Can property incorporation help landlords with rising interest rates?
Posted on: February 12th 2024 · read
Rising interest rates, together with restricted tax relief for finance costs, have left landlords in a difficult position.
Rises in interest rates have been well documented, with base rates currently standing at 5.25% – the highest level since 2008. Homeowners and Landlords alike have seen their mortgage payments increase significantly. However, given the tax relief restriction on mortgage interest, rising rates are bad news for landlords.
It would therefore be sensible for landlords to assess their tax options and consider how they can look to maximise the value of their assets.
How has the property market changed in recent years?
Prior to 6 April 2017, tax relief was given in full on finance costs (mortgage interest), giving landlords some relief for mortgage repayments. Since then, tax relief on finance costs has been restricted for landlords holding residential property.
As a result of the restrictions, landlords can only claim basic rate income tax relief at 20% on their finance costs (at a maximum), rather than a full deduction of the costs from taxable profits and tax relief at their marginal rates.
Essentially, any income from rental properties is taxable at the individuals standard income rate. If an individual is taxable on his rental profits at a higher rate or additional rates of tax, this would result in an effective 20% or 25% tax charge on notional profits, even if their rental property made a cash loss after finance costs.
How did this work in practice?
The above can be demonstrated in the following illustration.
If we take an individual who has a £4m residential property portfolio, funded by about 60% debt. Their portfolio generates a rental profit before any finance costs of £300,000. Following the interest rate increase, their annual interest costs have increased to around £156,000 per annum. The individual is a UK resident and has no other sources of income.
The individual’s cash profit and taxable profit will differ significantly:
After deducting finance costs, the individual will have a cash/ accounting profit for the year of £144,000. The tax liability on the profits (assuming the interest costs were fully deductible) would be £51,003 (based on current income tax rates).
With the current restriction of finance costs, the individual would have a taxable profit of £300,000. The tax liability (after deducting the basic rate income tax relief for the finance costs) would be £90,003 – a significant increase of £39,000.
Property Portfolio Incorporations – The Way Forward?
Due to the rising interest rates, a property portfolio incorporation may be the most tax efficient way to proceed – this involves holding the properties in a limited company.
The method of transferring property into a limited company involves the properties being transferred to a company.
With any property sales, there may be capital gains tax and stamp duty land tax payable on the transfer of the properties, although the transfers can be structured in a manner to ensure any available reliefs can be claimed.
As the interest restriction does not apply to companies, any finance costs are allowable as a deduction in full against any rental profits. It can, however, prove difficult to re-assign
mortgages into a company name, and banks can be hesitant to loan to new companies. This should be discussed with mortgage providers prior to transferring any properties.
A company would be taxable on the rental profits for the year. From 1st April 2023, the Corporation Tax rates are as follows:
- Businesses with profits of £50,000 or less taxable at 19%.
- Businesses with profits between £50,001 and £250,000 taxable at a marginal (tapered) rate of between 19% and 25% dependent on the profit made based on a formula set by HMRC.
- Businesses that earn profits of £250,001 or above taxable at 25% on the entirety of their profits.
If in the above illustration, the properties were held in a company, the company would have taxable profits of £144,000 for the year, as the finance costs would be an allowable deduction from the profits for the period. The corporation tax payable by the company would be £34.410 – the effective rate of corporation tax would be 23.9%, as the profits fall between £50,000 and £250,000.
Whilst companies are taxable at a lower rate than higher or additional rate taxpayers, and full relief is given for finance costs, it is important to keep in mind there will be tax due on any profits withdrawn from the company by an individual. However, this can be structured to ensure any cash is extracted in the most tax efficient manner and dependent on long term tax planning priorities.
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Each case needs to be considered on its own merit weighing up the cost of debt, the availability of new finance in a company, the need of any profits, and the likely direction of corporation tax rates in the future.
If you would like some more advice on operating your property business in a more tax efficient manner, please get in touch.