The Tax Insider Team considers the drawbacks of the popular property holding company structure – and considers a possible alternative.
Of course, there are other reasons, not related to tax, why you might want to set up a limited company to hold a property portfolio. But we’re going to stick to considering the merits or otherwise of a property company from a tax point of view.
What you might call the ‘headline’ advantages of a property company have always been quite straightforward and easy to follow. The most obvious headline advantage is the tax rate suffered on the rents received.
Currently, a limited company owning properties has a 19% tax rate on the rental profits, which compares with rates of 40%, or even sometimes 45%, in the hands of an individual receiving rents. Similarly, if a company sells an investment property it owns, the capital gains are chargeable at the corporation tax rate of 19%, versus a probable 28% rate for an individual property investor, assuming the property is residential in nature.
What’s more, limited companies used to receive ‘indexation allowance’, under which the base cost of the property was indexed up by the increase in the retail price index between the acquisition of the property by the company and its sale. So, effectively, only gains due to property price inflation (and any other causes) over and above normal retail price inflation were subject to tax.
Getting the properties in
Very often, property companies are set up from scratch, and new properties are acquired from third parties by the property company. This is a relatively straightforward scenario; the ‘fun and games’ really only begin, as far as the acquisition of the property is concerned, where you are looking at the situation where an individual transfers his portfolio into his own connected property company.
Here, there are two potentially very damaging tax charges in point:
- capital gains tax (CGT) will arise on the individual based on a deemed sale of the property at its open market value, at the time it is transferred to the company; and
- stamp duty land tax (SDLT) (in England and Northern Ireland) will also generally apply to this transfer, subject to an exception which will not normally be in point.
Protagonists of property companies will usually claim that both these tax charges – CGT and SDLT – can be avoided with due care. The CGT will not apply if you claim ‘incorporation relief’: that is, if your pre-existing holding of property comprises a ‘business’ which is transferred into the company in exchange for shares issued to you. Where these criteria are favourable, there is no CGT because of the availability of incorporation relief, under which the deemed ‘gain’ (by reference to the market value of the properties) is rolled over against the deemed cost of the shares issued by the company.
On the SDLT side, this tax will generally not apply where the property is transferred from a ‘partnership’ into a company which is connected with the partners in the partnership. However, both these tax reliefs depend on the correct interpretation of some fairly vague words; for CGT relief, the property portfolio which you transfer to the company needs to be a ‘business’: for SDLT relief, the previous ownership arrangements need to constitute a ‘partnership’. Both these words can be difficult to apply to the real situation in practice.
All that glitters is not gold
When I talked about the ‘headline’ advantages of the property investment company in the above summary, I was laying myself open to the accusation of being a little economical with the truth. Let me explain why.
First of all, it’s true to say that the company will often pay a substantially lower rate of tax on rents received than an individual receiving the same amount of rents would pay. But the issue here is that rents received by a company, after the corporation tax charge, may well still need to be distributed to the shareholders/directors of the company as income. The effect of this is to add on another layer of tax.
Similarly, if a company makes a capital gain on selling a property, it’s true that the rate of tax will probably be lower on the immediate gain – especially if indexation allowance is available. However, indexation allowance for companies has been abolished, and the same issue of a second, personal layer of tax falling due on distribution of the gain applies. Here are a couple of examples.
Example 1: Double tax on income
Cheapskate Limited owns a property portfolio on which it receives annual rents, after expenses, of £100,000. At corporation tax rates, the tax bill on these rents is, therefore, £19,000.
However, the balance of £81,000 still needs to be distributed to the shareholders of the company. As it happens, about half of the income is paid, by way of dividend, to shareholders who are basic rate taxpayers. The rest is payable to individuals who are in the higher rate bracket.
The (say) £40,000 received by the first category of shareholder is liable, after taking into account a £2,000 tax-free dividend rate, at 7.5%: that is, there is a tax charge in the region of £3,000. The balance, receivable by the higher rate taxpayers, is charged at a 32.5% dividend rate, and this comes to just under £14,000.
In the above example, if you add the approximately £17,000 personal tax to the £19,000 company tax, you are looking at a total tax charge of about £36,000, or 36%. If the same shareholders had simply owned the properties directly in the same proportions, the average tax rate would have been significantly lower; principally because the company adds another layer of ‘dividend tax’ to the overall mix.
Double tax charge on gains
The same figures could basically be applied to capital gains made by the company, except that the personal ownership scenario is generally much more favourable where you are looking at capital gains taxation. Whereas higher rate income taxpayers are potentially paying 40% or 45% on the rent they receive, individuals who make capital gains on property are looking at a maximum of 28%.
This is an even more cogent reason to think several times before building up a property portfolio in a limited company.
What’s more, capital gains within a limited company are very much more difficult to mitigate or avoid than capital gains arising to individuals. There are a number of instances where individuals may pay less tax on the same gain, but the one I would like to pick out is the tax-free uplift in value which occurs where assets are bequeathed from one generation to the next. Here’s an example.
Example 2: Company vs individual ownership
Montmorency Estates Limited was set up in the late 1950s and acquired a number of properties in London’s West End. At that time, a flat in South Kensington cost somewhere in the region of £5,000, and some of these prestigious properties are still owned by the company even now, in 2018.
Each time a generation has passed away (and three have done so since the company was set up), the shares are bequeathed to the next generation and are fully chargeable to inheritance tax (IHT) as investment company shares. However, the company itself doesn’t die, and as a result, a lot of these properties are still standing at the ridiculous book cost figure of £5,000 for a three bedroom flat in London SW7. Any sale of these flats would, therefore, give rise to tax based on virtually the whole sale proceeds.
Contrast this with the situation where the portfolio had been owned directly by individuals. On each death, the IHT would broadly be the same, but the new generation would take over the properties concerned at their probate value for the purposes of future CGT computations.
The ‘new kid on the block’ – and a possible alternative structure
The reason property companies are such a hot topic at the moment, of course, is the much-discussed ‘Clause 24’ – George Osborne’s contribution to taxation in this country, under which landlords who are individuals are denied tax relief for mortgage interest paid; whereas limited company landlords are not.
However, in some cases, it is possible to get ‘the best of both worlds’ by setting up the portfolio within a limited liability partnership (LLP), which has a limited company as a member. The property company is not the only option, and you should seriously consider the LLP alternative.