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A-LEVEL TAX PLANNING
Reeling from the shock
This is being steadily phased out, as almost all buy-to-let landlords will now know, over a four-year period starting in 2017.
The only good thing you can say about this is that the Government is giving us a while to adjust to the situation, and the purpose of this piece is to consider what options are open to buy-to-let landlords to respond – apart from selling up and moving to a more sensible jurisdiction.
“It’s not fair…”
We all remember this oft-repeated phrase in the mouths of children, who haven’t yet woken up to the way life works. It now seems to be a favourite phrase of our Chancellor of the Exchequer as well. If you play back, or read, his Budget speech in July of this year, he expressed the view that “it’s not fair” buy-to-let landlords get tax relief for interest paid while owner-occupiers of their own homes don’t get relief for mortgage interest.
He may be thinking here of the fact that owner-occupiers used to get mortgage interest relief: those of us who are longer in the tooth remember the days of MIRAS, or mortgage interest relief at source. This, too, was restricted to basic-rate relief only, before eventually being abolished. What the Chancellor may have forgotten, though, or may indeed have never known, is that the reason why mortgage interest relief was first brought in was because owner-occupiers paid income tax on the notional ‘benefit’ of living in their own home. This charge was abolished sometime in the early Sixties, but, probably by pure oversight, the corresponding mortgage interest relief continued. So owner-occupiers were arguably getting very unfair benefit in terms of mortgage interest relief.
The case of buy-to-let landlords, as any child over about the age of nine could see, is not at all on all fours. Letting property is a business, sometimes a very arduous and risk-laden one. The profits of that business are what the owner has left over after paying repairs, utilities, insurance and loan interest. The concept that it is somehow more ‘fair’ to charge landlords to tax as though they weren’t paying this interest completely defies logic. We have come across a number of examples already of people whose tax bill is likely to be more than their actual profits from the rental business – a more than 100% rate of tax. It’s not fair.
Where to now?
Aside from lobbying MPs, and signing the online petition on the subject, though, we probably have to accept we are being ruled by politicians with a twisted and distorted view of what is fair. However, they’ve given us time to sort our affairs out: so what should we do?
A number of newspaper features, in the FT and elsewhere, have set out a quick rundown of buy-to-let landlords’ options, and most of these are pretty obvious.
One possibility is to sell property in order to reduce or eliminate the offending borrowing. That’s all very well, of course, but it has obvious disadvantages. First, your property portfolio, and therefore your chance of enjoying future capital growth in your investment, is scaled down. Second, the sale of property may give rise to capital gains tax (CGT). Third, this obviously isn’t an option for those (still quite plentiful) who are in negative equity.
Another option that a lot of buy-to-let landlords will be forced to favour is that of tightening their belts, and using the cash flow to reduce the borrowing: obviously reducing the higher-interest loans before the lower-interest ones. But this is only a limited solution, and probably a lot of buy-to-let landlords were doing this anyway.
Incorporation
An option that is attracting a lot of attention at the moment is that of transferring the property portfolio to a limited company. Limited companies aren’t subject to higher-rate income tax, and therefore are outside these new rules. Many tax advisers and promoters seem to be heavily in favour of this option, but our own view here is that you should approach it with extreme caution.
First, there is the problem of getting the portfolio into the company without triggering big tax charges. The main enemies here are CGT and stamp duty land tax (SDLT).
The promoters have answers to both of these tax threats. CGT, they say, can be got round by ‘incorporation relief’. Even if your portfolio has gone up in value from when you bought it (which applies to most buy-to-let landlords), this gain does not crystallise in a tax charge, when you dispose of the portfolio to the company, if the portfolio comprises a ‘business’, and if the company issues you shares in exchange. This brings into operation a special relief for the incorporation of businesses.
On the SDLT front, there is a strange anomaly (so it seems to us) in the rules which says that the transfer of property from a ‘partnership’ to a connected company doesn’t give rise to SDLT.
Both of these ‘get out of jail free’ cards come with a caveat, though. First, the CGT relief relies on the portfolio being a ‘business’ – a very vague and undefined term and, second, the SDLT relief depends on the holding of property having been a ‘partnership’, another term which is not necessarily easy to define.
Because of these grey areas, it’s not possible, in our view, to incorporate a large property portfolio without a very real risk of substantial tax charges arising as a result.
What’s more, once the portfolio is in the company, it is subject to a different, and possibly less benign, CGT regime.
Having said all that against the ‘simple’ incorporation route, there may still be ways in which limited companies can be used, and we will come on to those later.
The commercial property option
Another possible option is moving from investment in residential property to investment in commercial property, which doesn’t seem to be covered by the new interest rate restrictions. The Government is clearly trying to depress the residential property market, which has seen very large prices rises recently.
This isn’t a tax decision, though, we would suggest. Except in extreme cases, an investment should be looked at from the point of view of its commercial merits rather than its tax advantages. However, one possible way of having your cake and eating it would be to buy commercial property that was nevertheless of the type which may at some point in the future be converted to residential, hence you have the possibility of residential levels of capital growth with the tax advantages of currently holding the property which is commercial.
Structural solutions
Apart from the incorporation option, all of the above ideas comprise what could be called commercial solutions: paying off borrowing, moving into commercial property investment and so on. But there are structural solutions as well, and probably the simplest of these (at least conceptually) is spreading the ownership of the portfolio amongst lower tax paying members of one’s family or household. The new rules only affect people who are paying tax at the higher rate, so if, for example, your spouse is a basic rate taxpayer with spare capacity, it would make sense to transfer properties into his or her ownership, or joint ownership with yourself.
For individuals other than one spouse or civil partner, on the other hand, there is a problem with CGT. The transfer of property to these people will trigger a notional ‘gain’ based on the market value.
To some extent this could be got round, if property of no more than £325,000 were going to be transferred, by transferring it to a trust in which the relevant individual had a ‘life interest’, that is the right to receive rents as they arise. Transfers to a trust do not give rise to capital gains if a ‘holdover election’ is put in. But transfers to trust of over £325,000 over a cumulative seven-year period are liable to inheritance tax, at 20%, instead. So this is only a solution ‘to an extent’.
Solutions involving companies
Despite the note of caution we sounded about the ‘straightforward’ incorporation option, there may well be solutions involving the use of limited companies and their freedom from the new interest relief restriction.
The simplest would be to set up a limited company to manage the portfolio, and put in a charge. This is potentially useful in small cases, but where the company is charging more than the VAT threshold, the added VAT (probably not recoverable if you are simply letting residential property) will likely more than counteract the benefit of the company’s income being chargeable at 20%.
A more sophisticated solution would be to bring the company, in some form, into shared ownership of the property portfolio. As a co-owner, its income is not a charge to the portfolio, and therefore it isn’t subject to VAT. It is possible to leave the money in the portfolio, or use it to pay off borrowing, without the company’s income having to be paid out as dividends; although, even paying out the income as dividends is still an advantage if it means the relevant proportion of the rents have secured interest relief.
Bringing a company into partnership in a more elaborate way can be formalised by use of a limited-liability partnership (LLP). With an LLP, the route to freedom from CGT and SDLT on introducing the company into the picture is a much more well-trodden path…
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