Iain Rankin explores potential ways to overcome the tax and finance challenges that make the decision to incorporate not as straightforward as some landlords believe.
Many property investors continue to incorporate their buy-to-let portfolios to avoid the mortgage interest relief restrictions that were fully implemented from April 2020, which do not apply to companies.
Incorporating a property portfolio
Few individuals buy investment property without borrowing at least some of the purchase price. Obtaining tax relief on mortgage interest is, therefore, an important part of the financial decision-making process. This article does not delve into the full detail of the mortgage interest changes; it’s enough to know that with tax to be charged from 5 April 2020 on pre-interest rental profits, with a flat 20% tax credit for mortgage costs, the increased tax payable can make lettings of residential property a lot less attractive. In some circumstances, it may even turn a profitable letting business into a loss-making one.
There are a number of potential solutions. These include consolidating a portfolio by selling highly geared properties or switching from residential property into commercial property, where the finance relief restrictions don’t apply.
These changes only affect individuals, joint owners and partners, not companies. Incorporation could, therefore, offer considerable tax savings. It is important to state at the outset that, if all profits are distributed to shareholders, the aggregate tax rate (corporate and personal) will be higher than if you held the property individually, with future capital gains allowances given up.
However, as well as ensuring full relief for interest costs, holding investment property in a company offers a lower rate of tax on retained profit. If this profit is reinvested after paying the lower rate of corporation tax (currently 19%) then faster growth in the company can be achieved. The precise tipping point for each individual will depend on rental yields, capital growth, and their own tax position. Carefully considering the comparative numbers is key to the decision to incorporate. In this instance, we shall assume that the numbers are favourable, and consider the issues arising on the incorporation itself.
Transferring the letting business to a company will involve transferring the ownership of the property to the incorporated entity. This raises two important tax consequences:
- Unless the property is of very low value, the company will need to pay stamp duty land tax (SDLT) on the value of the property transferred (land and buildings transaction tax applies in Scotland, and land transaction tax applies in Wales).
- To the extent that the property has increased in value since acquired, the transfer to the company will give rise to a gain chargeable to capital gains tax (CGT) payable at the point of transfer.
It may be that even after accounting for SDLT, CGT, and the professional costs of transfer, the tax advantages of operating the lettings through a company will nonetheless make incorporation worthwhile. However, if they do not, how do we save CGT, SDLT or both?
Incorporation relief (under TCGA 1992, s 162) may allow the capital gains to be ‘rolled over’ into the base cost of the company shares. This relief normally applies where the landlord transfers a business to a company in exchange for the company issuing shares to the landlord. 'Business' isn’t strictly defined in tax law. HMRC has historically challenged whether incorporation relief applies to rental business transfers. However, a 2013 case (Ramsay v HMRC  UKUT 226), which HMRC lost, has helped to establish tests which, according to HMRC, a landlord would need to pass so that incorporation relief could be claimed:
- The management of the properties must amount to a ‘business’. This is considered to mean that the owners must typically spend at least 20 hours per week actively managing the property portfolio and, usually, have no other occupation or significant income.
- The property business should be run to make a profit with normal commercial practices in place, for example a tenant management system and business bank account.
Claiming incorporation relief is only possible when the entire business (portfolio of properties) is incorporated. It isn’t possible to transfer individual properties to a company and claim incorporation relief.
Stamp duty land tax
Ordinarily, when properties transfer to the company at market value, SDLT is due on the transfer value (FA 2003, s 53). However, there exists a relief from SDLT for partnerships (within FA 2003, Sch 15), which can reduce to nil the SDLT payable on the transfer of property to a company. The relief applies if property is transferred from a partnership to a company that is controlled by the partners. This can be the case where a property portfolio is incorporated.
The statutory definition of a 'partnership' is persons carrying on a 'business' in common, with a view to making a profit. ‘Business’ is defined for these purposes to include any trade, occupation or employment. HMRC accepts that this definition can include a business of making investments.
It should be noted that joint ownership of property does not mean that a partnership exists. While a ‘partnership’ can be either a ‘simple’ partnership or a limited liability partnership, for a 'genuine' partnership to exist:
- A ‘partnership’ must, by definition, include at least two partners, who must each own some property within the partnership and each file annual tax returns.
- Each partner must spend sufficient time actively undertaking activities to evidence that genuine business activity is taking place. It is not a requirement of a partnership that each partner is capable of performing the full range of the activities of the business but that each must be capable of performing a share.
This problem can be encountered with husband and wife partnerships, for example, where one person only manages the property letting business and the other has minimal involvement; in such cases, HMRC might argue that there is a partnership in reality.
In addition, a signed partnership agreement, which sets out how the partnership profits are to be apportioned, would normally be required.
Once a partnership is established, it should be operated for two or three tax years to minimise the risk that HMRC may challenge the partnership as having been set up purely for tax-planning purposes, as per the general anti-abuse rule. The partnership should be run on a day-to-day basis as a true partnership to avoid the wide-ranging SDLT anti-avoidance legislation (for reference, HMRC’s views on a ‘sham’ partnership can be found in its Business Income manual at BIM82065).
Incorporating a buy-to-let property portfolio is one potential solution to the mortgage interest relief restrictions, which for some landlords will cause greatly increased tax exposure.
While incorporation involves some costs and a degree of tax risk, ‘running the numbers’ will often show a clear tax benefit for many landlords.
While incorporating a property portfolio can be extremely beneficial, it is a process, not an event, and one best suited to those with a high income, at least a handful of properties, and the desire to hold them long-term and re-invest profit.
Each case is different and, with so many variables and tax implications to consider, advisers should ensure that the implications and associated costs are fully understood prior to making a final decision to incorporate.