Tax Efficient Property Investment

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Before you buy another property you need to understand this …

The correct ownership structure is a vital ingredient to your success as a property investor. The following Case Study and explanatory notes explain why, by comparing a property private rental property business owner with a private hotelier.

Let’s assume that both businesses own assets worth £2,000,000 and have mortgages at 75% of value secured on them at an interest rate of 5%. In other words, their annual finance cost bill is £75,000.

Now let’s assume that both businesses make profits after finance costs and all other expenses of £50,000.

The hotelier will pay £7,500 of income tax. This is broken down as follows; £nil on his first £12,500 of net profit and 20% tax on the next £37,500 (based on the 2021/22 tax bands).

However, the private landlord cannot treat his finance costs as a legitimate cost of business in the same way as the hotelier. Accordingly, his tax bill is £27,500. This is because his taxable income is treated as being £125,000 due to being unable to claim his finance costs as business expenses. Furthermore, for every £2 of taxable income over £100,000 he loses £1 of his personal allowances (also know as his nil rate tax band). Accordingly, the landlord pays tax at a rate of 20% on the first £37,500 (which equates to £7,500) and then 40% tax on the other £87,500 (which equates to £35,000). This adds up to a whopping £42,500. The government then grant him a tax credit equal to 20% of his finance costs, in other words £15,000 off the £42,500 leaving him with a net £27,500 of tax to pay.

To summarise, the private landlord pays more nearly four times as much tax as the private hotelier, even though their financing costs and business results otherwise produce identical levels of actual profit.

HOWEVER, if both the landlord and the hotelier operated their businesses within a Limited Company structure, they would pay exactly the same amount of tax.

How crazy is that? !!!

But before you rush off to form your Limited Company, please read on …

Not all Limited Companies are the same!

You can form a Limited Company on the internet for as little as £12.99 and you will get the benefits described above. However, what you will end up with is a company with ordinary shares and no other tax planning whatsoever. This is a missed opportunity of HUGE significance!

One such example is that an ‘alphabet share structure‘ will provide significantly more tax planning opportunities to utilise the lower rate tax bands of other family members to save income tax, and most accountants can create a company on that basis for a fee of £500 + VAT. It’s great value for money, because the savings in just one year could be many times the cost.

But it’s not all about income tax!

Most landlords choose to retain their profits in the early years in order to build a retirement fund and to create a legacy to leave to their loved ones.

That’s all great at face value, and by the time the Queen celebrated her 70th Jubilee on the throne properties had increased in value 138 fold, so property is definitely an investment with a strong pedigree.

Who would have thought, back in 1952 when an average property was worth under £2,000, that by January 2022 the average property value would have been £274,000? That’s the equivalent of an average property 70 years from now being worth nearly £38,000,000, assuming history repeats itself.

Given that Government have frozen the Inheritance Tax Threshold, a person who owns just one average property today could be storing up an Inheritance Tax liability of £15,000,000 for their grandchildren to have to pay before they are allowed to inherit just that one property. Ludicrous isn’t it?

Just to be clear, Inheritance Tax is 40% of the net value of your estate exceeding £325,000.

By the way, by the time your Grandchildren inherit it’s likely that your children will also have paid the 40% inheritance tax on the value of your estate too.

However, by cleverly structuring the company shares it is possible to accrue all future growth outside of your estate, meaning that when you die that growth isn’t subjected to Inheritance Tax, nor are those shares subjected to tax when your children, grandchildren and so on pass away.

This form of Tax Planning cannot be undertaken by Accountants, because it involves reserved legally activities such as redrafting the company rules registered at Companies House as well as drafting a Shareholders Agreement to ensure that HMRC’s General Anti-Avoidance legislation doesn’t come into play.

Back in 2019, HMRC was so worried about the loss of income to the Treasury that they created a “Special Investigation Unit” to look into what they termed “Family Investment Companies“. However, by Summer 2021 the unit was closed down on the basis of their own findings, which in simple terms confirmed that business continuity and legacy planning of this nature (if done correctly) is a perfectly legitimate form of financial planning.

Up until 2015, when Property118 and Cotswold Barristers formed a strategic alliance, the form of tax planning mentioned above was unaffordable to most UK private landlords. A discussion alone with a Barrister could cost several £1,000’s and the costs of implementation would often run into £100,000 or more. Nowadays, a Landlord Tax Planning Consultation with Property118 is priced at just £400 and comes with a guarantee of total satisfaction or a full refund.  The entire costs of implementation of what we have branded and trademarked as the “SmartCo” structure typically costs less than £20,000 to implement and also includes a full review of the other key forms of legacy planning including Wills, Discretionary Trusts and Lasting Powers of Attorney and their implementation where required. The costs, which can easily be financed for most people who should consider this planning, pale into insignificance when compared to the savings

If you already own investment properties and would like to transfer them into a structure of this nature, OR if you have a Limited Company already in place for to own your investment property that you would like to consider converting into this type of structure, we can help with that too.

The following is a ‘Readers Question’ that was posted on the Property118 discussion forum in September 2021. Feedback on our response has included phrases like “Outstanding!”, “Solid Advice” and “I wish I had known about your services years ago”.

We need some Buy to Let Tax Advice on our Let to Buy plans please.

My wife and I are looking to buy a larger more expensive home and let the one we currently live in.

Barclays have offered us some great interest rates because we have a large deposit for the new property and a lot of equity in the existing one, which they will give us a Buy to Let mortgage on.

We have a perfect credit score and plenty of income to cover the loans and being Barclays Premier Banking clients I think that’s why they are offering us such a good deal.

I have two initial questions in regards to tax and will look into booking a tax consultation with Property118 if you can help me with these two questions,

I do have a few ideas of my own, but I will not share them at this stage because I am curious to see what Property118 and it’s Members suggest first.

My first question is in regards to Stamp Duty Land Tax.

Is there are way around paying the additional 3% rate on the new home we are planning to buy?

My second question is in regards to the Section 24 restrictions on finance cost relief. We think we understand this means that we will not be able to offset the mortgage interest on our Buy to Let mortgage against rental income, but instead we will receive a 20% tax credit. If I am right, this means that we will effectively paying a 25% rate of tax, because we are 45% tax payers, on our mortgage interest on the Buy to Let.  So, what’s the best way to structure this please?

Thanks in advance for your help.

Regards

Neil

Response from the Property118 Tax Team

Hi Neil

Our initial suggestion is that you sell your existing home (the one that will become a Buy to Let) to a newly formed Limited Company. There will not be any Capital Gains Tax to pay because this property has (presumably) been your home from the day you first purchased it. Your company will pay Stamp Duty Land Tax plus the 3% additional rate on this transaction, however, you will then save the 3% additional Stamp Duty on your new home.  We will be happy to help you to do the number crunching to see whether the Stamp Duty Land Tax saving on your new home would more than cover the Stamp Duty Land Tax that would need to be paid by the company, but you should not make your decision based on that calculation alone.

There are other advantages of having your Buy to Let property in a company. The first is that Section 24 does not apply to companies. This means you will be able to offset 100% of your mortgage interest against the rental income.

If the interest rate that Barclays are offering on your new home mortgage is similar to the Buy to Let mortgage they are offering, it might make sense to borrow more against the rental property and less against your new home. This is because you won’t get any tax relief on the mortgage interest on your home.

If the interest rate on the Buy to Let mortgage is higher than the interest rate on your new home mortgage then a bit of number crunching will be required to calculate the best outcome when also factoring in tax.

Another advantage of selling your existing home to a Limited Company is that the element of the sale and purchase consideration which isn’t subject to a mortgage can be regarded as a Directors/Shareholders loan. One of the additional benefits of structuring the deal that way is that you will then be in a position to retain your rental profits in your company at a much lower corporation tax rate than the 45% rate of tax you would pay if the property was owned in your own names. Furthermore, the company can use that retained profit to repay your Directors/Shareholders loans to you and the repayment of that money would be tax free for you.

Last but not certainly not least is inheritance tax, which may well be important for you if you and your wife plan to leave a legacy for your loved ones.

By structuring your Buy to Let transaction as per our suggestions above, the value of your shares in the company will be negligible at the beginning. However, as your Buy to Let property appreciates in value, so will the value of your shares in the company. If you do nothing about this, your loved ones may well be subjected to 40% inheritance tax on that capital appreciation when they eventually inherit those shares. For example, if we assume that your Buy to Let property is worth say £300,000 on day one, it might quadruple in value by the time you die. That’s £900,000 of growth which could be subjected to a whopping £360,000 of inheritance tax! However, there is a way you can solve that problem for your beneficiaries by doing the right things now.

With professional legal advice, it is possible to amend the Memorandum and Articles of Association of the Company to dictate which classes of shares accumulate any such growth. Naturally, this would also require your company to have multiple share classes too. If you give those “growth shares” away whilst they are worth very little, then any growth can accrue outside of your estate for inheritance tax purposes.

The growth shares could be gifted to one or any number of people, but for the purpose of flexibility we suggest you gift them to a Discretionary Trust. That way, you set the rules and you can also amend them during your lifetime. For example, you may change your mind over who you want to benefit from the trust over your lifetime.

As you may have gathered, the inheritance tax planning we have described above is extremely complex. You will probably need a professionally drafted Shareholders Agreement too. This sort of planning should never be DIY and Financial Advisers and Accountants can’t help either, because the work required involves “reserved legal activities”. There is also a huge amount of anti-avoidance legislation you could fall foul of, such as GAAR, DOTAS and the settlement Legislation, which is why insured professional advice from a fully trained, practicing, regulated, experienced and insured Barrister-At-Law is so vital.

As an indication of the legal costs to implement all of the above, you would need to budget around £20,000 – of which circa 75% would be for the inheritance tax planning. You will never see the benefit of your Inheritance Tax Planning of course, but it will eventually save your loved one’s a fortune. That’s why we used the words ‘the right thing to do’. The other thing to bear in mind is that if you get a taste for being a landlord, the structure we have recommended above is sufficiently flexible to accommodate any number of additional rental properties you acquire. You only need one structure like this, regardless of how many properties you own.

The above is just an initial overview based on the information you have shared with us. It must not be regarded as professional advice at this stage, but we hope you have found it helpful.

For anybody reading this who already owns a rental property business, it’s never too late to start your planning. We have helped several very established landlords to restructure their rental property businesses in this way. Whilst the inheritance tax structure we have described will not solve the problem for assets you have already accumulated, we can stop the clock so that any future growth accrues outside your estate.

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