The tax position surrounding owning property, either to live in or as an investment, can be complex. One of the best ways to protect your investment is to make sure you pay tax on income or gains as efficiently as possible. This guide explains some of the tax issues surrounding property investment to illustrate how making small changes could save you money.
Property investment can be in many forms, from buying a house to live in, let out or use as a furnished holiday home for extra income. Ensuring tax is minimised for each can be very different.
Whether you have a single property or large portfolio, with direct ownership the tax treatment is generally the same. The following are the main taxes that affect buy-to-lets.
Any rental income after most expenses will be charged to income tax at your marginal rate.
With the rate of income tax now as high as 45%, you should aim to ensure that all personal allowances and lower rate bands of tax are used in full.
Any losses arising from the rented property have to be carried forward and offset against any future profits arising from your rental business and cannot be offset against other income.
Ownership structure is important. It is possible to own property jointly or in partnership with other family members. This means that income can be shared to minimise tax rates.
As a buy-to-let landlord, many of the expenses incurred in the course of letting your property are allowable for tax purposes.
Landlords are also able to deduct the costs incurred in purchasing replacement furnishings, including white goods, when calculating their taxable profit.
As part of an ongoing clampdown on the buy-to-let market, from 6 April 2017 relief for finance costs incurred on residential properties, such as interest and mortgage costs, has been restricted to the basic rate of income tax of 20%. The restriction was phased in over four years, with the full interest restriction taking effect from 6 April 2020.
These changes will not apply to furnished holiday lets. Where the property is owned by a company rather than an individual, finance costs will be allowable in full.
The sale of a residential investment property is usually charged to Capital Gains Tax (CGT) at 18% or 28%. CGT rates on the sale of assets were reduced to 10% or 20% but these rates do not apply to residential property. Each person is entitled to an annual exemption, which for 2020/21 is £12,300.
If a property is bought simply to be renovated and sold at a profit, this is deemed to be trading income and charged at income tax rates.
Qualifying for Business Asset Disposal Relief (formerly known as Entrepreneurs’ Relief) by making the property a business asset can secure a lower 10% rate of tax on a capital gain.
This usually only applies to furnished holiday lets, or very large portfolios. HMRC has to be satisfied that you are genuinely running a trading business rather than simply collecting rents for this to apply.
Inheritance Tax (IHT) reliefs on investment property are limited. However, there are some simple steps which may help reduce the tax burden.
IHT is charged on assets in your estate at 40% over and above the nil rate band, currently £325,000. This band has not kept pace with inflation or the increase in property prices, so many people find that there are hefty tax bills arising on death.
An additional nil rate band of £175,000 is being phased in from April 2017. This only applies to properties that have been your main residence at some point and which are left to one or more direct descendants on death.
It is important to note that CGT charges can arise to the donor on the gift, other than on gifts between spouses and civil partners.
Furnished holiday lets, can be treated as business assets and attract some preferential tax reliefs. The property must meet specific criteria in order to qualify. Essentially they must be let on a commercial basis, for example the property must:
Significant CGT and IHT savings can be made if the furnished holiday let conditions are met.
The property could qualify as a business asset for Entrepreneurs’ Relief, meaning any capital gain on sale would be taxed at a reduced rate of 10%, rather than 28%.
Qualifying as a business asset also has benefits for IHT. Business assets may qualify for 100% Business Relief (formerly known as Business Property Relief or BPR) which means that no liability to IHT arises on the property. This also applies to lifetime gifts of these assets, the property could be settled on a discretionary trust to be protected for future generations with no charge to IHT.
The income could then be used as a tax efficient way of paying grandchildren’s school fees. The transfer can generate a charge to CGT, but in these circumstances, any gain can be held over until the eventual sale.
It should be noted that it has become more difficult for holiday letting businesses to qualify for Business Relief. HMRC is paying closer attention to the services that are provided to establish whether a genuine business is being run and several cases have lost in the courts. The more additional facilities and services that can be provided i.e. over and above those which would be expected of a landlord, the better the chances of a successful claim.
Most people know that the sale of their home is exempt from CGT, but what is less commonly known is that if you own two properties and live in both, the exemption does not automatically extend to the second home. A common misconception is that married couples can have an exemption each, which is not the case.
While income tax is not generally an issue in these circumstances, CGT and IHT can often prove expensive — but there are ways to make some savings.
The CGT exemption on your main residence is known as Principal Private Residence Relief (PPR).
If you are a UK resident and have two or more homes, it is possible to nominate one of your properties to be your main home and it would then qualify for relief. This would generally be the property with the highest increase in value.
The rules for PPR are complex, there are separates rules if one of the properties you own is overseas, or you are a non-UK resident but spend a significant amount of time in the UK.
The value of a second home forms part of your estate for IHT. Complex planning arrangements, using trust structures and debt arrangements were introduced to mitigate IHT on family homes. Most of these planning opportunities have now been removed by HMRC.
If the property is gifted, but the donor still wants to use the property, such as for a weekend retreat, this would impact IHT relief due to the reservation of benefits rule. The simplest way of mitigating this would be for the donor to pay full market rent for the use of the property. The income would be taxed on the recipient after expenses. The rental payments would also help to reduce the value of the estate of the donor.
Shared ownership allows you to give away part of the value of the property. However, care must be taken to ensure that an undivided share of the whole property is given away rather than specific parts, as this will negate the tax saving. Similarly, all associated outgoings on the property must be shared equally.
There are various ways to structure ownership of your property investments to mitigate your tax liability. The main ones are: direct ownership, joint venture, partnership and limited company.
The tax position for direct ownership, joint ventures and partnerships is very similar. In each case, profits are taxed at your marginal rate and capital gains charged on sale. The difference with a partnership is that there is the opportunity to utilise the personal allowances and lower rate bands of all partners, who can be other family members.
Holding property within a limited company can help to save tax as the rate of corporation tax is currently 19%. Whether this is beneficial largely depends on whether the income needs to then be drawn out of the company. If this is the case, there is likely to be a double tax charge, removing the saving.
As with partnerships, it is possible to bring other lower earning family members in as shareholders. These arrangements are commonly known as family investment companies. Provided the shareholdings are structured correctly, dividends can be paid to utilise the dividend allowance and lower rate tax bands of the shareholders and extract profits efficiently.
This can often assist families with the funding of university fees, or first homes for young adult children.
There can also be significant IHT savings as the value of property or capital invested in the company is passed to other family members when they become shareholders in the company.
A double tax charge can also arise when properties are sold, as the gain is charged within the company and then tax may be due on the distribution to shareholders. This type of structure is not always beneficial for those requiring an income stream which would be taxed at higher rates or with the prospect of an impending sale.
Company ownership can be advantageous for the most part where it is not necessary to extract all the profits. If profits and gains are to be retained for investment, or to be protected for future generations, then they can be an extremely tax efficient way of owning property.
This also depends on whether the property owned is a higher value residential property. The consequences of this are covered later in this guide.
Stamp Duty Land Tax (SDLT) is due on all residential property purchases over £125,000.
For purchases of second and additional properties a further 3% is added to existing rates. This applies to property purchases over £40,000.
The additional 3% will not be charged where the purchase is replacing your main residence. The transaction must occur on the same day (or before in certain circumstances), otherwise SDLT must be paid and reclaimed once the original property is sold.
There is a 36 month window in which to do this. Trusts and companies will pay the additional 3% regardless of the number of properties they own. These SDLT rules can be complicated, particularly in cases of separation and divorce. Our team can help you get it right.
Annual charges now apply on high value residential property, owned by a non-natural person, which includes companies. These charges, which apply to properties valued at over £500,000, start at a rate of £3,700 per year in 2020/21 and are intended to encourage investors to de-envelope and bring the property back into the ordinary SDLT regime.
To discourage enveloping further, the rate of SDLT for properties worth over £500,000 bought by a non-natural person was set at 15%. Many exemptions are available against these additional charges including those properties let out commercially but the exemptions must be claimed.
The Annual Tax on Enveloped Dwellings (ATED) rates from 1 April 2020 to 31 March 2021 are outlined below.
How a property investment is structured can be one of the key factors in determining the return. Our team has extensive experience of working with investors from the UK and overseas to advise on how best to invest, hold and dispose of UK real estate.
For more information on the issues outlined in this guide or advice on your individual circumstances please get in touch with your usual Crowe contact.