By Simon Misiewicz
Are you going to be paying more tax on your self assessment given the budget announcements?
Are you going to be paying tax on your property portfolio despite making a loss? This article will answer all your questions on incorporation relief.
Paying more tax due to the budget changes
Earlier this year I wrote an article that went into detail about the budget announcements set out in July 2015. I demonstrated how people with modest profits would be paying a lot more tax because of the mortgage interest relief cap and the removal of the 10% wear & tear allowance.
I went on to say that basic rate taxpayers could also find themselves becoming higher rate taxpayers even though they made only £35,000 from their employment income. The reason for this is the mortgage interest relief cap. As a higher rate taxpayer the mortgage interest that you are allowed to offset against your income will be halved.
Example: mortgage interest relief capping
£45,000 rental income
£35,000 mortgage interest
£10,000 other costs
£0 taxable profit
The above example is relatively easy to follow but after the 2015 budget announcement we were faced with a situation whereby the following takes place:
£45,000 rental income
£17,500 mortgage interest (£35,000 halved for higher rate tax payers)
£10,000 other costs
£17,500 taxable profit
The above example shows how a property investor will have to pay out £7,000 despite not making any money at all.
Can you relate to the above?
Can you see how the amount of tax you will pay may increase?
If you have answered yes to these questions then this article will be an interesting read.
Transfer your properties into a limited company
It is possible to transfer your properties into a limited company to ensure that you pay less tax on your property portfolio. By 2020 corporation tax will fall to just 18%.
The issue with this strategy is that you will pay Capital Gains Tax (CGT) based on the market value of the properties and the price you paid for them.
Example: George has built a property portfolio over the last 20 years. The property portfolio is now worth £2,500,000. Over the 20 year period he only paid £500,000 for the properties. This means that he has a £2,000,000 taxable gain. He now needs to work out his CGT liability, which is something I wrote about in a previous article.
George is a higher rate taxpayer because of his property income. He will therefore have to pay a CGT bill of:
£2,000,000 capital gain
£11,000 CGT allowance
£1,989,000 taxable gain (ignoring any other reliefs for simplicity)
£556,920 tax at 28%
As you can see the amount of tax George would pay would be significant and may outweigh the tax savings introduced by the budget announcement.
Incorporation relief for property investors
It is possible to transfer properties into a limited company without paying CGT through incorporation relief. All you need to do is transfer the property value in exchange for shares in the limited company. This is allowed under Section 162 of the Taxation of Chargeable Gains Act 1992. Guidance can be found here and here.
There are no forms to complete. Once you have incorporated your property into a business then you can take all the tax benefits.
Example: John Smith incorporated his business and received 1,000 £1 ordinary shares in ABC Ltd. The business was worth £100,000 on incorporation, so that the shares had a market value of £100 each, and the agreed chargeable gain on the assets transferred amounted to £50,000. Mr Smith does not pay Capital Gains Tax immediately. His cost of the shares for the purposes of any future disposal would normally be £100,000 but this is reduced by the amount of the deferred gain (£50,000), leaving a base cost of £50,000.
This is a great incentive, OK everyone lets go incorporate!!
Before you do please note the following criteria that must be met as a property investor. HMRC have challenged a number of incorporation relief cases and had them overturned. The one case that seems to stand out from the crowd is…
The case of Ramsay v HMRC (2013)
Mrs Ramsay inherited a one-third share of Moat House, Moatland, Old Holyrood Road, Belfast (“the Property”) in 1987. The Property is a single large building, divided into 10 flats, of which five were occupied at the relevant time.
HMRC raised an assessment in this respect on Mrs Ramsay for the tax year 2004/05 in the sum of £19,538.77 for the Capital Gain that they had identified by transferring the assets into a limited company. HMRC upheld that property investments did not constitute being a business but were an investment, for which no CGT relief was due.
However, the Upper Tribunal upheld Mrs Ramsay’s case to suggest that incorporation relief was due and that CGT should not be paid. They upheld this because it was proven that Mrs Ramsay and her husband carried out the following activities within the property business:
a) Met with tenants to discuss rental disputes and payments
b) Checked utility meters and made payments to utility providers
c) Carried out maintenance to unblock drains, fix garage doors and refurbish properties when tenants left
d) Carried out work to ensure that they were compliant with fire regulations as required by Belfast City Council
e) Carried out garden work and ongoing maintenance
f) Cleaned communal areas and cleared rubbish
g) Project managed the development of their property
Mrs Ramsay had demonstrated that they spent at least 20 hours per week on their property and as such proved that they were in fact in business.
The appeal hearing
Judge Roger Berner said in the appeal hearing: “I am satisfied that the activity undertaken in respect of the Property, again taken overall, was sufficient in nature and extent to amount to a business for the purpose of s162 TCGA. Although each of the activities could equally well have been undertaken by someone who was a mere property investor, where the degree of activity outweighs what might normally be expected to be carried out by a mere passive investor, even a diligent and conscientious one, that will in my judgment amount to a business. I find that was the case here. For the reasons I have given, I allow this appeal.”
So, what does this mean for you? If you can prove that you work with your properties on a daily basis (at least part-time) then you may be allowed to incorporate your property business without having to pay CGT.
If you are working in another business or are employed then you will find it very difficult to prove your case for incorporation relief.
The Ramsay case endorsed the approach in the 1978 case of American Leaf Tobacco, confirming that for there to be a business eligible for incorporation relief there has to be “activity” and that the degree of activity must be significant. It is the quantity, not the quality, of the activity that is important.
Next steps — incorporate your property business
If you want to understand how to implement this strategy or to discuss other finance or tax questions then please book some time with us using the below calendar:
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