Incorporating a Property Letting business
Turning your business into a company to avoid the changes to the Mortgage Interest Tax Relief rules
The Government have announced changes to the mortgage interest relief regime for individuals (and partnerships). In the future they will only be able to claim interest on borrowings against income tax at basic rate. This measure is being phased in and will be fully effective from 2020 onwards. Interest on borrowings will only be relieved at the basic rate. This will result in increased tax bills for individual landlords (and partnerships), with many of these landlords being dragged into higher rates of tax. These rules will not apply to companies, although there is no guarantee that this will not change in the future.
Many affected landlords will be considering whether or not to incorporate their existing property rental business as a result. The Government say that they are giving landlords time to change their businesses as they are phasing in the new rules. As we shall see, transferring your existing business to a limited company may not be a solution although it could be for some landlords. It is important to understand that if you do transfer your business to a limited company then there is a change of ownership. The company becomes the owner of the business and in future it is the company that is taxed. You would become a shareholder in the Company and the properties themselves would no longer be yours. They belong to the Company instead.
- As a result of the Government's intention to limit mortgage interest relief for private landlords to the basic rate of tax, affected landlords have been considering whether or not to incorporate their existing property rental businesses. These changes only apply to individuals, joint owners and partners; not limited companies. Incorporation could therefore offer a way out but will it? Different rules apply depending on whether you are an individual, a joint owner, or business partners. Establishing your current status is important.
- A key issue will be transferring your rental properties. You have to remember that if you incorporate your business that properties will then belong to your company and you will no longer own them. Instead you will have shares in the Company. It may be possible to transfer the properties subject to their existing mortgages. Otherwise, you will have to pay off the mortgages and take out new ones in which case the Company would have to buy the properties from you. If you need to obtain cash from the Company to buy the properties and pay off existing loans the Company itself will then have to take out fresh borrowings. This could mean that the capital gains tax (CGT) which you may have to pay would make the whole idea impractical.
- The next thing to look at is what will be the CGT bill as a result. It may be possible to defer this bill but you need to know how much you could have to pay.
- You need to consider whether or not you will have to pay Stamp Duty Land Tax (SDLT); this would make it expensive because almost certainly you will have to pay SDLT on the open market value of your properties which are being transferred, unless your business is legally constituted as a partnership, i.e. a business partnership.
- If you have CGT liabilities, there is potentially roll over relief on incorporation available to defer having to pay the tax. However, to qualify for this your lettings must be a "business". If you are legally constituted as a partnership H M Revenue and Customs (HMRC) should treat you as being in business. If, instead, you are an individual or just joint owners (not business partners) then whether or not you are in business needs to be looked at. This will depend mainly on how much time you personally spend managing your rental properties. HMRC Guidance indicates that if you personally work in your lettings business for at least 20 hours per week you should qualify for relief. For those who work for less than this amount of time this is a far from straightforward issue. There is an informal scheme under which you can get advance clearance from HMRC to see if you can qualify.
- To obtain CGT incorporation roll over relief you must take shares in the Company in return for transferring the properties over. If you take cash instead then the relief is not available so any CGT would then have to be paid. If you take part shares and part cash then, again, CGT is payable on the cash element. Always remember as well that to qualify for roll over relief on incorporation you must be a "business".
- At the end of the day the major issue may be whether or not your existing mortgage lender will allow you to transfer the property subject to the existing mortgage/loans. If not, then it is likely you will have to take cash from the Company to repay the existing loans (even if the Company re-borrows the money to raise the cash to pay you for the properties). If you have capital gains then you will have to pay CGT on the cash element, which may mean that it is not practicable. Again, even if you take shares as well, you need to be in business.
- Remember, unless you are a business partnership, beside any CGT which you might have to pay (unless you can get CGT rollover relief) you will have to pay SDLT. This is assessed on the open market value; not any value you yourself might put on the properties. Only if you are a business partnership are you able to avoid this, unless you are able to engage in some kind of SDLT planning (but beware this may not work).
- The ideal scenario is that you are a business partnership with a lender who will allow you to transfer the existing loans. Then you should obtain CGT corporation roll over relief and not have to pay SDLT.
- Even if a property is owned jointly it does not mean that you are necessarily a partnership. You will need to check the position with your professional adviser. Where you are an individual or a joint owner (but not a business partnership) then you are going to have to pay SDLT. If your existing lender will allow you to transfer the property subject to any existing mortgages/loans you can obtain CGT roll over relief on incorporation but only if your activities amount to a "business" as opposed to you just being "an investor". On the other hand, if you have to take out cash to pay off existing loans you are not going to obtain CGT roll over relief on the cash element and if your property letting activities, not regarded as being a "business" you are not going to get the roll over relief anyway.
- There are potentially a lot of hurdles to jump over and the chances are it may simply prove too expensive to incorporate. Do not forget that there will be significant professional charges and fees to be paid.
- Even if you can incorporate you need to think about whether you will want to draw earnings out of the Company. Changes to tax on dividends will make this more expensive and if you take out a salary National Insurance will be payable.
- There are however some advantages in operating as a limited company beside avoiding the impact of the mortgage interest tax relief charge.
- As an alternative you may want to consider that if you are going to acquire any new properties that you incorporate the Company for this purpose but keep your existing properties under their present arrangements.
This note will now explain everything in more detail. However, it is important that you take professional advice on your particular circumstances. We are only setting out the basic rules; not giving advice. You need to take great care because claims are often made about ways of saving tax which turn out not to be good advice.
Tax and other consequences of incorporation
If you transfer your existing business to a limited company then, because there is a change of ownership, there are tax and other consequences. In summary -
- You could have to pay CGT even though you still have an interest in the business through your shareholding. It is important that you work out your potential CGT liability. You will pay 28% tax if you are a higher (or additional) rate tax payer. If you are a basic rate tax payer you will pay 18% or 28% depending on the size of the gain and the amount of your income. A personal allowance of £11,600 each (2015/16 rates) is available. 10% entrepreneur relief is not available.
- SDLT could be payable.
- The business is transferred into the enveloped property tax regime (which is relevant if the any individual properties worth more than £500,000), although there is an exemption currently for let property businesses. Higher rates of tax are being introduced for dividends which are taken out of companies.
- National insurance is payable if you are employed by the Company.
- On a subsequent disposal in certain circumstances there can be two charges to capital gains tax (CGT); firstly, the company pays when the property is sold and secondly, you as a shareholder pay when the proceeds of sale are paid out to you.
- Annual exemption allowances against individual CGT are not available to companies.
There are also some advantages -
- Initially, your rental income could be taxed at the lower corporation rate - currently 20% assuming that the Government announced changes to corporation tax are implemented. If you take out a salary or dividends, you could be taxed at higher rates depending on the amount paid.
- You have more protection against claims as you are not normally responsible for a company's debts, unless you have given a guarantee.
- CGT uplift if you want to sell properties; thus deferring the CGT bill.
Thus, in particular, it can be beneficial if the profits are retained within the business because you are taxed on rental income at much lower levels than individual, but this does leave the problem of having to pay extra tax if you want to withdraw profits, e.g. to meet day to day living expenses. You can be employed by the Company and draw a salary but then both you and the Company have to pay national insurance contributions on the salary.
Another advantage is that if the Company then wants to sell the property it will only pay corporation tax on any capital gain on any increase in value subsequent to the date of incorporation. The CGT hit will come when the shares are disposed of. Therefore, if you can claim CGT incorporation roll over relief you can transfer over the properties which are pregnant with capital gains intending to sell them so as to avoid immediate CGT liability on the sale by the company. This is an area where you need specialist advice. This results because the company is treated as having acquired the properties at their current market values at the time they are transferred from the existing landlord into the company. This is an attractive side effect of the incorporation process.
This is only a brief overview. As we say tax advice is needed to consider your own circumstances.
The mechanics of the transfer
The way in which the transfer is normally effected is for you to sign over your properties (along with anyone else such as your wife/partner/husband who may have an interest in the properties) to the limited company in return for shares. There are other ways including selling for cash but these do not allow you to claim CGT incorporation roll over relief. To be able to obtain CGT relief (if you are eligible) the way the business must be incorporated is for you to receive shares in the company in the same proportions in which you own the existing business
Bearing in mind that there is a change of ownership involved this can be a far from straight forward process. For a start you have to secure the agreement of your mortgage lender or pay off the present mortgage and find someone else who will lend money to you. Lenders may agree to such transfers subject to the existing mortgage in some cases but this then has to be documented. The whole of the business and the whole of the assets (other than cash) have to be transferred. Some lenders do not like dealing with limited companies, although perhaps this attitude is beginning to change.
You will need detailed tax advice from your accountant or other tax adviser and your lawyers will have to be involved to effect the transfer. It is a far from cheap process and it is time consuming. Companies are also subject to more formalities, notifications to Companies House etc. Companies, however, can give more scope for tax planning but again this is something that is dependent on your personal circumstances and you need to take professional advice about this.
It is important that you do not look at the mortgage interest relief issue in isolation. Incorporating a business is a significant change of direction and there are many issues to be looked at as part of an overall decision.
Another option to consider is keeping your existing business as it is but forming a company to go forward if you are buying new properties.
Stamp Duty Land Tax (SDLT)
Before moving onto the key consideration of capital gains tax roll over relief, it is important to consider whether SDLT will be payable on incorporation. Here, importantly, there are vital distinctions between individuals and joint owners on the one hand and partnerships on the other. If your property is jointly owned and you are partners, in law, then relief from SDLT could well be available which would mean that SDLT is not payable. Vitally, however, you must understand that just because you own a property jointly, e.g. it is owned by spouses or partners, i.e. partners in life as opposed to business partners, it does not automatically mean that H M Revenue and Customs (HMRC) will accept that this is a partnership for these purposes. If you are unsure of your status you need to check with your accountant, solicitor or other tax adviser. The general rule for partnerships is that if partnership property is transferred to a "connected" company then no SDLT should arise.
For individuals or joint owners who are not partners, the position is the opposite. They will have to pay SDLT on the full value of the properties transferred normally.
All transfers between transferors who are individuals or joint owners who are not partners and the company connected with them who acquires the property are treated as being at open market value, irrespective of whatever is actually given in return. This applies particularly where the consideration given in return for a transfer of the properties is the issue of shares in the Company (or transfer of existing shares) where the person making the transfer is connected to the company. If a landlord incorporates an existing business, then he/she will be connected with the company for these purposes. There is an exemption normally for gifts in the case of SDLTs but this does not apply in this situation.
There are SDLT avoidance schemes available but beware because they may well not be effective.
SDLT and joint owners/partnerships
As already indicated, where there are joint owners the important thing to do is to establish whether or not there is a partnership so far as HMRC are concerned.
As we see elsewhere normally the market value rule applies for SDLT purposes where a property is transferred to a company. However, HMRC accept that the special rules relating to partnerships override this rule. So long as existing partners are connected with the new company, i.e. they have control of the company generally speaking, there is a complex formula which means that for a family owned partnership there should be no SDLT liability because of the operation of the connected person's rules.
The beneficial effect of these provisions might tempt some existing individual landlords or joint owners to form family partnerships shortly before proposed incorporation. However, if such arrangements are made HMRC is likely to be successful in invoking the general SDLT anti-avoidance rule. The imposition of the partnership prior to incorporation in order to avoid SDLT can then be overridden, leading to the full charge applying under the market value rule which would otherwise apply.
Capital Gains Tax (CGT)
One of the first things that you have to do is, of course, consider whether or not there will be any capital gains and, if so, how much. There may be some carry forward losses which can offset gains. Depending on this, you will need to consider whether you would be entitled to claim incorporation roll over relief. It only applies if there is a "business" and not if your property lettings are just an "investment".
You may be able to delay paying CGT if you transfer your property letting business to a company in return for shares. You will have to consider if the way in which you operate your lettings does constitute a business. There are difficulties if you want cash, e.g. to pay off a mortgage.
If you do qualify for this incorporation roll over relief, it means that you will not have to pay any tax until you sell or otherwise dispose of the shares in the company which you will receive in return for transferring over the properties to the company.
The basic requirements for qualifying for incorporation roll over relief are that you must -
- Be an individual joint owner or in a partnership.
- Transfer the whole of the business and all of its assets (optionally you can keep back cash or debts) in return for shares in the company. As such you do not have to claim this relief as you will get it automatically if you are eligible. However, you can opt not to claim it even if you are otherwise entitled to it.
- As an alternative you can receive cash from the company as well as shares but if you do you will only get incorporation roll over relief on the proportion of the business which is exchanged for shares. CGT would have to be paid on the cash element of the amount paid to you by the company.
- The business is transferred as a going concern.
The relevant provisions are contained in Section 162 of the Taxation of Chargeable Gains Act 1992.
You can transfer the existing business either to a new company or to an existing company.
The existing business can be owned by more than one individual, whether or not in partnership. This, however, means that on the transfer the proportionate ownership should be the same before as after.
Obviously, the requirement to transfer all assets means that the properties themselves must be included which raises issues around SDLT especially for individuals or joint owners who are not legally partnerships.
Is it a business?
A buy to let landlord is not necessarily in business so far as the tax man is concerned. It may just be treated as an investment.
For the buy to let landlord the key question is whether or not they are in business for these purposes. The starting point for an individual or a joint owner is that the mere receipt of rents from property which the individual owns (individually or jointly) raises no presumption that he or she is carrying on a business. A partnership should be a business so it should qualify for roll over relief.
Once the company is the owner the position is different. In the case of a company which is incorporated for the purpose of making profits for its shareholders, any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business.
The meaning of "business" in the context of incorporation relief for residential property ownership was considered by the Upper Tax Tribunal in the case of Ramsey v HMRC  UK UT 236. The general principle is that for there to be a business, if you wish to claim CGT incorporation relief, there has to be sufficient "activity" and just a modest degree of activity will not suffice. It is the quantity of the activity not its quality which is important.
Is buy to let a business?
This is and remains a grey area although the Ramsey case and HMRC Guidance does shed some light on it. To avoid CGT by relying on incorporation roll over relief there must be a business. As is so often the case the distinction between "business" and "investment" is vital. On this occasion, you should not confuse this distinction with the "trade" v "business" question. A property rental business is not a trade (unless it is furnished holiday lets). Here we are concerned with the wider definition of "business"; not the definition of what is a "trade".
In the Ramsey case, Mrs. Ramsey owned five sixths of a large single building divided into ten flats. Mr. and Mrs. Ramsey transferred the property, subject to a then existing bank loan, to a limited company in exchange for shares. All the other requirements for the relief were complied with; the only dispute was the question of whether or not the property transferred to the company was a business at the time. The Lower Tribunal dismissed the case and Mrs. Ramsey appealed to the Upper Tribunal. Mr. and Mrs. Ramsey had managed the property for around two years before it was transferred. What they did themselves was summarised as follows -
- On taking over management they met the tenants. An accountant collected the rents.
- They took responsibility for checking and payment of the quarterly electricity bills for the communal areas.
- They dealt with arranging insurance.
- They visited the property when necessary to unblock the drains.
- They repaired and cleared the garages.
- They returned post to tenants who had moved on.
- They dealt with fire regulations including fire extinguishers.
- They arranged for a boundary fence to be put up and laid a flower bed.
- They took garden rubbish to the tip as well as weeding the back garden and car park, including cleaning the flagstones.
- The communal areas were vacuumed and dusted on a regular basis.
- When passing the property frequently they checked security to the rear.
- They cleared dumped rubbish to the tip.
- They cleaned and cleared vacant flats.
- They gave some individual help to an elderly tenant.
Overall, they spent approximately 20 hours per week carrying out these various activities and they had no other occupation during the relevant time. This property was their only activity of this nature.
Additionally, Mr. and Mrs. Ramsey had made arrangements for plans to be prepared for refurbishing and redeveloping the property. They retained surveyors and Mr. Ramsey was responsible for securing planning permission. However, no actual building works were carried out before the transfer.
There has to be sufficient activity and this is a question of fact and degree.
Factors to be looked at are -
- whether the activity is a "serious undertaking earnestly pursued" or a "serious occupation, not necessarily confined to commercial or profit making undertakings".
- Whether the activity is an occupation or function actively pursued with recognisable continuity.
- Whether the activity has a certain measure of substance.
- Whether the activity is conducted in a recognisable manner and according to sound and recognised business principles.
- Whether the activity is predominantly concerned with making a charge to its users.
- Whether the activities are of a kind which are commonly undertaken by those who seek to profit by them.
The Upper Tribunal Judge said that the proper approach is to interpret business broadly, according to its ordinary meaning.
The Upper Tribunal decided that it was wrong to find that there was a qualitative test to see whether the activities undertaken were of a type which is different to those which are ordinarily associated with management of an investment property. It does not require something different or even of a unique nature. Rather it is about scale.
The scale of activities is not to be ignored simply because they can be explained by reference to the size of a portfolio.
It is the degree of activity as a whole which is decisive. It is not the extent of that activity when compared to the number of properties or lettings.
Based on the list of activities and the principles summarised above, the Appeal Judge was satisfied that, looked at overall, in this case there was a business. However, importantly, it is a question of degree. This is because, in the context of property investment, the same activities can equally relate to a passive investment on the one hand or a property investment/rental business on the other. It is the degree of activity undertaken, i.e. the extent of the activity which is key. Looking at matters overall the Judge was satisfied that the activities undertaken by Mrs. Ramsey were sufficient both because of their nature and extent to amount to a business for these purposes. The Judge pointed out that each of the activities could equally well have been undertaken by someone who was a mere passive investor but the degree of activity outweighed what might normally be expected to be carried out by such a passive investor (even an investor who was diligent and conscientious). That was the test and the Judge found that that that applied here. Mrs. Ramsey "got over the line".
When do you cross the threshold? Clearly, a full time self manager with a large portfolio is going to qualify. Ramsey suggests that on a part time basis at least 20 hours per week involvement should be sufficient. HMRC Guidance says that they will accept that if you work personally in the business for 20 hours per week then you should qualify for relief. It could be less than 20 hours which is required but we do not know. HMRC Guidance merely says that such cases must be carefully considered.
Someone who relies entirely on an agent is clearly not going to qualify at the other extreme.
Unqualified assertions on the internet such as letting is a business for CGT roll over relief should not be relied upon. It depends ultimately on what you do but importantly the amount of time spent doing it.
There is an informal HMRC clearance system available so that you can apply for advance clearance to see whether you can obtain relief or not.
You have to remember that when working out the values of any properties transferred because the individual joint owners or partners are treated as connected with the Company the open market value rule applies so that you cannot put your own figures on properties. You will undoubtedly need a professional valuation and ultimately this will need to be agreed with the Valuation Office Agency at HMRC on behalf of HMRC.
Director's loan accounts
If cash is credited to a Director's loan account instead of shares being issued, then this is treated as cash. CGT is potentially payable on this element a result. This is the common way of incorporating businesses generally but if you want to obtain the full benefit of CGT incorporation relief, if you are eligible, taking the whole of the consideration from the company in shares is the normal way in which the transaction has to be effected
There is no need to transfer a liability to the company although this would usually be done. However, if liabilities are actually transferred over, e.g. existing mortgage debts, this can potentially give rise to a complication because additional SDLT having to be paid. This is because the assumption of debt for SDLT purposes is treated as a consideration on which SDLT can be paid.
When it comes to CGT it would appear that so long as the liability is a business liability you can net off any outstanding mortgages loans or other debts which are taken over. The calculation of the valuation of your shares for CGT purposes in the company (which is then your base cost later on when you dispose of the shares) is reduced by the amount of any outstanding mortgage debt or other liability.
However, as we have mentioned, beware that this could give rise to a potential issue in relation to SDLT as assuming a debt in this situation is consideration. The company takes over the debt if the business is transferred subject to an existing mortgage. The problem then is that this could be included in the market value for SDLT purposes. In determining the amount of debt for SDLT purposes each person's liability for the debt is taken as a proportion of the debt corresponding to the share that they own in the property if there are joint owners. You could pay off the existing mortgage and take out a new one in the company's name. This avoids the assumption of debt/SDLT problems but if you then need to extract cash to pay off the mortgage so you could lose the CGT incorporation roll over relief.
As we have seen joint ownership of a let property does not of itself make the activity a partnership. A tax payer can jointly own properties which are let out as part of a partnership business which runs a letting property business (although not amounting to a trade). This is then treated as a separate business from any other rental business carried on by individual partners in their own right.
Whether or not a partnership exists depends on the facts. A partnership is unlikely to exist where the tax payer is one of a group of joint owners who merely lets a property that they jointly own. It could be a partnership according to HMRC where the tax payer is one of a group of joint owners who -
- Let the jointly owned property/properties and
- Provide sufficient additional services in return for payment.
This will depend on the amount of business activity involved. The existence of a partnership depends on a degree of organisation similar to that required in ordinary commercial business.
Just receiving a share of rent is not enough. There must be a business.
Such a partnership can exist where properties are jointly owned by husband and wife so long as the normal requirements apply.
Since the existence of a partnership is dependent on there being a business and "business" is given its wider meaning for the purposes of CGT incorporation roll over relief, if an existing partnership incorporates then incorporation roll over relief should be available to the partners concerned. This is because the statutory definition of "partnership" is the relationship which subsists between persons carrying on a "business" in common with a view of profit. Business is defined for these purposes as "including any trade, occupation or employment" so "business" is a very wide term and HMRC guidance accepts that it can include a business of making investments. Obviously, if there is a formal partnership in existence then this is indicative of there being a partnership but this is not conclusive. However, the agreement does have to be implemented and, if it is not implemented, then it is not effective for these purposes.
It is not a requirement of partnership that each partner is capable of performing the full range of the activities of the business but each must be capable of performing a part of those activities. The problem can be encountered with husband and wife partnerships, for example where one person only manages the property letting business and the other has little or virtually no involvement; in such cases it is unlikely to be a partnership in reality.
In our discussions with HMRC they had advised that the non statutory clearance scheme will be available so informally landlords will be able to gain advance clearance so they would be eligible to incorporation relief from Capital Gains tax when transferring existing letting businesses as a limited company.
The decision of whether or not to incorporate is one that must be carefully taken. Appropriate professional advice is essential. This note can only give you an outline of the issues. Above all do not rush into incorporation simply to avoid the mortgage interest relief changes. A whole host of factors, particularly the impact of taxes such as CGT and SDLT, must be considered. You must not rely on this note other than as a very general guidance and you should seek your own professional advice which will vary according to the particular circumstances.
If you would like to speak to a qualified accountant for specialist tax advice please contact our service partners RITA4RENT to discuss what services you would like to employ them for.