Tax Issues for landlords of UK residential properties

Tax Issues for landlords of UK residential properties

Tax changes affecting rental income from residential lettings There have been many changes to taxation affecting the property letting market recently (summarised below), impacting residential landlords in the UK. Part of the reason for the changes is to ensure landlords with high income no longer receive higher rates of tax relief compared to those with lower incomes. Mortgage Interest Relief Landlords who own residential property can currently claim tax relief on all interest paid on a loan/ mortgage taken out to purchase the property as an allowable expense from the letting profit. With effect from 6 April 2017, mortgage interest relief is gradually being withdrawn as a deduction from property income with the phasing in and introduction of a 20% tax credit being given instead and transitional rules applying until 2020/21. This will often have the effect of individuals tax bills increasing significantly especially if they are highly leveraged, since landlords will receive an income tax deduction at the basic rate of 20% on the interest paid instead. During the transitional years, the amount of tax deduction from rents will reduce and the proportion of loan interest that will only qualify for basic rate tax relief will increase. In the transitional years landlords can claim the following: In 2017/18, the deduction from property income will be restricted to 75% of the finance costs incurred, with the remaining 25% being available as a basic rate reduction. In 2018/19, 50% of the finance costs will be given as deduction and the remaining 50% will be given as a basic rate reduction. In 2019/20, 25% of the finance costs will be given as deduction and the remaining 75% will be given as a basic rate reduction. The new restrictions of relief only apply to individuals, trustees and partnerships and does not apply to commercial properties including furnished holiday lets or corporate owners. The disallowance of mortgage interest would result in higher taxable income which in turn could lead to a restriction in tax credits or personal allowance. Those that are highly leveraged will tend to be most affected. One option to minimise the impact of the changes would be to try and pay off or reduce the outstanding loans/mortgage over the coming years. Another option to minimise the effect would be to incorporate the rental business which would in turn give rise to other tax benefits as explained below. Impact of changes in interest relief Year Finance Cost Unrestricted relief of loan interest as a deduction Finance Cost Relief restricted to basic rate at 20% as a tax credit 2017/18 75% 25% 2018/19 50% 50% 2019/20 25% 75% 2020/21 0% 100% Wear & Tear Allowance From 6 April 2016 the former Wear and Tear Allowance, which allowed 10% of net rental profits to be written off for notional wear and tear for furnished rental properties even if there had been no such actual expenditure in that particular year, was replaced with replacement furniture relief. This relief provides a deduction for the cost incurred during the tax year to replace furnishings in the property and will provide relief to all landlords who incur such expenditure. The relief is available to all landlords of residential dwelling houses, no matter what the level of furnishing. Items that are eligible for the relief include furniture, furnishings, appliances and kitchenware, white goods, carpets, curtains, linen, crockery and cutlery. The replacement of fixtures such as central heating would be an allowable cost categorised as a repair. Relief would not be available for an improvement to an asset but only for a like for like replacement. The replacement cost may however be increased by any costs of disposing the old item but must be reduced by any disposal proceeds received for the old item. There will be no changes to the treatment of capital allowances on replacement in commercial and furnished holiday let properties.

Stamp Duty Land Tax From 1 April 2016, a supplementary 3% SDLT charge is applicable on the acquisition of additional residential property. This appeared to be an attempt by the government to slow the buy to let market. Where a property is already held (even if it is outside the UK), the acquisition of a further property will give rise to an additional 3% of SDLT for each band on the entire value of the property, as shown in the table below. The new rates are also applicable to furnished holiday lets but are not applicable to non-residential transactions even when they include an element of residential property. The supplementary 3% SDLT surcharge is not due when replacing the only/main residence, regardless of the other properties held by the individual. However, it is often the case that long chains are involved, resulting in potential buyers pulling out and delays in selling the main residence. In these scenarios, the supplementary 3% SDLT charge must be paid and HMRC allow for a claim to be made for its repayment provided the old home is sold within 3 years of the purchase of the new home. This can potentially cause cash flow issues and additional financing options may be required. If a property is being acquired in joint names and one of the partners already owns a property in their name, the additional surcharge would apply to the whole transaction. Similarly, if a partnership is acquiring the property, they are deemed to be acquisitions made by the individual partners and consequently likely to give rise to the higher SDLT charge. Married couples and civil partners living together are treated as one unit and as having one residence between them at any one time. This is consistent with other areas of the tax system including the treatment of principal private residence relief. As a result, the higher SDLT rates may be applicable if an individual is buying a property if his or her spouse/civil partner has an existing residential property. Many parents/grandparents/family members etc. are now helping children and family members to acquire a property. If the parents simply act as a guarantor for the mortgage or lend the funds, no additional SDLT would arise. If the family members are actually buying the property the additional SDLT charge would apply. When an individual buys more than 6 residential properties in one transaction, these will be treated as non-residential properties for SDLT purposes i.e. the 3% supplementary SDLT will not be due. SDLT rates Purchase price of property Rate of SDLT SDLT on additional property Up to 125,000 0% 3% 125,001 250,000 2% 5% 250,001 925,000 5% 8% 925,001 1,500,000 10% 13% 1,500,001 and above 12% 15% Capital Gains Tax CGT arises on the gain made when an asset is sold that has gone up in value from the time of acquisition. It is paid at a basic or higher rate depending on the corresponding rate of Income Tax paid. From 6 April 2016 CGT on the disposal of all assets has been reduced from 28% to 20% for the higher rate and18% to 10% for the basic rate. However, CGT on the disposal of residential properties and carried interest will continue to be at 28% and 18%. The CGT on disposal of a property that has been one s main residence, attracts both principal private residence relief and lettings relief if the property was let at any point, which significantly reduces and can even eliminate the CGT due in its entirety. Previously non-uk residents were not generally subject to UK CGT. However, from 5 April 2015 all UK residential property becomes subject to CGT with only the gains accruing since 5 April 2015 becoming taxable, even if it is owned through an offshore company and/or trust.

Restructuring a Buy to Let Portfolio Given the recent changes in treatment of mortgage interest on buy to let properties, CGT on residential property and the increase in SDLT on additional properties, it may be tax efficient for individuals who hold property portfolios and actively manage them to move the property business into a corporate structure and at the same time take advantage of section 162 TCGA 1992 incorporation relief. Property investment companies are tax efficient vehicles providing many benefits. These include the ability to retain the money within the company until required without giving rise to any further tax charges. Profits retained within the company can then be reinvested within the company. Many hold their properties within a corporate entity, effectively as a private pension pot. It may be that at retirement the shareholders will be non-tax payers or basic rate taxpayers making it possible to plan and control amounts withdrawn to ensure maximum tax extraction efficiency. Incorporation relief rolls over any gains on the portfolio into the base cost of the shares within the company. If any of the properties are to be retained personally, incorporation relief would not be available since all business assets, excluding cash, must be transferred to the company. The relief is automatic but it can be disapplied by the first anniversary of the final filing date for self-assessment for the year of incorporation. There is a disadvantage of incorporation in that profits will be subject to tax twice: once as Corporation Tax within the company and the second to (in most cases) income tax when profits in the form of dividends are withdrawn from the company or profits distributed. However not all of the distributable profits need to be paid out and instead they can be reinvested thereby restricting the tax payable. It is important to note that although individuals can receive 5,000 of dividends tax free from 2016/17, no tax credit is now available and the tax due on the dividends is also more significant. At present, companies are not restricted in claiming relief for mortgage interest, and additionally, corporation tax is also at a lower level than income tax. The main rate of Corporation Tax has already been cut from 28% in 2010 to 20%, and will further reduce to 19% in 2017 and 17% in 2020 making incorporation more tax efficient. Capital Gains Tax There may be substantial capital gains tax efficiencies to incorporation. When new shares are subscribed for on incorporation, it would be possible to reduce and potentially avoid any CGT issues. Properties transferred to the company will obtain an uplift in their base cost to market value at the date of transfer, which effectively means that the significant historic capital gains that had been built up over many years will be washed out. This in turn means that certain properties could be sold shortly after incorporation with little or no chargeable gain, thereby increasing the cash proceeds that could be spent on new property acquisitions or a new venture. The base cost of the new shares will be reduced by the deferred gain arising from the transfer of the properties to the new company. Any gains on disposal of a property within a corporate structure will receive indexation allowance and be taxed at the corporation tax rates. Annual Tax on Enveloped Dwellings High value residential properties held by nonnatural persons such as companies, are likely to be governed by the ATED regime. However, if the property is let on a commercial basis, there is an exemption from the charge, which then has to be claimed. Under the new rules, from 1 April 2016, if any of the properties held within the company have a market value of 500,000 or more, it may be that ATED returns will need to be completed and ATED charges will become due. Where non-resident companies are subject to CGT under the normal CGT regime and ATED regime, ATED gains take precedence where gains are taxed at 28%. SDLT SDLT would be charged on the market value on the purchase from or gift by an individual to their connected party. Provided all property owning partners become shareholders of the newly incorporated company, no SDLT will arise on incorporation from a partnership. By owning property in joint names and having a partnership agreement, does not necessarily constitute a partnership or confirm that the properties can be transferred free of SDLT. A business must be carried on in common with a view to profit, for a partnership to exist. Once incorporated, the 3% SDLT premium applies to the acquisition of residential properties by the company.

Inheritance tax There are various IHT implications that need to be considered as well. It is unlikely that Business Property Relief (BPR) will apply for properties held by individuals in their personal capacity. Although a property rental company is likely to be considered a business for corporate tax purposes it is regarded as a non-qualifying business activity for IHT and therefore BPR will not apply unless the company has significant other non-investment activities. Beneficiaries of an estate receive an automatic uplift to market value on properties left in an estate and as result, there would be no CGT due on immediate sale. For properties held within a corporate structure, on the death of a shareholder their shares will receive an uplift to market value in the hands of the beneficiaries, but the properties themselves do not receive an uplift. VAT & Other Considerations of Incorporation For properties held individually and within a corporate structure the VAT treatment should be neutral. Property letting income is exempt from VAT although commercially let property is standard rated if the owner or company has opted to tax. The letting of furnished holiday lets is standard rated. It is often easier for other family members to be involved in the property investment company thereby benefitting from multiple personal allowances and basic rate bands as well as benefitting from the 5,000 tax free dividend band. Shares can be given to family members in tranches so that the CGT annual exemption is utilised. This will also enable control to gradually be passed down to children or grandchildren. There are practical considerations in connection with incorporation including administrative obligations, such as the need to file annual accounts and annual returns to Companies House, filing corporation tax returns and potentially ATED returns. It would also be necessary to obtain permission from the mortgage lender to transfer the property to a company. The new company should also open a bank account in its own name for receiving the rental income and paying the rental expenses from. Final Thoughts... The raft of changes facing landlords of UK residential letting property and the effect on their letting income is substantial. UK residential property can be owned in many ways. A detailed analysis of the existing ownership structure, together with an in depth understanding of the landlord s future aims and aspirations will be necessary to establish the most suitable options available. Sehjal Gupta FCA, CTA Lancaster Knox is a firm of Chartered Accountants and Chartered Tax Advisers who specialise in providing tax advisory services. If you are a landlord of a UK residential letting property and considering your options, we would be delighted to offer you advice on any matters relating to the content of this leaflet. Please contact our London office: T: +44 (0) 203 75 75 669 W: lancasterknox.com Lancaster Knox LLP is registered in England & Wales. Registered No. oc402665. Registered Office: 7 Old Park Lane, London W1K 1QR. Registered with the Chartered Institute of Tax as a firm of tax advisers. The information contained in this summary solely outlines the recent changes affecting landlords of UK residential property and does not constitute advice. It is merely a guide and not a substitute for specialist advice in respect of individual situations. Lancaster Knox disclaims to the fullest extent permissible all and any liability howsoever arising in connection with use of the information set out in this bulletin.