When rental properties are transferred to a Limited Company the Capital Gains Tax “CGT” position is ordinarily no different to selling the properties to a third party, i.e. acquisition costs and capitalised improvements are deducted from the open market value of the property(ies) to establish the capital gain. This gain is then added to all other income and taxed at a rate of 18% for basic rate tax payers or 28% for higher rate tax payers. However, in certain circumstances, CGT may be substantially reduced or negated completely with incorporation relief.
TCGA92/S162 ‘incorporation relief’ applies where a person other than a company transfers a business as a going concern with the whole of its assets (or the whole of its assets other than cash) to a company wholly or partly in exchange for shares. In these circumstances, the charge to CGT on the whole or part of the gains will be postponed until such time as the person transferring the business disposes of the shares. Essentially, the capital gain is ‘washed out’ of the properties and into the shares.
The way the relief works in practice is that all or part of the gains arising on the disposals of the assets are ‘rolled over’ against the cost of the shares.
An easy way to understand “Washing Out CGT On Incorporation” is to consider the following analogy.
Imagine you have just cleaned a muddy floor with a white towel. The towel isn’t white any more is it? This is because the mud has been transferred from the floor onto the towel. The floor might well be clear of mud but the towel isn’t is it? The mud still exists, it has merely been transferred.
Now imagine washing the towel in a bucket of water. You can wash the mud out of the towel but the mud remains in the water doesn’t it?
In both scenarios there is no less mud after the transition than there was before. You have simply moved the unwanted mud from an inconvenient position to a more convenient position for you.
In this analogy, the mud represents the capital gains on which CGT is ordinarily payable. The towel represents shares in your new company and the bucket of water might represent your long term exit strategy.
Imagine a scenario where a property was originally purchased for £100,000 but transferred to a company for £500,000. If that property was sold for £500,000 the following day, the company would have made no profit, hence there would be no capital gains. This is because the £400,000 of capital gain has been washed out of the property and into the company shares. Therefore, the CGT is deferred until the shares (not the properties) are disposed of.
Where equity in a property rental business is greater than the capital gain a further tax planning opportunity exists. This is achieved by increasing the liabilities of the businesss to the acquisition cost plus capitalised improvements of the business prior to incorporation.
Here’s an example:-
In this scenario the landlord could increase liabilities to £3,000,000 to fund the withdrawal of the £1,000,000 of investment capital tied up in the business.
When the landlord then incorporates, £2 million of shares created offsets the £2 million of capital gains.
The landlord could then lend the £1,000,000 of capital withdrawn prior to incorporation to the company.
The company could then reduce its liabilities back to £2 million.
The net result is that the company now owes the landlord £1,000,000. Repayment of a loan from a company to landlord incurs no income tax. Therefore, the landlord can now withdraw £1,000,000 from the company in the form of loan repayments without incurring any additional income tax liability. The funds could be raised by the company through refinancing, property sales or post tax profits.