Are you looking to grow a property portfolio?
Are you also looking to build family wealth?
IHT, CGT and income tax destroys your family wealth
As higher rate taxpayers you could be subject to 40% or even 45% income tax on the property profits that you work so hard to generate. Once the mortgage interest relief cap comes in, the actual tax you could pay may extend beyond 55%, even to more than 100% tax. For every pound that you receive you will be giving George Osborne at least 50p.
Let’s be honest, you must be wondering what the point of keeping an asset that is generating more revenue for HMRC than it is your good self is. But, you’ll be subject to 28% Capital Gains Tax (CGT) if you decide to sell.
It does not get much better. Once you depart this wonderful world, you could be leaving your children with yet another tax burden, paying 40% inheritance tax (IHT) for any assets that exceed your personal allowance.
As you can see from the above, the tax implications of investing in property can be quite disturbing, especially after the 2015 budget announcement, which:
- introduced a 3% Stamp Duty Land Tax (SDLT) surcharge for second properties
- introduced a mortgage interest relief cap for higher rate taxpayers
- removed the 10% wear & tear allowance for furnished properties
- reduced CGT but not for property investors
I think it is understandable that many property investors feel a little hard done by given the budget changes. Not only are you penalised for buying property, you are also penalised if you sell the asset. You may now be stuck between a rock and a hard place, as the saying goes.
A real life client example
For the purpose of this article we are going to name my client John to protect his identity. John is a higher rate taxpayer earning £125,000 as a medical consultant. He has been building up a property portfolio with his wife Joan, who is also a doctor. Their property portfolio is generating £30,000 income per year, but they are highly geared with mortgage interest payments being £15,000.
They decided to go for 75% loan to value mortgages and they wanted little involvement with the properties so decided to take the furnished single let portfolio approach using a managing agent. After costs, John was making a £10,000 profit. However, because the properties were furnished John also benefited from a £3,000 wear & tear deduction, which reduced his profits to £7,000.
The tax that John paid on the £7,000 profit was £2,800, being 40%.
However, given the budget announcement changes, the 10% wear & tear allowance is removed. Additionally, the mortgage interest allowable costs are technically halved as John is a higher rate tax payer. So the following applies:
- £7,000 profit from above
- £3,000 add back the wear & tear allowance no longer allowed
- £7,500 add back mortgage interest costs as only half will be allowed in this example
- £17,500 paper profit
The tax rate remains at 40% so by 2020 John will pay tax of £7,000. As you can see, the tax bill will be the same as the £7,000 that his property portfolio is generating. So John makes no profit from his properties and if interest rates rise and his costs increase, will face a situation where an asset has turned into a liability. His tax bill has increased from £2,800 to £7,000.
How to mitigate CGT when selling properties
Sadly, in the case of John and Joan there is very little they can do apart from sell their properties or pay down their mortgages. You may think there would be a large CGT liability upon selling their investments but as I pointed out in another article, that CGT could be mitigated while benefiting from an income tax relief through other types of investments.
If John wanted to continue to build his portfolio then our suggestion is that future property investments would be held in a limited company. Buying properties in a limited company would avoid the mortgage interest relief cap.
One of the biggest benefits is that the rate of tax in a limited company is 20%, which will fall to just 17% by 2020. You can also take £5,000 in dividends out of the limited company, irrespective of how much money you earn elsewhere, if you generate profits in the limited company. If there were four shareholders then £20,000 could be taken out of the limited company — tax free.
How to mitigate IHT using a limited company
When a limited company is started they could set up the company with £1 shares for John and Joan, being a £2 investment. The rest of the money they put into the limited company may be entered as a loan to the company that may be paid back anytime tax free.
They could also give their daughter Jackie £2 shares, being 50% of the company. This means that any uplift in the company through property price increases would benefit Jackie by half the amount of the total gain.
Let’s say that the company has properties worth (net) £1m and it increases to £1.5m. Lets assume that John and Joan have no other assets. If John and Joan pass away and their IHT personal allowance is £1m, then they would be leaving Jackie with a £500,000 asset that will be subject to 40% IHT.
If Jackie does not have the funds to pay the IHT liability then she would have to sell some properties.
If John and Jackie set up the company so that they only owned 50% of the company then the nets assets from them would be £750,000 and £750,000 for Jackie. As you can see, John and Joan’s share of £750,000 is below the £1m personal allowance. This means that Jackie would not be liable for any IHT.
Not only that but John and Joan could transfer £11,100 per year to Jackie in shares to utilise their CGT allowances (£22,200 in total). Provided they survive for seven years after the transfer, then no IHT would apply to these transfers as long as the total transfers in their lifetime do not exceed their Personal Exempt Transfer (PET) allowance.
As you can see it is possible to eliminate the bulk of property-related tax provided you structure your company wisely.
Next steps — set up a property limited company
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