Selling some properties to reduce our exposure to risk

Selling some properties to reduce our exposure to risk

10:14 AM, 30th August 2022, About a month ago 8

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My wife and I only found Property118 a few months ago and we’ve since become huge fans. We have read dozens of your articles, mainly about the economic prospects for the rental property market, mortgages, strategies and tax.

Approximately half of our properties are on good fixed rates and the rest are on tracker mortgages without penalties for early repayment. It’s the latter we are thinking about selling.

We don’t take any money out of our rental property business. Instead we live off the profits from another business. We look at out rentals as our pension fund. However, with taxation, rising interest rates and other increasing costs we are worried that we might soon find ourselves in a position where we are forced to subsidize the rental business from our other incomes. The biggest problems for us will arise if interest rates are the same or higher than they are now when our fixed rates end. This would be untenable, so we have concluded that selling a few properties, to reduce our exposure to rising mortgage interest rates might be the way for us to go. At face value the properties without any early repayment charges on the mortgages look like the best to sell first, because they also have the lowest LTV’s and the highest equity in them.

I’ve calculated the average LTV across all 22 properties at 44.6% LTV. When we first purchased them we put 30% deposits down from the sale of another business. The reduction in LTV’s has come about partially as a result of us having taken repayment mortgages over 30 years and partially due to capital appreciation. Therefore, if we do sell some properties we will have Capital Gains Tax to pay, and that’s part of our dilemma. The properties without repayment penalties attached to mortgages are also the ones with the highest equity and are the same properties that are the most exposed to Capital Gains Tax.

My wife and I are intrigued by how incorporation can wash out Capital Gains. If we have understood it correctly, incorporation would involve us selling the whole property business to a Limited Company at market value in exchange for shares. Any Capital Gains would then be rolled into the company shares. On this basis it seems that if we then sell any of our properties after incorporation there would be no tax to pay unless the properties have gone up even further in value. Have we understood that correctly? If we have it would appear to be the logical path for us to follow.

RESPONSE FROM THE PROPERTY118 TAX TEAM

Your understanding of how incorporation washes out capital gains is correct.

Whilst you haven’t provided all the necessary figures, it also seems highly likely that there will be other positive benefits of incorporation for you, some of which are not tax related at all. Limited Liability status is one such example.

Also, based on what you have said, it appears highly likely that you and your wife will be higher or additional rate tax-payers. If this is the case you will be paying income tax at 40% or 45% on any rental profits you do retain in your property business, minus your 20% tax credit. This is because your existing structure will not allow for mortgage interest to be offset against rental income. In a Limited Company structure you will be able to offset finance costs against rental income and the rate of corporation tax is likely to be significantly lower than your personal marginal rates of tax, so you could be looking at considerable savings there too. A ‘smart company’ structure could also enable you to solve a potentially huge inheritance tax problem you may not have thought about.

Before you rush off to form a company and appoint solicitors there are a few other important things you need to take professional advice on. The first is whether your company will need to pay Stamp Duty when it purchases your rental property business. We suspect there may be a way to negate that completely. The second consideration is how the company will acquire the properties without repaying all existing mortgages and applying for new lending in the company name. Again there are ways around this and a Property118 Tax Strategist will be delighted to consider all of the pros and cons associated with incorporation and present their recommendations for you to consider. If you subsequently decide to instruct our Joint Venture partners at Cotswold Barristers to implement our recommendations they will adopt them as their professional advice, for which they carry Professional Indemnity insurance of £10,000,000.

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Comments

Martin Thomas

10:23 AM, 31st August 2022, About a month ago

I'm not sure the response from the Property118 tax team is correct with regards to interest on mortgages. The team said "you will be paying income tax at 40% or 45% on any rental profits you retain in your property business, which under your existing structure will not have allowed for mortgage interest to be offset against rental income either".
My understanding is that you even if you are a 40% or 45% taxpayer, you will receive tax relief on mortgage interest at 20%. With a limited company structure, the company will receive tax relief at 19% so arguably, you get more tax relief as an individual or partnership.
The downside for an individual or partnership is that you have to pay tax at 40% or 45% NOW rather than potentially leaving the profits in the company and having the company profits taxed at only 19%.
However, when you draw the profits out as dividends, you are then taxed at 33.75% if you are a 40% taxpayer, so the profits from the company end up being taxed at 52.75% which is a lot more than 40%!
Drawing out a huge sum as dividends in one year could push you into the 45% tax bracket.

Mark Alexander - Founder of Property118 View Profile

11:06 AM, 31st August 2022, About a month ago

Reply to the comment left by Martin Thomas at 31/08/2022 - 10:23
I think you may be confusing the 20% tax credit applied to finance costs with tax relief. They are very different.

For example, a landlord who is making zero real profit (no other income) after finance costs of say £100,000 would pay tax on the full £100,000 of those finance costs. In other words, the landlord would have to pay tax despite having actually made no money at all. The 20% tax credit deducted from the landlords tax bill would provide little comfort in that scenario.

In a Limited Company, the same landlord would pay no tax at all, i.e. no income tax and no corporation tax.

Every situation is different of course. Where profits are made, the correct company structure provides significantly more flexibility to 'manage' the distribution and/or retention of that profit. For example, a typical husband and wife setup could pay themselves a salary of £12,570 each tax free and this would reduce their corporation tax bill by a similar amount. If they had young adult children or elderly parents with low or no incomes they could do the same for them. In addition, they can each take £2,000 of annual tax free dividends if they have their own class of shares.

Each shareholder could then be allocated dividends to fully utilise their basic rate tax band and any remaining profits could be retained in the business. Retained profits could also be used to pay down mortgages or Directors Loans without further personal taxation.

Any dividends declared to basic rate tax-payers would be taxed at 8.75% so there is an argument to say that equates to 27.75% tax after factoring in corporation tax at 19%. That's significantly less than 40% or 45% income tax but the comparison isn't a direct one. This is because individuals and Partnerships cannot offset finance costs against rental income but a Limited Company can, so the levels of profits exposed to any form of taxation can be significantly different. That's why Property118 uses bespoke software to calculate the "real" net effective rate of tax to compare both scenario's side by side.

The above is just a high level overview of what can be achieved. With advanced tax planning the results can be further enhanced.

Perhaps a more important point though is that your analysis is based purely on income tax, whereas the original poster had correctly raised the question about the Capital Gains Tax planning benefits associated with incorporation. The CGT savings might well dwarf the income tax benefits in the scenario he outlined. Furthermore, potential to mitigate Inheritance Tax on future growth in property values (if they incorporate into a SmartCo structure) could make even those huge CGT savings look small.

There is no 'one-size-fits-all'

Martin Thomas

12:31 PM, 31st August 2022, About a month ago

Hello Mark
Thank you for your reply and I take note of your comments on Property118.
I take your point that there are a number of other factors to consider and it is a very complex area - "one size fits all" certainly doesn't apply here!
However, I was just looking at the impact of mortgage interest in isolation because the tax team response implied that if they were 40% or 45% taxpayers there wouldn't be any relief for mortgage interest, whereas there would be, albeit as you correctly commented, it is a "tax credit" and limited to 20%.
I think the other points I made about the tax credit being larger than the interest relief available to the company is correct as is the effect of dividends on the marginal income tax rate, particularly if you are lucky enough to have a substantial share portfolio that uses up the £2000 dividend allowance.

Mark Alexander - Founder of Property118 View Profile

12:39 PM, 31st August 2022, About a month ago

Reply to the comment left by Martin Thomas at 31/08/2022 - 12:31
I do understand the points you are making and your logic isn’t wrong. However, our experience is based on 1,000’s of the ‘side-by-side’ tax comparisons, as mentioned in my previous response and I can assure you that the vast majority of these reveal incorporation and the clear winner for tax savings. the savings become more pronounced the larger the portfolio and the more exposed the landlords are to finance costs.

Mark Alexander - Founder of Property118 View Profile

13:11 PM, 31st August 2022, About a month ago

Reply to the comment left by Martin Thomas at 31/08/2022 - 10:23
Hi Martin

I also wish to pick up on the following line in your comment ...

"With a limited company structure, the company will receive tax relief at 19% so arguably, you get more tax relief as an individual or partnership."

Based on this logic, if corporation tax was to fall to say 10% and the basic rate of tax remained at 20% your argument implies that the private owner would receive just half the "tax relief" of an incorporated landlord. This is confused logic. You only have to run the numbers based on a realistic scenario to prove this to be the case.

Here's a worked example.

Rental Income £150,000
Finance costs £100,000
Other allowable expenses £50,000
Real profit = £0
Other income £0

Regardless of the rate of corporation tax, the Limited Company owner pays £nil tax.

Based on the current tax legislation for 2022/23 the private owner pays tax of £27,428.40 less 20% tax credit on £100,00 of finance costs = £7,428 of tax to pay.

Here's a second worked example ...

Salary £100,000
Rental Income £150,000
Finance costs £100,000
Other allowable expenses £50,000

Regardless of the rate of corporation tax, the Limited Company owner still pays £nil tax in the company and £27,428.40 of tax on his salary.

Based on the current tax legislation for 2022/23 the private owner would be exposed to tax of £91,799.45 less 20% tax credit on £100,000 of finance costs = £71,799.45 of tax to pay.

It's quite a difference whichever way you look at it, isn't it?

If you would like to share a different scenario, where finance costs are a significant expense to the landlord, I will be happy to run the numbers for you.

Meanwhile, below is a link to another Case Study scenario explaining why some landlords with no debt whatsoever can still be significantly better off in an Limited Company combined with carefully thought through advanced tax planning ...

https://www.property118.com/benefits-incorporating-rental-property-business-no-mortgages/

Royston Olner View Profile

14:46 PM, 31st August 2022, About a month ago

Mark.
I have tried my best to follow all of your observations and I am probably going ask your company to analyse my situation, with 8 let's. 1 block of 4 converted flats. Value 800k, mortgage 200k.
1 block of 3 flats (good for holiday let, sea views & Close to seaside and town and train station) value 700k, mortgage 340k.
1 house, that I did live in for 7 months, value 350k, mortgage 140k.
My main house. No mortgage.
Looks quite good on paper.
However, all my fixed rate mortgages finish within 12 months.
If I switch to a Smart Company, can I draw down the Capital that I've introduced to the company free of tax. I'm 60 next year & have no other income. Savings of 100k.
I'm due to inheritance of around 500k at some point in the future, as an only child.
I don't need a lot to live off, just can't be taxed to the hilt.
Obviously I could sell one property every other year. That would give me plenty in the bank and make me 76.
I could then sell my main house, buy a yacht and sail around the world. If I'm fit enough.
Thanks in advance for any input.

Mark Alexander - Founder of Property118 View Profile

16:17 PM, 31st August 2022, About a month ago

Reply to the comment left by Royston Olner at 31/08/2022 - 14:46
Without completing the full consultation process we cannot make recommendations, but your understanding of what might be achievable is definitely on the right lines.

Below are links to two other readers questions and our answers should provide you with further clarity on what is achievable. For absolute clarity and certainty you will obviously need to book a bespoke tax planning consultation and we will then be able to assist you to weigh up all of the pros and cons including the investment required to restructure.

First linked article >>> https://www.property118.com/should-we-consider-a-capital-account-restructure/

Second linked article >>> https://www.property118.com/capital-account-restructuring-capital-vs-equity/

We look forward to assisting you further.

Prafula

23:37 PM, 10th September 2022, About 4 weeks ago

National Tenants Database to tackle rogue tenants costing landlords thousands of pounds

Campaign to start to protect landlords, utility suppliers, local councils from the rogue fraudster, criminal tenants and also their supporters’ friends and families who provide fraudulent, misleading documents to gain access to rental properties.
I and so many other landlords have been the victims of professional fraudster tenants who provided false references and the referencing companies have failed to recognise the false information and are then not willing cooperate and not willing to admit their mistakes.
These tenants are professional graduates, struck off lawyers, etc who get the rental properties and then do not pay rents, utility bills, council tax and cause damage before leaving the rental properties. This is causing landlords very big financial losses, stress and leading many landlords to sell their properties.
I need your support to request the government to legislate for a law for National Tenants Registration database with rogue criminal tenants’ records.

Please support on following link:

https://chng.it/wFRTrhKp

Prafula Copp

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