Bad advice and a more proactive (some might say, ruthless) HMRC can be a dangerous mix. And I think that you only have to look to the recent changes made to Income Tax rules for landlords to see this in action.
Prior to those changes, the interest and costs on loans taken out to buy residential properties could be deducted from rental income. However, this relief on finance costs is now restricted to the basic rate of Income Tax (the changes are being phased in over the next four years).
Depending on your circumstances, if you own buy-to-let properties, this restriction could result in incredibly high rates – and understandably, many rental property owners have sought steps to avoid this.
Why was this policy introduced?
According to HMRC, the objective of this policy was to make the tax system fairer. Essentially, the amount of Income Tax relief on residential property finance costs (such as mortgage interest) has been restricted to the basic rate of tax to ensure that landlords no longer receive the most generous tax treatment.
While that all sounds great in theory, it led to something else entirelyâ€¦
A rush to incorporate
These changes caused a huge amount of confusion, and it initially led to a rush to incorporate buy-to-let businesses, as the restrictions do not apply to companies. And this is where the bad advice I mentioned earlier comes into play.
You see, itâ€™s never going to be as simple as starting a company to avoid tax. Yet some viewed this as the quick and easy way of sidestepping this restriction. But with so many rules and regulations – not to mention other tax implications – associated with operating a company, incorporation in this instance is often nothing more than an attempt at a short-term solution to a long-term challenge.
Plenty of advisors have suggested the company route to steer their clients away from this restriction, but to me this screams of a reactive response, when a measured, proactive approach was required.Â Â
A mistake years in the making
It might not be today, it might not be tomorrow, but many buy-to-let property owners will wake up and discover that their decision to incorporate was the wrong one. Their liabilities and responsibilities will be far greater than if theyâ€™d met the restrictions head on in the first place.
Starting a company to avoid these changes could be a mistake years in the making, particularly when you consider the following:
- You might minimise liabilities in one area, but running a company involves other forms of taxation, admin costs, legal and fiduciary responsibilities, and so much more;
- If youâ€™re drawing a large income from your company, the additional income tax payable on dividends could negate any potential savings;
- You may not be able to borrow at the same interest rates as you were previously as an individual;
- And there are often more hoops to jump through when dealing with mortgage lenders as a company.
The bottom line
This isnâ€™t to say that there wonâ€™t be times when incorporation makes sense for buy-to-let businesses, but as with just about anything else in life, it should be done with a great deal of consideration. Many rental property owners are trying to have their cake and eat it, presenting themselves as one thing (a business) to HMRC, and another (an individual) to the banks. And thatâ€™s a very risky game to play.
The bottom line is, what appears to be a very simple choice to make is actually one fraught with complication. Both in terms of deciding to change the status of the properties from being individually owned to being owned by a limited company, and also the many tax implications involved, the decision to incorporate is not one to be taken lightly.Â
Not sure about your next move? We can helpâ€¦
As ever, we’re looking at legislation as it is today. What appears to be cast in stone could very well change. And with this level of uncertainty, it pays to be prepared.
In my next blog post, Iâ€™ll discuss how the interest charges related to buy-to-let properties work, and why theyâ€™re so often misunderstood.
But in the meantime, if youâ€™re unsure if you need to incorporate, Caplan Associates can help. Get in touch today to find out more.