Should I use a company to purchase my buy-to-let property?
Before you rush to purchase your buy-to-let property through a limited company, make sure you understand how the structure works, including the ins and outs of the latest tax rules.
In this guide we explore the differences between buying an investment property in your own name and through a limited company known as a Special Purpose Vehicle (or SPV).
(N.B: The terms limited company and SPV are used interchangeably in this guide as an SPV is the type of limited company commonly used in this context).
Let’s start with the new tax rules for landlords
- An additional 3% stamp duty for investment property which came into force in April 2016
- Landlords who pay the higher-rate of income tax (40% — 45%) will have the tax relief they can claim on mortgage interest reduced to 20% by April 2020 (the example below illustrates how this works). This reduction will be phased-in gradually over four years, starting in April 2017.
- From April 2016, the wear and tear allowance will also be restricted so that landlords can only claim tax relief when they replace furnishings.
The above tax rules apply to both individuals and companies with the exception of the second point about mortgage interest relief. This only applies to individuals, meaning someone with an investment property held in their own name and earning over £43,000 of income from any source (including rent) will be forking out more tax on their investment property.
So, what are your options?
There are alternative ways to purchase a property, one of which is to buy through a limited company (SPV). This has been the most popular alternative since the introduction of the new tax rules. Buying through an SPV will not necessarily be beneficial for everyone and you should seek professional financial advice on whether it makes sense for you based your individual circumstances.
What is an SPV?
SPV stands for Special Purpose Vehicle and is a form of limited company that is used solely for investment purposes. Purchasing, managing or selling a property (or properties) through a limited company is a commonly used form of SPV. The company, rather than the individual will be named as the owner of the property with the land registry. Investors can create an SPV to purchase one property or several, and then become shareholders in the resulting company.
Properties held in an SPV are only subject to 20% corporation tax which can mean a big saving for landlords depending on their personal circumstances and investment goals. This saving will be greater still once this rate is cut to just 17% in 2020. In addition, as mentioned previously, the new restrictions on mortgage interest relief do not apply to SPVs, and therefore the company can still utilise the full allowance, increasing savings further still.
Another attractive feature of an SPV structure is the flexibility it offers in ways to sell a property. For example, you can sell and acquire shares in the SPV which holds the property, rather than having to sell or buy the property itself. Detailed later in this article are the various ways to sell shares and withdraw cash from the SPV along with the tax implications of each scenario.
How does tax on rental income work in an SPV?
The tax structure for purchasing property through an SPV is more complicated than doing so as an individual. For individuals, rental income is added to their total annual income and tax is paid on the whole amount at the corresponding rate. Tax on rental income from a property held in an SPV is paid in two main ways:
1: Corporation tax
20% of a company’s profit is currently payable to HMRC in the form of corporation tax. In the summer budget of 2015, it was confirmed this will be reduced to 19% in April 2017, and further still to 17% in April 2020. Good news for investors looking to purchase through an SPV.
2: Income tax on dividends
In addition to the corporation tax detailed above, an investor would also be liable to pay dividend income tax on any profit they take out of the company. The rules for this are as follows:
Up to £5,000 dividend taken out = 0% (Free!)
N.B. The 5K tax free limit applies to ALL dividends an individual receives from all sources, not just the SPV property (within a tax year).
Any additional funds withdrawn above the 5K limit are taxed based on your own personal tax band:
Basic Rate Tax Band = 7.5%
Higher Rate Tax Band = 32.5%
Additional Rate Tax Band = 38.1%
Dividends are discretionary and tax is only paid when an investor decides to withdraw the funds. Profits that are not withdrawn as dividends and are kept in the business are known as retained earnings. Generally retained earnings are held back to re-invest into the company, pay off a debt or purchase another capital asset (i.e another property)
Dividends received via pensions and ISAs are unaffected by any dividends withdrawn from the company.
Buying as an individual vs. buying through an SPV
Example 1 — Buying as an individual: Old vs New tax rules
John has a current salary of £50,000 p.a. and he also earns secondary income from his investment property which he rents out. He receives rental income of £22,000 p.a and pays total mortgage interest of £15,000 p.a.
As John’s combined income exceeds £43,000 p.a he is considered a higher-rate tax payer and will therefore be taxed at 40% on his rental income. The amount of mortgage interest he is able to claim as an expense will be reduced by half under the new rules (see above).
John was able to deduct £6,000 under the old tax regime but by 2020 this will be significantly reduced to just £3,000.
The tax he pays on his rental income by 2020 will be £5,800, an additional £3,000 per year compared to the old tax regime where he paid just £2,800!
These new tax rules will be phased in from 2017 and will be in full force by 2020. It’s important to understand what the full effect of the tax changes will mean by 2020 so you can plan how you will invest in your property effectively now.
Example 2 — Buying through an SPV
Now let’s compare the tax John would pay if he was to purchase the property through a company (SPV). We are going to assume John wants to withdraw all net profit from his rental income every year.
In this case John will pay two lots of tax: the first is corporation tax which is currently 20% of net income but by 2020 this will stand at 17%. As he’s using an SPV he will still be able to utilise the full tax relief on his mortgage interest. Therefore the corporation tax he pays (using the 2020 rate) is simply 17% x £7,000, meaning a total £1,190.
The second portion of tax John pays is on the dividends he receives to extract his net profit on rental income. The total funds remaining in the company after paying corporation tax is £5,810. John will pay 0% on the first £5,000, and 32.5% on the remaining £810, meaning he must pay a total of £263 in dividend income tax.
The total tax he pays under an SPV therefore equates to £1,453, comprised of £1,190 corporation tax plus £263 dividend income tax.
Purchasing a property through an SPV company will save John a total of £4,347 per year in tax (a huge 75% saving!)
Example 3 — Lower rental income:
John’s less fortunate brother Rob (who is also a higher-rate tax payer) purchases a similar house and pays the same amount of mortgage interest as John but only receives rental income of £19,000 p.a (after deducting the costs of managing his property).
If Rob held the property in his name, he would have to pay the tax man £4,600, even though the total profit he actually receives on his £19,000 rental income after he pays his mortgage interest (£15,000) is £4,000. This means he would now have to fund a tax shortfall of £600 from of his own pocket. This would be tough on poor old Rob as he would have to fund this shortfall from salary he has already paid tax on.
Example 4 — Small mortgage & Dividend exempt utilised elsewhere
Lets look at the example of John and Rob’s parents: Ned & Caitlin who are also purchasing an investment property. They are both higher-rate tax payers and have deep enough pockets to fund most of the property from their savings, needing only a very small mortgage from the bank. They also receive dividends of £5,000 each in shares they hold in another company. They receive a net rental income of £22,000 p.a. and pay mortgage interest of just £5,000 a year.
In their current situation they would not benefit from having the property in an SPV. They will have a large amount of net profit of £14,110 to extract from the company and if they do so in the form of dividends they will pay tax at 32.5%.
If however their long term goal is to retire on the rental income then pass the asset (property) on to their children, or re-invest their net profit into another property, they may be better off having it held in a company.
As you can see, the benefits of an SPV can vary depending on your personal circumstances and it is important that you seek professional financial advice before deciding what is best for you.
What happens when you sell the property?
Ok, things may get a little more complicated here but stay with me………
Selling as an individual
Selling property as an individual means you will have to pay capital gains tax (CGT) on any profit above £11,000 that you have made (the first 11K of profit is CGT free). Current CGT rates are 18% for individuals in the lower rate tax band and 28% for those in the higher tax band.
(N.B. The lower rates of CGT (10% or 20%) as announced in Budget 2016 do not apply to the sale of residential property).
Let’s continue on John’s journey where he decides to the sell his investment property after owning it for 10 years. The original purchase price was £300,000 and he sells the property for £530,000. All his tax deductible expenses add up to £50,000 therefore, his taxable profit is £180,000.
So, the total CGT John pays if he owned the property in his own name is:
£180,000–11,000 (CGT free tax) x 28% = £46,537
Selling as a company (this is where it gets complex..)
There are two types of tax payable when selling property that is held in an SPV. One is capital gains tax (at the same rate as corporation tax) and the second is income tax on the withdrawal of funds residing in the company after the sale.
Step 1: Work out capital gains tax
Capital gains tax is also payable when selling a property through a company. It is however paid at the same rate as corporation tax which is currently 20% (17% by 2020). Corporation tax also has an indexation allowance which accounts for the movements in the Consumer Price Index (CPI) over time.
So in our example, if John had his property held in an SPV he would pay capital gains tax of £14,978
Step 2: Decide how to withdraw the remaining profit from the company
After paying CGT, John is left with a profit after tax of £162,226 which he wishes to extract from the company. Detailed below are some of the scenarios in which he could choose to do this.
Scenario 1: Extract dividend at higher-rate tax payer
John decides to extract the remaining profit immediately at a high tax rate after selling the property in the form of dividends. As a higher-rate taxpayer, he will be at a significant disadvantage. He will be taxed the additional tax rate of 38% as both his salary and capital gain combined will exceed £150K putting him in the additional tax band. If he wind-ups the company (leaving £25K winding-up cap allowance) and withdraws the rest as dividends, the overall tax he will pay will be £68,023.
With CGT tax paid by the company and dividend income tax taken into consideration, John will pay a total of £82,556 upon sale of his property. This is £21,486 more than he would pay if he were to sell a property owned in his name. However, he has been paying £4,347 less tax each year on his rental income as the property was held in an SPV. Therefore, over the 10 years he has owned the property he has saved a total of £43,470. This results in an overall net tax saving of £21,987.
Scenario 2: Full liquidation
To get clearance from HMRC to wind up his company John has to pay £2,000 to the Members Voluntary Liquidation service who ensure all his company’s affairs are in order. His net profit once the company is wound up is £162,226 which is taxed as capital gain rather than a dividend. As this capital gain tax is on the SPV’s shares and not a residential property John’s rate will be 20%. Therefore the tax he pays will be £32,445.
Including both taxes, John will only pay £47,422 of tax overall. Therefore he will make a significant saving of £44,332.
Scenario 3: Extract dividend at a basic-rate tax payer
John decides to get out of the rat race and retire. He withdraws the profit from the sale of the property (the SPV company’s asset) over several years as dividends. Being retired he is now in the basic rate tax band and pays only 7.5% tax on his dividends. No maths required here…as you can see John stands to make considerable savings.
Scenario 4: Sell company shares
An alternative option is to sell the company shares, which means passing on all assets (the property) and any liability to the new owner. This process would require an article of it’s own to explain in detail but in short, John will sell his shares in the SPV to a buyer. The buyer may seek a price reduction due to the inheritance tax they will become liable for as a result of owning the SPV. The key benefit for the buyer is that they pay only 0.05% stamp duty on shares rather than UK stamp duty land tax.
From John’s perspective, this scenario may be more beneficial if he needs the cash immediately at a higher tax rate, as his capital gains tax upon selling the company shares will just be 10% to 20%. Selling and buying SPV shares requires due-diligence on both the property and company accounts so it’s important to bear in mind administration fees for lawyers and accountants in this scenario.
If you have managed to read this far without giving up, give yourself a pat on the back…
The table below shows the type and total of tax John will pay over the lifetime of the investment, depending on which scenario he chooses that best suits his needs.
Management of property held in an SPV
The ongoing management of the property itself (maintenance, finding tenants etc) and the costs involved are the same for a property owned by a company or an individual.
It is also necessary to ensure the company that holds the property is properly managed throughout the lifetime of the investment. Companies require regular reporting including filing annual returns and accounts with HMRC and Companies House.
Generally an administrator is appointed to help manage the regulatory reporting requirements, structure and set-up the company, and manage the ongoing general accounts. Orbis SPV property exists to do exactly that for investors and landlords, taking all the hard work out of property investment through limited companies.
Is using an SPV right for me?
Before, I would say “it depends”, now with the new tax changes, I will still say “it depends” but more leaning towards SPV. As demonstrated in John’s scenario, a higher-rate tax payer who also pays high mortgage interest will benefit tremendously from purchasing a property through an SPV. The net increase in profit would be between 20% to 60% over the full investment period depending on which scenario John selects. Even with the additional company accountancy and management cost, he will still feel the benefit of having the property in a company.
The main factors that influence whether you use an SPV are:
- Your current tax band or projected tax band by 2020
- Your end goal for the property investment (e.g. to fund your retirement or to pass it on to your children)
- Will profit be retained in the company, reinvested or withdrawn?
- Do you intend to withdrawal equity for personal use?
- The amount of dividends you receive each year
- The cost of financing involved in the purchase of the property
- Are you aiming for high rental yield or high capital growth?
As demonstrated in the scenarios above, an SPV provides more flexibility when it comes to tax planning, and different outcomes from selling depending on your situation. The scenarios highlighted in John’s case are just a few examples, there are others not touched on in this guide such as re-investing to grow your portfolio or passing the property to to your children.
The other key benefits of an SPV are increased efficiency when re-investing profits and the flexibility it offers when selling the property. The obvious disadvantages are the potential for high capital gains tax if there is a lack of proper planning and the additional company management and reporting requirements.
It’s therefore very important to have a proper plan of how you intend to withdraw funds from the SPV in order to make maximum net profit from your investment. Orbis SPV Property can help you with this process, anlaysis and take the hard work out of the entire set-up and management process if you are planning to use an SPV.
(N.B. You should seek professional financial advice to ensure that buying through an SPV is right for you).
Disclaimer: This guide provides general information only and does not constitute professional financial, legal or tax advice. Legislation and policy are constantly changing and all information is correct at the time of publication. We recommend that you seek professional advice based on your personal circumstances.
Originally published at thepropertyinvestor.co on August 3, 2016.