recent changes made to stamp duty land tax rules mean that a company will pay 15% tax on all purchases over £500,000; below this standard stamp duty applies: 1 per cent for properties up from £125,000 to £250,000, and 3 per cent on properties from £251,000 to £500,000. In addition if you are fortunate to have investment property held in a company which has a value in excess of £2 million there will be an additional liability to the annual tax on enveloped dwellings (ATED).
So when should you consider operating through a company? The answer of course is it depends on your individual circumstances. Much will depend on:
- How much income you and your spouse or partner earn. If you are paying income tax at 40% or higher, and you do not have a lower-earning spouse whose name the property income could be put into paying 20% corporation tax rather than 40%+ income tax is going to be more attractive.
- How many properties you hold. The extra costs involved in operating through a company will be similar whether you have one or several properties. The more properties you own may mean that operating through a company is more beneficial.
- Are you a property trader or investor? If you buy a property to make value-adding improvements and sell on for a profit, then you will be a trader and as such you are likely to be best off buying and selling as a limited company.
- What is your exit strategy with regard to the properties? If it is your plan to pass on your properties to your children and grandchildren holding them within a company if structured correctly could result in IHT savings.
Finally of course you should always bear in mind that the current tax rules relating to buy to let properties could be changed by the Government in the future; indeed mortgage interest relief for companies that are just investment property vehicles could be withdrawn. At the very least investors should wait for the Autumn Statement on 25th November to see if the Government decide to tinker with this area further.
If you have any queries regarding the taxation of buy to let properties then do contact us.