One of the questions that investors in rental properties frequently want answering is whether they should purchase a new rental property personally or set up a limited company to purchase it. Is there a correct answer and where do you start?
There are certain elements to consider when looking at this, including the current personal tax position, whether the rental income is needed as an income stream or can be saved, potential increase in the value of the property and inheritance tax.
If the property is held personally, the entire rental profits are chargeable to income tax each year. Total income therefore increases, with the rental income being added on to other income. A basic rate tax payer could be pushed up in to the higher rate tax bracket and incur tax at 40%.
Further consideration should be given if the rental income pushes your income over £100,000 as the personal allowance starts to be restricted at this level of income.
If the property is held within a limited company then the rental profits are taxed at the Corporation Tax rate, currently 19%. No further tax is incurred until the profits are taken out of the company.
This should also be looked at in conjunction with the recent implementation of the restriction on tax relief for mortgage interest incurred. This is restricted for higher rate tax payers, there is currently no such restriction within limited companies.
In these situations, using a limited company can certainly be an attractive option if there is scope to leave the profits in the company and not extract them personally.
Need for Funds
When there is scope for leaving the funds in the company there is no additional tax charge. The cash can then build up in the company for investments in future properties or to make employer pension contributions if there is no need for an income immediately.
However, if all profits are to be extracted as they are needed as income then suddenly the situation changes. On top of the corporation tax charged, the extraction of funds will be taxed personally too. The most likely extraction method is to take dividends. These are then taxed personally at 7.5% within the basic rate band and at 32.5% in the higher rate tax bracket.
The tax benefits of using a limited company can therefore be lost if you need to take all the profits out of the company.
Can a company be a pension pot?
If there is no need for you to extract the profits from the company and you can leave the cash to accumulate then the company option can be powerful. If profits are left to accumulate until retirement, then the cash can be accessed when income levels have decreased and any dividends extracted could be taken at a level to ensure only basic rate dividend tax is incurred (7.5%).
Increase in value of the property
It is also important to consider the longer term aspect of purchasing a property, ie the increase in the value of the property (the capital value).
When a property is sold the increase in value is taxable as a capital gain. If the property is held personally the gain is taxed at 18% or 28% within the basic and higher rate tax bands respectively. Within a limited company the gain is taxed at the rate of corporation tax.
Extracting the cash after the sale of a property also has it’s own tax consequences, however if the cash is to be reinvested or put in to pensions etc then there is no further tax.
Regardless of the property being held personally or within a company there are no tax reliefs and there will be an inheritance tax issue.
However, if effective tax planning is done from the outset, with shares being divided up with children for example, then a company can be an effective inheritance planning tool that can yield substantial benefits.
There can be clear tax benefits to using a limited company as an investment company. However, all circumstances differ, and each case should be considered on its own merits. If only one or two properties are to be bought then it is likely that the compliance costs may negate some of the tax savings.
Tax advice should be sought before purchasing a property to see how this applies to you. For further information, or to discuss your particular situation, please contact Jane at Townend English on 01759 305989.
Jane Frith BSc PhD CA