One of our clients has recently come into a substantial amount of money via an inheritance. She is looking to build up a rental property portfolio, and wants to know whether to do this via a company. What did we advise?
Our client was the sole beneficiary of her late mother’s estate, including several insurance policies. All in all, there is just over £2 million after accounting for IHT. Probate has just been granted, and she was keen to use around £1.5 million to start building up a mortgage-free rental property portfolio. She is 56, and has a relatively good job, with a salary of £48,000 per annum and doesn’t wish to give up work just yet. She has not yet identified any properties to buy, but is looking for some advice on whether to purchase personally or through a limited company. So where did we start?
To perform some illustrative calculations, we assumed that our client purchases ten similar properties worth around £150,000 each, with an average rent of £650 pcm. We anticipated net rental profits to be £66,000 every year. We will also assume her salary remains unchanged (the associated tax and primary NI liability on this is £8,400 + £4,292), and use 2016/17 rates and allowances for simplicity.
We have not factored in the proposed reductions to the corporation tax rate due to uncertainty over exactly what will happen post-Brexit. It goes without saying that any fall in the rate will increase the comparative benefits accordingly.
Comparison of tax
Let’s start with a straightforward comparison of the personal tax position versus the company tax position.
If our client holds the properties personally, the entire £66,000 will be chargeable to income tax each year. Her total income will increase to £114,000, meaning her personal allowance will be restricted to £4,000. The additional tax attributable to the rental profit is £29,200, i.e. an effective tax rate of 44.2%. By comparison, the corporation tax due if the properties were purchased through a company and all the profits were left in it would be just £13,200, i.e. 20%.
Over ten years, i.e. up to the time she becomes eligible for the state pension, the tax saving by holding the properties through a company would be £160,000. But is it realistic to assume that none of the money will be extracted from the company?
Need for funds
Looking at her situation, it could well be a realistic position. She has a good salary, plus cash in the bank of £500,000 being the residue of the estate. She may well be happy to preserve the profits in the company until she retires.
Every client has different personal circumstances and aspirations, and so there will be no one size fits all solution when looking at the options for holding rental properties.
If, however, she wanted to extract all of the profits (presumably as dividends) and just hold the properties in the hope of capital growth, we need to consider the impact. In this situation the dividends each year would be £52,800, i.e. residual profits after corporation tax.
This would mean that the personal allowance was only restricted by £400. The overall tax attributable to the rent would therefore be £13,200 + £15,195 = £28,395. This is a small saving of £800 per annum compared with just owning the properties personally. However, in all probability this will be eaten up by the additional costs of running a company – accountancy fees and so on.
Pro advice 1. If you are likely to want to extract all of the profits like this, there is little tax benefit to using a company. However, there could be some benefit to using a property management company, which we will consider in a future article.
Pro advice 2. The profits could be used to make employer pension contributions if there were no need for an income immediately, but our client didn’t want the cash to be languishing in the company.
Company as a pension pot
If we assumed that our client had no need to extract funds, the company option could be very powerful. If the profits are left to accumulate until her retirement age she could then access the funds when she is only a basic rate taxpayer, and use planning to strike a balance between a desirable income and an acceptable tax bill.
Example. Upon attaining the age of 66 she retires, with a state pension entitlement of £8,000 per annum. She decides to take £35,000 of dividends each year to fully utilise her basic rate band as she has no private pension. This leaves her with just under £41,000 after tax – which is actually better than her take home salary was. The company bank balance continues to grow by around £17,000 every year because not all the profits are being extracted, and the underlying capital remains untouched.
It is important not to overlook the capital value of the properties. Property value growth (or decline) varies from location to location. However, if we assume moderate growth of 2% per year, there will be a gain of £328,000 (using compounding) at the date she retires.
If she wanted to cash in on the properties at that time, CGT will be payable at 28% if she holds the properties personally. If they are in a company, the gain would be chargeable to corporation tax at 20%. The company will also benefit from the availability of indexation to reduce the gain chargeable. Extracting the cash after a sale within the company will of course have its own tax consequences.
If our client had not accessed the profits from the company then, including the capital growth, she will have a company with £1.83 million of capital assets and £528,000 in cash. If she follows the pension pot route discussed above, this will also increase by around £17,000 per year. The shares qualify for business property relief (BPR) and so there is going to be an IHT issue.
Pro advice. Of course, the initial £1.5 million used to fund the company could be extracted tax free as a return of capital, for example on a winding up. The excess would be subject to tax under the rules relating to distributions on a winding up. The extracted cash would still be subject to IHT, though there could then be some more flexible planning undertaken.
If she has children, a company could be an effective way of planning for IHT because company shares are generally easier to divide up than a legal share of the properties. To be most effective, any planning should be carried out at the outset, i.e. when the company is being set up.
In our client’s case, there is a clear tax benefit to using a limited company as an investment vehicle. This is mainly due to the following factors:
- There is a relatively high number of properties in the portfolio
- Her circumstances mean that it is likely that she will not need much (if any) of the income generated from the rentals until her retirement.
All of our clients will have differing circumstances so we would need to consider each case on its own merits. If only one or two properties are to be bought, it is likely that the compliance costs would negate most of the tax savings.