Property Company Taxation
Can Using a Property Company Save You Tax?
It’s one of UK landlords’ most frequently asked questions. Answering it is far from simple, as it involves a great many factors, not all of which relate to tax.
Nevertheless, tax is often the main reason that the question is asked in the first place for the simple reason that property companies generally benefit from much lower tax rates than higher rate taxpayer individuals. Changes currently being made by the new Coalition Government are widening this gap even further.
Most companies pay Corporation Tax at the ‘small profits rate’. This rate usually applies to the first £300,000 of taxable profit each year. In April, it will reduce from its current level of 21% to just 20%.
Companies with profits over £300,000 pay a higher rate of tax but, even then, the highest marginal rate that any company suffers is currently just 29.75% and even this will reduce to 25% by 2014.
Compared with higher rate Income Tax at 40% and ‘super tax’ at 50% for individuals with income over £150,000, it is easy to see why so many landlords are attracted to the idea of using a property company to save tax.
For basic rate taxpayers, however, a company will not usually provide any advantage, as the tax rate applying to rental profits in a company is currently higher and, even after the reduction in April, will simply be the same.
What about Capital Gains?
To work out a company’s Corporation Tax bill we simply add all of its profits and capital gains together and apply the same tax rate to the total. Hence, a company pays tax on capital gains at the same rate as on rental profits. Large capital gains can push the company’s total profits over £300,000 and thus lead to a higher tax rate on the excess but, by 2014, the highest effective rate applying will still be just 25%.
With higher rate taxpayers now paying Capital Gains Tax at 28%, the Corporation Tax bill on most capital gains made by companies will be lower.
Furthermore, companies have the advantage of indexation relief: a special deduction designed to exempt them from tax on the inflationary element of their capital gains. This relief was fully withdrawn from individuals in 2008.
Combining the lower tax rates paid by property companies with the indexation relief available means that many capital gains on investment properties will be subject to far less tax if those properties are held within a company.
Buzz and Jessie are both higher rate taxpayers. In April 2011, they each buy a rental property for £200,000. Buzz buys his property personally, but Jessie buys hers through her company: Small Storey Ltd.
Both investors hold on to their properties for four years and then sell them for £270,000.
Buzz can deduct his annual exemption of, say, £12,000 from his gain of £70,000, leaving him with a taxable gain of £58,000. His Capital Gains Tax bill, at 28%, will therefore be £16,240.
Small Storey Ltd is not entitled to an annual exemption but the company can claim indexation relief. If we assume an average annual inflation rate of 3.5%, the total inflation for the relevant four year period would amount to 14.8%, giving Jessie’s company indexation relief of £29,600 (£200,000 x 14.8%).
The company therefore pays Corporation Tax at 20% on a net capital gain of £40,400 (£70,000 - £29,600), giving it a tax bill of just £8,080: less than half the tax paid by Buzz!
As we can see, companies will often pay far less tax on the sale of a rental property. There are some important exceptions to be aware of, though. For example, an individual will generally pay Capital Gains Tax at just 10% on a property which qualifies as a furnished holiday let.
Individuals can also drastically reduce their Capital Gains Tax bills by adopting properties as their main home for a year or two. Property companies cannot do this. In fact, in most cases, living in a property owned by your company is an absolute disaster from a tax viewpoint!
So far, the picture we see emerging is that a company seems to be beneficial for higher rate taxpayers holding investment properties.
The problem, however, is that the advantages gained by using a company are pretty much wiped out if you take your profits out of the company. This is because, as a higher rate taxpayer, you will be taxed again when you extract the profits from your company.
The best way for an individual to take money out of their own company is usually to pay themselves a dividend. Unfortunately, however, a higher rate taxpayer suffers Income Tax on dividends at an effective rate of 25%.
For every £100 of profit your company makes after April 2011, it will be left with £80 after tax (assuming its total profits are less than £300,000). If you take out that £80 as a dividend, you will have to pay another £20 in Income Tax, leaving you with just £60.
If you’d simply held the property yourself, you would have paid Income Tax at 40% on your rental profit: in other words, you would keep £60 after tax for every £100 of profit. So, it’s the same: the company has saved you nothing!
Individuals with income over £150,000 pay Income Tax on dividends at an effective rate of 36.1%, so they would be left with just over £51 from a dividend of £80. It’s a little better than the £50 of net after tax profit for an individual landlord, but most of the advantage has still been lost once again.
And capital gains? In our example above, Buzz was left with a net gain after tax of £53,760. Jessie’s company was left with £61,920, so she initially seems better off. However, if Jessie then takes her net gain as a dividend, she will have to pay a further £15,480, leaving her more than £7,000 worse off than Buzz in the end!
The extra tax arising on dividends means that it is generally only worth using a property company if you intend to reinvest the majority of your profits within the company over a long period.
When a property company is used in this way, the lower Corporation Tax rates can really pay off because you will be reinvesting more after tax profits than you could have done if you had held your properties personally. Over a long period, this means that you can build up a much larger, or more valuable, portfolio. Then, when you eventually sell up and finally extract your profits, the extra value in the portfolio is more than enough to compensate for the extra tax arising.
As I said at the start of this article, this is a highly complex subject with a huge number of issues to think about. Hopefully, however, I have given you a good insight into the main factors to be considered.
The key points to remember are:
- A property investment company is seldom of any benefit to basic rate taxpayers or to individuals who extract most of its profits every year
- A company can, however, be beneficial when used as a long-term investment vehicle
- Companies generally pay less tax on the sale of investment properties but cannot benefit from some important reliefs available to individuals
- Property companies provide far greater scope for interest relief
In the end, only you can decide whether a property company is appropriate for you, but let me leave you with one final thought:
There is absolutely nothing to stop you from running two property businesses in parallel – one as an individual and one through a company. In fact, for many landlords, the best route is to start with a small property business owned personally and then start up a second business in a company later on.
As well as lower tax rates, property company taxation has one other major advantage: interest relief.
Individual landlords can only set interest costs against their rental income, often leading to rental losses which can generally only be carried forward for set off against future rental profits.
Companies, on the other hand, can set their interest costs against any income or capital gains within the company.
Alternatively, if you borrow personally to invest in your property company, you can generally claim tax relief for your interest against any of your personal income, including salary, self-employment income, or rental profits from properties owned personally.Either way, the scope to get tax relief for interest costs is vastly increased!