When looking at property tax there are many different aspects to consider in the main differences between property investment and property trading activities, and their implications from a UK tax perspective. As this is a popular property tax subject, here at Tax Insider we have produced a comprehensive report which has recently been updated to reflect changes in tax legislation. This report examines and looks at some of the opportunities and pitfalls of both activities, whilst evaluate different vehicles to undertake the respective activities.
Pitfalls And Challenges
The following is a non-exhaustive list of some of the issues that can catch landlords out – even some accountants and tax advisers.
Interest Relief Restriction
One of the biggest challenges facing residential property landlords is that, from 2017/18, tax relief for interest on loans (and related costs) to finance residential property lettings is being restricted (ITTOIA 2005 ss 272A, 272B, 274A, 274B, 399A, 399B). The usual deduction will be added back in 25% increments starting in the 2017/18 tax year and the amount disallowed will be replaced with a 20% tax ‘credit’ or reduction in the taxpayer’s bill. In effect, tax relief is being progressively capped at no more than 20% – and the full extent of the tax credit is not always available, (e.g. where there are property losses or the taxpayer has insufficient of what the legislation deems to be the ‘right’ categories of other, non-property income).
- 2017/18 75% of finance costs still allowed as normal; 25% will get no more than a 20% tax reduction.
- 2018/19 50% of finance costs still allowed as normal: 50% will get no more than a 20% tax reduction.
- 2019/20 25% of finance costs still allowed as normal: 75% will get no more than a 20% tax reduction.
- 2020/21 No finance costs allowed as normal: 100% will get no more than a 20% tax reduction.
These new rules will apply only to individuals, partners, trusts (trustees) and other taxpayers that are subject to Income Tax. Companies are basically unaffected (except where they are acting in a fiduciary or representative capacity – very rare).
We shall look at the impact of the interest restriction in an example later on but, in summary, it is likely to affect a very substantial proportion of non-corporate BTL landlords with mortgaged property. Historically, companies have not compared well against direct personal ownership, when considering the taxation of rental profits; companies have become significantly more tax-efficient than they used to be, but thanks primarily to the effects of the new interest restriction (businesses with relatively little finance cost may still prefer to remain unincorporated).
Commercial property has arguably become more attractive because interest costs are not restricted for them; finance costs in a ‘mixed’ portfolio should be apportioned on a ‘just and reasonable basis’. For more detailed information on this important new development, see another of our reports, ‘Landlords – How to Beat the Tax Rises’.
Corporation Tax ‘Double Charge’
Perhaps the main reason why companies have not previously found much favour with property investors (amongst other types of business) is that, while Corporation Tax rates are comparatively low, that is only half the story: moving the company’s profits into the hands of the individual owner usually results in a second charge, either to Income Tax or, sometimes, to Capital Gains Tax.
It has, in the past, been possible to use companies to save reasonable amounts of money by using dividends to extract company profits, into the hands of its shareholders. But this was commonly down to the fact that dividends were not (and are not) subject to National Insurance Contributions while salaries and trading profits generally are; property letting business profits are not subject to National Insurance Contributions in the first place, hence why the corporate route had relatively little to offer in the way of tax savings, in terms of letting income. We shall consider the costs of extracting funds in examples to follow but as a simple rule of thumb:
- a director/employee of a company will be able to take out around 51% of the company’s profit as a bonus or additional salary, after accounting for Employers’ and Employee’s NICs and 40% Income Tax (assuming the director is already a Higher Rate taxpayer);
- if he or she is a shareholder in the company and is, therefore, able to take dividends instead of a bonus, the director/shareholder will be able to take out about 55% of the company’s profit, after taking 19% Corporation Tax and 32.5% Higher Rate Income Tax on dividends into account; and
- if, occasionally, the director/shareholder is able to access the company’s profits by way of capital gains on a share disposal, then he or she will be able to secure around 65% of the company’s profits after 19% Corporation Tax and Capital Gains Tax at 20% (this yield will rise to almost 73% if the shareholder and the company satisfy the criteria for Entrepreneurs’ Relief, available to qualifying interests in trading companies).
The extra cost of getting the company’s funds into the director/ shareholder’s personal possession shows why companies are not quite so attractive or popular as they might first appear.
Nevertheless, companies do have their uses, and the double tax charge will not always apply – if the director/shareholder can afford to leave a good proportion of the profits in the company to re-invest, then the relatively low rate of Corporation Tax on its own can, over time, yield significantly better returns.