1. Mortgage interest restrictionThe amount of residential loan interest payable by an individual landlord is restricted such that only basic rate relief can be claimed. Relief is given as a reduction on the lower of the amount of interest, the rental profits, and the individuals income (excluding savings and dividend income) for the tax year. Importantly the restriction does not apply to companies.
The amount of interest claimable is further restricted to the market value of the property at the time when it was first let if originally not purchased with an intention to rent. This reduction applies before any mortgage interest relief.
Obviously these restriction rules affect those landlords already taxed at higher rates, however, basic rate taxpayer landlords could also find themselves as a higher rate taxpayer once the interest is restricted.
2. Practicalities
The practicalities are that a company is incorporated to provide management and letting agent services to the property owner. The services undertaken include the collection of rent, arranging ongoing maintenance and repairs, property inspections etc. on behalf of the property owner who is charged a management levy for the service. The shareholder/owner/director of the company is the same individual who owns the properties. The management charge is deducted from the rental income received before the net amount is sent to the property owner. As such, the charge is an allowable expense against the rental income received in the hands of that individual property owner and therefore receives tax relief on the management charge itself at his/her marginal tax rate.
Example: This example shows the calculation that needs to be undertaken to determine the possible tax benefit of a management company.
John owns five properties with rental income of £150,000 making a profit of £100,000 a year. He has other income against which the personal allowances are allocated.
Without the use of the management company John's marginal rate of tax will be 40 percent:
£37,500 x 20% £62,500 x 40% Total tax £32,500
With the use of the management company and an assumed management charge of 15% (assuming no other expenses to deduct):
Management charge: £150,000 x 15% = £22,500
Deduction of this amount as an expense produces a profit reduction for the individual landlord down to £77,500.
This will create a revised tax liability of:
£37,500 x 20%
£40,000 x 40%
Total income tax £23,500 A reduction of £9,000
However, it must be remembered that there will also be a corporation tax liability on the company profit of £22,500 x 19% = £4,275.
Therefore the use of a management company results in a total overall tax liability of £27,775 with total tax saving of £4,725 (£22,500 x 40% - 19%).
3. How much to charge?
It is important that any dealings between the landlord owner, the management company and the tenants renting the property are made at an arms' length basis. It is also important that the management charges are set at a similar percentage in comparison with other local independent commercial letting agents. If the amount charged by the company is more, then HMRC could contend that the company is not being run as a separate business and tax any profit as if it were the landlord's or add back a proportion to the profit chargeable to the individual.
Commercial letting agents usually charge around 12%-15% of the gross rental income for a full management service. An additional charge could be made for the drawing up of a tenancy agreement or the taking of an inventory. Any legal fees relating to the tenancy are payable by the management company and are tax deductible against the management income received.
4. Practical Points
It is suggested that the number of properties used in this scenario should be at least four or five as the cost of preparation of the management company accounts and the legalities involved are higher than for an individual property investor. The higher the number of properties, the higher the management charge and therefore the higher the tax relief thereon.
For more extensive property portfolios there may be the problem of the management charge exceeding the VAT threshold of £85,000. Taking a generalisation of a 15% management charge the rental income would need to be in the region of £567,000 for this to be a concern. If the company does have to register for VAT this will add 20% to the charge, effectively reversing the benefit of using a management company in the first place. Further the landlord himself/herself will not be able to reclaim the VAT charged.
5. How to withdraw the money tax effectively?
There would usually be a profit remaining in the company after deducting allowable expenses (phone, mileage, stationery, etc.) so the question is – how do you withdraw the profit tax efficiently - if it is withdrawn?
As salary
A salary can be taken by either a director or another employee as payment for working in the management company. Drawing a salary will reduce the amount of corporation tax chargeable on the company as the payment is an expense. A tax efficient profit extraction strategy is to take a small salary and withdraw further profits as dividends, the amount being dependent on whether Employment Allowance (EA) is available (or whether the director is under the age of 21 years). EA is not available to a company where the sole employee is a director; if there is one director and two employees then EA can be claimed.
If the EA cannot be claimed then the amount of £9,500 is the 'optimal amount' to withdraw as a salary as this amount results in no NIC payable by the employee (although, the employer will be liable for NIC on the amount in excess of Secondary Threshold of £8,788 (i.e. (£9,500 - £8,788) x 13.8% = £98.25)). As corporation tax relief is available on the salary and associated employer's NIC's, by allocating an 'optimal' salary amount of £9,500, the corporation tax deduction outweighs the amount of employer's NIC due by £55.70.
If EA can be claimed then the optimal amount is higher at the personal allowance of £12,500.
At this amount an overall tax saving of £210 is possible due to tax relief being available for corporation tax paid (assuming that the personal allowance has not been allocated against other income). The employee will be liable to pay NIC whilst the employer will not. However, the benefit of withdrawing a salary need not be just for tax reasons; if the director has not clocked up enough years to achieve a full state pension then a salary at the amounts given above need to be considered.
As dividends
Profits withdrawn as dividends above the £2,000 'Dividend Allowance' attract a tax charge tax at 7.5% for a basic rate taxpayer, 32.5% for a higher rate taxpayer and 38.5% for an additional rate taxpayer. These percentages effectively eliminate the benefit of using the company for a higher or additional rate taxpayer unless either no withdrawals are made and the monies remain in the company or the £2,000 limit only is withdrawn.
Closing the company
If the intention is to close the company and the money withdrawn at that date then there may be a tax charge on winding up which may negate any tax benefit gained in using a management company. If the amount of cash to be distributed is less than £25,000 then the cash can be treated as a capital gain rather than as a dividend. Capital gains attract an annual allowance of £12,300 for the year 2020/21 with the balance being taxed at 10% if a basic rate tax payer or 20% otherwise. Any amounts greater than £25,000 will be deemed as dividends and taxed using dividend tax rates unless the company is closed via the Members' Voluntary Liquidation. In a Members' Voluntary Liquidation, a Liquidator's distribution to shareholders are classed as capital and therefore subject to CGT. This route can therefore prove highly tax efficient where a company has net distributable assets above £25,000.
6. Practical pointThe benefits of a management company are reduced if withdrawals from the company are made, however, it is not a legal requirement for the money to be taken. Instead of a tax bill on the dividends it might be preferable to retain the monies within the company until the director/shareholder's marginal rate of tax has reduced. Should this be the plan then the problems of withdrawal and dividend tax charge will not apply.
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Tax Strategy 2
