As tax advisers, one of the most frequent questions we get asked is: What structure should I hold property in? It’s such a frequent question that I thought it would be useful to give you a quick printout ‘n’ keep guide here. Obviously any blog like this can only talk in general terms, and can’t give direct advice. But hopefully this guide will give you the general idea.
Question Number 1
It’s a sort of knee jerk reaction. When anyone asks this question: how should I hold my property? The response is always to drill down into what side of a very important line the property stands.
So what is this dividing line?
Readers of my book Practical Tax Planning for Business will have access to a much more detailed discussion of this crucial point, but it could be summed up simply by the question: Is the property held for trading or investment purposes?
To put it another way, is the property stock of a development trade, or a fixed asset, to use accounting terminology?
Rather than writing reams about this, which no one would read, let’s fire off a salvo of bullets which give the key features.
Your property is trading if you:
Are holding it with a view to selling at a profit;
Are holding it for the comparatively short term;
Incur expenditure on it (including demolishing and rebuilding) whose aim is to sell for an enhanced profit;
Use short term finance (like bank overdraft, or short term loans) to acquire it;
Are in the business of buying and selling properties at a profit, and perhaps have lots of other such transactions, and a “track record” of doing so; and
Show the property in your accounts as trading stock, and proceeds of sale as “turnover”.
By contrast, you are investing in property, rather than trading, if you:
Hold the property long term;
Hold the property for the rent it yields rather than the profit you will make on selling;
Finance the property using long term finance, such as fixed term loans, or even share capital in a company; and
You show the property in your accounts as a fixed asset investment, and the proceeds of any sale as disposal proceeds of a fixed asset.
At the end of the day, it’s all about your intention: that is, what’s going on in your head. This can have some quite interesting implications, as the remarks that I’ll come on to about inheritance tax will hopefully bring out.
A Rule of Thumb
There are no absolutes in tax planning, because every situation is different. But it may help to give a quick rule of thumb, in moving towards providing an answer to the basic question that this article poses.
With all due emphasis on the fact that this is a general view rather than a cast iron law, then, the rule of thumb is this: if your property is a trading property, hold it through a limited company. If it’s an investment property, on the other hand, hold it either individually, or through a partnership or Limited Liability Partnership (LLP). From most points of view, this treatment is going to be the same whether property is held directly by an individual or is held in a partnership of individuals.
What’s the thinking behind this rule of thumb?
Quite simply, the aim is to achieve the lowest possible rate of tax on a disposal of the property. In general, and with specific exceptions, the tax system treats profits on sale of trading properties as income, whereas profits realised on the sale of investment properties are taxed as capital gains.
If you’re a limited company, there’s no difference in the tax rate applying between the two sorts of profit: income or capital. If you are an individual, though, there can be a very substantial difference indeed. Income can be taxed on individuals at rates of up to 45% (together with national insurance). Capital gains, on the other hand, are subject currently to a rate of 20% for non residential properties, and 28% for residential. So there’s a very substantial difference indeed. Very broadly, income can be taxed at something like twice the rate of capital gains, if you are an individual.
Trading through a Limited Company
If you are a property developer, then, the chances are that you are either trading through a limited company or, if not, that you ought to be. There is no magic or mystery about this: the reason for this advice is that companies currently pay 19% on their income, whereas individuals can pay over twice that. Here’s a very simple example just to show what I mean:
Colin and Ian are both what you might call serial property developers. That is, they find a property, do it up and sell it at a profit, then plough the proceeds back into another property, and so on.
Let’s imagine in the beautifully simple make believe world of such examples, that both Colin and Ian buy properties for £100,000, which they are planning to spend £50,000 on and then sell for £300,000. Colin buys his property in the name of Colin Limited, his personal limited company. Ian buys his in his own name.
In due course of time, both realise their £150,000 profit. The tax on Colin’s company is £150,000 at 19%, that is, £28,500. So, out of its £300,000 proceeds from selling the developed property, Colin Limited has £271,500 left over to invest in its next project.
Ian’s £150,000 profit, on the other hand, which is not the only income he has received in the year, is subject to a combined tax and national insurance rate of 43% (in his case). So he has £64,500 tax etc to pay, and therefore only has £235,500 to invest in the next development project.
It doesn’t take much working out to realise that Colin will be able to reinvest gradually greater and greater amounts than Ian, and therefore, hopefully, make more and more substantial profits than him.
Property Development: The Tax “End Game”
All that’s very well, you might say, but don’t you realise that putting profits into a limited company is ultimately only deferring tax, not saving it? At some point, when Colin stops trading, or where he actually wants to cash in some of his profits for spending on himself, the comeuppance arrives. If he takes the money out of Colin Limited as a dividend, there will be personal tax to pay on that dividend at whatever Colin’s top rate is, and the rates of tax are such that the benefit of having paid less tax in the company is then more than counteracted by the income tax that has to be paid on the dividend.
True: but only if you take the money as dividend. If we are truly talking about “end game” when Colin has finally hung up his trowel, the money can actually be taken out of the company by way of liquidation. The tax on liquidating a company, under current rules, is 20%, or 10% if entrepreneurs relief applies, and this is generally significantly less than the income tax that an individual such as Colin would have paid on the development profits if he had been in Ian’s position. What’s more, the very fact that the tax has been deferred can be very useful, for the reason we have explained: a successful entrepreneur with more money to reinvest will make more profits as a result, and you therefore have a “compounding” effect.
Investment Properties
Now let’s look at the very different environment for property that falls on the other side of the line, that is properties held as long term investments for rent. Because profits on selling such properties are capital gains, not income, the rate of tax applying to individuals (which includes individuals who are partners or LLP members) is likely to be much lower than the rates they would pay on the income profits of trading. Gains made by individuals on commercial properties are currently taxed at 20%, and on residential property at 28%.
Given this, our rule of thumb generally favours direct ownership rather than ownership through a limited company, because of the fact that, where a company realises a gain and distributes that gain to its shareholders, there are two layers of tax which between them tend to be much higher than the capital gains tax rates.
Minimising Tax on Income
So far I could be accused of a kind of “tunnel vision”, though, in that I have concentrated entirely on the tax that arises when a property is sold. But what about the tax on the rents?
Proponents of the limited company structure for holding property investment portfolios will no doubt point out that a straightforward on obvious benefit of the company holding structure is that rental income is taxable at a flat rate of 19%, as against income tax rates of up to 45% which are payable by individuals.
True, but again this is in danger of ignoring the second layer of tax that is paid as and when the company pays out dividends (derived from the rents) to its shareholders.
Also, there are ways of minimising the tax rate on rents received whilst stopping short of the fairly drastic expedient of holding those properties in the ownership of a limited company.
One such way of doing this is to spread the ownership of the properties amongst various family members, all of whom will have personal allowances and lower income tax bands. More ambitiously, you could have a limited liability partnership with a company member, where a proportion of the rental profits are attributed to that company member and tax is therefore paid on the rents at 19% to that extent.
In fact, if the circumstances are right and the planning is done properly, an LLP with a limited company partner is in severe danger of giving you the “best of both worlds”: the single rather than double charge to tax on capital gains, and a reasonable rate of tax on income.
Also, an LLP can give you a lot more flexibility with regard to attribution of income than a company normally does. If you have an LLP with various family members, you can, if the LLP agreement is flexible enough, decide to allocate the rental profits between the members in different proportions each year: whatever give you the least tax. With a company it’s generally speaking not so easy to “duck and dive” with the dividends paid out of the company in this fashion.
So far I could be accused of a kind of “tunnel vision”, though, in that I have concentrated entirely on the tax that arises when a property is sold. But what about the tax on the rents?
Proponents of the limited company structure for holding property investment portfolios will no doubt point out that a straightforward on obvious benefit of the company holding structure is that rental income is taxable at a flat rate of 19%, as against income tax rates of up to 45% which are payable by individuals.
True, but again this is in danger of ignoring the second layer of tax that is paid as and when the company pays out dividends (derived from the rents) to its shareholders.
Also, there are ways of minimising the tax rate on rents received whilst stopping short of the fairly drastic expedient of holding those properties in the ownership of a limited company.
One such way of doing this is to spread the ownership of the properties amongst various family members, all of whom will have personal allowances and lower income tax bands. More ambitiously, you could have a limited liability partnership with a company member, where a proportion of the rental profits are attributed to that company member and tax is therefore paid on the rents at 19% to that extent.
In fact, if the circumstances are right and the planning is done properly, an LLP with a limited company partner is in severe danger of giving you the “best of both worlds”: the single rather than double charge to tax on capital gains, and a reasonable rate of tax on income.
Also, an LLP can give you a lot more flexibility with regard to attribution of income than a company normally does. If you have an LLP with various family members, you can, if the LLP agreement is flexible enough, decide to allocate the rental profits between the members in different proportions each year: whatever give you the least tax. With a company it’s generally speaking not so easy to “duck and dive” with the dividends paid out of the company in this fashion.
The “Osborne Tax”
The tax which is given this nickname (sometimes also called “Clause 24” Tax or “Section 24” tax) is really a disallowance for income tax purposes. Where a residential property portfolio is held by an individual, and there is loan finance out to buy that portfolio, the interest on the loan is no longer allowable for higher rate income tax purposes.
“Ha!” say the proponents of investment companies, “this points to the obvious superiority of the company structure as a holding vehicle. Companies aren’t affected by the Osborne Tax – for the simple reason that they don’t pay higher rate income tax.”
True, but sometimes personal ownership, through an LLP or in the form of simple joint ownership, can also be achieved in such a way that none of the recipients of shares of the income is a higher rate taxpayer. More ambitiously, again, an LLP with a limited company partner can sometimes be brought into the future, to get the best of both worlds in the form of freedom from Osborne Tax and higher rate tax on income generally, whilst enjoying the benefits of the arguably much more benign CGT regime.
Yes, No, or “Don’t Know”?
Hopefully I’ve given a fairly clear picture of the overall position in the above: if you are buying property to develop and sell, you will tend to go down one route (the limited company route), and if you are buying it to hold on to for rent, you are likely to go down the personal ownership or LLP route. But if only life were actually that simple!
In practice, what very often happens in this sort of situation is that the property owner doesn’t know, at the time of purchase, whether he will be holding the property long term or developing it for sale. Sometimes there are nasty practical problems to do with market forces which interfere with our beautifully simple tax planning rules.
For example, it sometimes turns out that a property developer acquires a property, perhaps develops a number of units, and holds on to some of them long term, whilst selling the others. And it’s not always possible to be dogmatic, at the outset, which units are to be sold and which are to be retained.
Unfortunately this can sometimes be a problem without a very clear solution. The difficulty, for example, with acquiring the whole property in a limited company in this situation is that you end up with an investment property held within a company: undesirable for a number of reasons including the double capital gains tax charge we’ve mentioned. On the other side of the coin, if you acquire property intending to hold it as an investment, but then decide to sell one or two units short term, you are risking an income tax charge on the profits.
My only real “solution” this problem is to urge property purchasers to make up their minds as soon as they can which side of the dividing line a particular property will fall, and hope to get the relevant units into an appropriate structure before any increase in value has arisen.
VAT
Sooner or later this monster is always going to raise its ugly head in any discussion of tax efficient structuring. There’s one particular trap that you need to avoid, and I’ll sum it up as simple and quickly as possible.
Imagine that you are one of those people in the situation of not knowing whether you are going to sell or keep a property that you are developing. The worst case scenario comes about where you have been developing a property which is new build residential, and you’ve been incurring costs yourself (such as materials and professional fees), and reclaiming the VAT on the basis that you’re going to sell the resultant new homes. If you then go on to let them out instead (perhaps because the market has changed, and your plans have changed with it) you then have the potential for a nasty shock with the VAT you’ve reclaimed being clawed back by HMRC. The technical reason for this is that renting out residential property is VAT exempt (that is, it doesn’t give any right to reclaim VAT on your expenses), as contrasted with the sale of new built residential property, which is zero rated (no VAT on the sale, but you can reclaim the tax on your expenses).
The way to get around this is quite simple: you have a “captive” contracting company which incurs all the VAT and bills on to you zero rated – as a tax favoured service of building new homes. As the property owner, you then have no VAT charged to you, and there is nothing for HMRC to claw back.
Inheritance Tax
The way you structure your business can make a difference, first of all, to how easy it is to plan against inheritance tax by making lifetime gifts. In our humble opinion, an LLP is likely to be a very effective way of holding an investment portfolio from the point of view of inheritance tax planning: because first of all you can give away capital in an LLP without giving away control; and secondly, a gift of capital in an LLP is very arguably free from capital gains tax. There’s too much here to tack on to the end of a piece which is generally about the more immediate and direct taxation of property profits, but it’s something which certainly needs to be taken into account if inheritance tax is important to you.
The second inheritance tax planning point that needs to be made is that property trading is fully relievable from the tax, whereas property investment is fully taxable. So a situation that looks fairly identical on the surface can give rise to 40% tax on the death of someone, in one scenario, or no tax in the other.
How, then, do you decide whether inheritance tax business property relief, at 100%, applies to a property business? You look at the features of trading versus investing, which we started off by giving above, and in this regard how you account for the property ownership is very important. What’s more, and very interestingly, since the distinction between trading and investing is ultimately one of intention, a change of intention can in principle either reduce your tax bill from 40% to nil (by changing an investment property portfolio into trading stock of a development trade) or vice versa. It’s by no means impossible that the inheritance tax distinction, which is such a marked one, could be the most important aspect of your tax planning: more important even than the income or capital gains treatment of profit or gains from year to year arising from the property ownership.
Tax Planning Minefield
Picture the tax planning environment here as a kind of minefield or obstacle course, with obstacles, or landmines, in the path labelled “income tax”, “capital gains tax”, “VAT”, and “inheritance tax” dotted around the place. The chances are – let’s be realistic – you’re not going to be able to negotiate all of these completely unscathed, but the art is to take the right advice at the right time, and make sure that your tax “leakage” is as small as it reasonably can be.
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