Lettings Mortgage tax relief changes and Incorporation
Updated: Oct 28, 2018
As we get close to finalising personal tax returns for 2017/18, the impact of the chancellor's recent changes to mortgage tax relief is starting to be felt. The bad news is that will only get worse as the tax relief removal is being staggered over four years and the relief, for what is a real cost, will soon disappear.
So, first of all: what has changed, what can be done to remove the impact of it, and is it worth it?
The key change for buy to let properties is the limiting of mortgage tax relief at the basic rate. This means that if you are renting out properties and you are a higher rate tax payer (either through your other earnings or due to the rental property income) interest on the mortgage is only deductible at the 20% basic tax rate.
Let's take an example to make it simple. You are a higher rate taxpayer with rental properties profit before interest of 50K. The properties are mortgaged and you pay interest of 40K per year resulting in a 10K net profit. Previously you would be taxed on that 10K profit at 40%, resulting in 6K tax.
For the 2017/18 tax year, the mortgage interest relief for 25% of the interest will be limited to the basic rate of tax i.e. 20%. For 2018/19, this will be become 50% and by 2020/21 it will be 100%. So putting numbers against this over the next four years (other things being equal) will be as follows:
As you can see, at the extreme the result is by 2021/22 when the relief is completely gone. In this example, the tax payer would suffer a loss when previously the properties generated a £6K gain after tax. The business has become unviable.
So what can be done about it?
Well, one thing that people are now revisiting is incorporation (putting the properties in a company). This has the benefit that mortgage tax relief is given in full (i.e. as it was prior to 2017/18). The tax rate is also significantly lower if you are a higher rate taxpayer – company profits are taxable at 19% in 2017/18 and set to reduce to 18% next year. Be careful though, just simply incorporating and then extracting the profits would still result in a higher tax as the company pays 19% but then the tax payer pays tax on profit extraction (assume dividend) at potentially 32.5% (or whatever their marginal rate is).
So should you incorporate?
There is no simple answer to this and, yes, you have guessed it, it all depends on your personal circumstances. What may be beneficial for one person, may not be for another. (In other words, don’t do it without working through all the numbers and potentially seeking professional advice.)
In summary, the main things to consider are:
1. Capital Gains Tax implications. If the property or portfolio has been recently acquired, this is less of an issue but, if not, then any transfer to the company is a transaction and, if sold for a gain, will result in a potential CGT liability. There are potential reliefs/exemptions which I will come on to shortly but, suffice to say, CGT needs to be considered and the numbers examined.
2. Stamp Duty. Another significant tax, is the stamp duty on property transactions which is higher on buy to let properties and, depending on the value of the property, can be significant. Personally it astounds me that we tax transactions that result in reducing liquidity on properties and stopping people moving easily (movement of labour becomes harder!) but I digress…
3. Long term plan for the portfolio. Is it designed to generate income for today, for the future (retirement), to generate capital gains, etc? Incorporation is very beneficial in that it puts the income, capital in a box, that can taken out as and when required. If the plan is (and the need is) to use the income that the property is generating to live your lifestyle today, incorporation is less likely to be that beneficial .
4. Inheritance tax plan / gifting of properties. One of the simple benefits of incorporation is that companies can be shared in a way that properties can't (or it's harder) so, on death, passing on to your beneficiaries shares in a company rather than a share of a property can be significant.
5. Annual Tax on Enveloped dwellings. This tax was brought in to stop people buying properties in companies that they lived in. The tax starts on properties >500K but there are exemptions if the property is rented out to third parties at commercial rents. The impact of this should not alter the decision to incorporate a buy to let property although there are additional administrative tasks required so worthwhile to highlight.
As noted above they can be relief in certain circumstances for capital gains tax which given the rise in house prices over the last 20 years in the UK this is often likely to have the biggest impact on the decision to incorporate. The key reliefs are as follows:
1. Principle Private Property relief. If you live in the property and it's your only residence then potentially there is no capital gains tax. This could be relevant if, for example, you are going overseas (or are coming back from being overseas) and want to rent out your property. Putting it into a company may be a tax efficient option more so if you don't plan to come back and live in the property again.
2. Incorporation relief. If you incorporate a business by transferring the assets into a company at market value in exchange for shares, relief for CGT may be available. However, this is a difficult relief to get for buy to let properties as the Inland Revenue historically has seen buy to let properties as an exploitation of land rather than a business. What is required for it to be considered a business is active participation and so it is likely that a couple of properties rented out to long term tenants would not suffice for relief but a property portfolio being actively managed with significant management time may well be. Several court cases have evidenced this.
Finally, people often say incorporation is more work from a compliance perspective. While it may be marginally the case, it shouldn't be significant but again only through crunching the numbers on the various scenarios in your circumstances will you know whether it is beneficial or not.