What if Section 24 is applied to recently incorporated landlords?Make Text Bigger
I see this question posted on Facebook every few weeks, so I have decided to write an article on the topic, which I can share a link to whenever it pops up again.
It wouldn’t matter if Section 24 was applied to LTD Companies, because the 20% tax credit on finance costs is greater than the 19% corporation tax payable by companies, and that’s scheduled to reduce to 17% in 2021.
In other words, incorporated landlords would actually be better off if S24 was applied to them!
Here’s a very simple worked example.
- Rental income £300,000
- Mortgage interest £100,000
- Other expenses £100,000
- Net profit £100,000
At the moment, a corporate landlord would pay 19% tax on £100,000, which is £19,000.
An individual landlord would be taxed on £200,000 at his/her marginal rate and then receive a £20,000 tax credit (20% of finance costs). Even if the landlord had no other income whatsoever, and assuming the tax legislation doesn’t change, as of the April 2020/21 tax year the landlord would pay £55,000 of income tax a year on this basis.
If Section 24 was applied to a Limited Company, it would be taxed at 19% of £200,000, which is £38,000. However, the company would then receive the £20,000 tax credit (20% of finance costs), which would reduce the tax payable to £18,000. When corporation tax rates reduce to 17% the company would pay £34,000 of tax, less the same £20,000 tax credit, so the effects of Section 24 on the company would result in even more savings.
The above assumes the corporate landlord takes no income from the business whatsoever. If the landlord was to declare 100% of profits as dividends, the total amount of tax then payable would rise to £30,388. Even then, that’s still £24,612 less tax than the private landlord would pay!
The software we used to crunch these numbers can be purchased for just £97 via THIS LINK
Ah, but what if the Government cancel the 20% tax credit, the negatively minded might ask.
Well that’s when things get really interesting, because I think it is fair to say that even more landlords would consider selling up and investing into other asset classes, especially those who are unincorporated. That’s when tax on capital appreciation kicks in. For individuals this is CGT, which is likely to be 28% of the capital gains. However, the Limited Company will not pay CGT, instead it will pay corporation tax at 19% on any capital appreciation of assets since the date of incorporation, not the date at which the properties were fist acquired by private landlords before they incorporated.
Incorporation relief and latent gains explained
A common question asked by landlords who are considering the transfer of their rental property business into a Limited Company is this; how does incorporation relief work and what does washing out Capital Gains Tax (CGT) on incorporation actually mean?
I will explain this first using an analogy, which will make a lot more sense when I then relate it back to the question.
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.
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 and the towel represents shares in your new company.
When a property rental business is transferred into a company it is treated as a sale, which crystallises capital gains. However, a piece of legislation called TCGA92/S162 enables business owners to exchange equity in their business for shares and to offset the value of the shares created (the value of the equity in the business) against the capital gain resulting from the sale of the business, to reduce or even eliminate the payment of CGT at this point by deferring it. Effectively, the capital gains have been transferred from the properties into the shares in the company, much like the mud being transferred from the floor to the towel.
Imagine a scenario where a property was originally purchased for £100,000, but transferred to a company for £200,000. If that property was sold for £200,000 the following day, the company would have made no profit, hence there would be no tax due. This is because the £100,000 of capital gain has been washed out of the property and into the company shares. The CGT is deferred until the shares (not the properties) are disposed of.
However, there is a scenario where CGT would not fall due on disposal of the company shares, i.e. if the owner of the shares dies before they are transferred – rather an extreme way to avoid paying tax though!
The above often leads to another question; “what are latent gains?”
Latent gains occur when equity in your business is less than your capital gains. Capital gains are current value minus acquisition costs. Equity is current value minus liabilities. If a latent gain exists, it is because you have insufficient equity to convert into shares in order to offset all of your capital gains at the point of incorporation. Accordingly, CGT remains payable on the element of latent gains. There are only a few ways to avoid this problem. The first is to move abroad and become non-resident, in which case your acquisition costs are deemed to be the value of your properties as of April 2015, or the date you purchased them if they were acquired after April 2015. The others are to reduce your debt, or to add assets to the business, so that your equity is the same level as your capital gains.
Landlord Tax Planning Consultancy is the core business activity of Property118 Limited (in association with Cotswold Barristers).
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There will never be an optimal ‘one-size-fits-all’ business structure for tax purposes. The presentation below provides a useful overview of some of the options you might like to discuss with us.
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