Property Investment Vehicles And Tax Consequences
Monday, April 23, 2007
by
Ronnie Brown and Carol Goodwin
Thinking of investing in property? We take a quick look at the different investment vehicles available and the tax consequences arising from them.
Individual Investors
The first option open to any property investor is to invest as an individual. However, this comes with significant commercial risk as the investor is exposed to personal liability without limit for any costs incurred. Profits are taxed at the individual’s prevailing income tax rate which may be as high as 40%.
However, there can be a major CGT advantage in individuals investing where the investment is in certain types of commercial property, namely, property used by an unlisted trading company, a partnership or an individual for the purposes of their trade. Such an asset will attract business asset taper relief for capital gains tax (“BATR”) even although the property investor has no connection with the business being carried on in it. BATR is much more beneficial than its alternative, non-BATR, as the following example shows:-
Example
Mr B and Mrs B realise gains on two separate assets in 2005-06.
Asset 1, being a local retail unit belonging to Mr B, is sold on 1 July 2006 giving a gain before taper of £1,000,000. The unit was bought on 1 June 2002 (and has been occupied by a private company for the purpose of its trade throughout). The qualifying holding period for full BATR is 2 years. Accordingly taper relief is available at 75% reducing the chargeable gain to £250,00. The tax thereon will be around £100,000.
Asset 2, being a block of flats Mrs B bought as an investment in Edinburgh, is sold on 1 August 2006 giving a gain before taper of £1,000,000. The asset was bought on 1 January 2002 (as residential property it will have been a non-business asset throughout). The qualifying holding period is 4 years. Taper relief is therefore available at 10%. This reduces the chargeable gain to £900,000. The tax charge will be around £360,000.
Given unlimited liability is generally viewed as inadvisable, another option is to hold the property through a limited company. This limits the investor’s liability to the nominal value of the company’s shares. Aside from limited liability, a company has certain tax advantages. Profit generated from investment will be taxed at 20%, 30% or 32.5% rather than 40%. Thus if the intention is to re-invest income into further acquisitions, retaining profits in a company may offer a cheaper way of doing so.
Single Purpose Vehicles
If individual properties are acquired in single companies, commonly known as single purpose vehicles or SPVs, the company can be sold by the owner rather than the company selling the property. This can result in a significant tax saving as a company’s shares are subject to stamp duty at 1/2 % whereas property is subject to SDLT which will be levied at 4% on property worth more than 500,000. A seller would reasonably expect to share in this saving with a purchaser.
The disadvantage of the corporate vehicle becomes apparent when the owner tries to extract income or gains.
Gains within the company may have been taxed at up to 30%. If the owner then extracts the balance, it is subject to a further tax charge either as a capital gain on the shares at the individual’s prevailing CGT rate or as an income dividend at an effective rate of 25%. The following example demonstrates this again using the same circumstances for Mr B above except rather than owning the property directly, he holds it through an SPV:
Company X makes a gain of £1M from the sale of its commercial property. Even allowing, say £100,000 for indexation allowance, it will pay tax on this of £255,000 as it is not a close investment-holding company. This leaves a net amount available for distribution of £745,000. If the company is wound up and the amount distributed, Mr B will be subject to CGT on the gain he has made on his investment. As Company X in not a trading company he will not get BATR on his gain. If we assume £745,000 is his gain (ignoring liquidation costs) then taper relief will reduce the taxable gain to £670,500. He will be subject to tax on this at 40%, resulting in a tax liability of £268,200. His net return will be £476,800 which clearly compares unfavourably to the return of £900,000 from direct ownership.
Even if the gain were to be distributed by way of a dividend, his net tax charge would be £186,250 and his actual return would be £558,750.
Selling the company rather than the property does not necessarily get round this double charge as a purchaser is likely to factor into the price that he pays for the shares, the tax on the inherent gain within the company.
Real Estate Investment Trusts
It is partly in response to these tax issues that REITs have been introduced. In its Discussion Paper back in March 2005, HM Treasury stated that it would be a key feature that “the tax treatment of a property investment held indirectly through a REIT is broadly comparable to that of property held directly” as “This ensures investors are able to make decisions about the appropriate form of property investment based on risk and return profiles, without tax having a disproportionate influence” (Section 2.3)
However, the need for REITs to be listed vehicles means that for the majority of DIY property investors, other options still have to be considered.
Partnerships
Where collective investment is desired, the alternative to a company is to form a partnership. A general partnership is not regarded as good news because, again, liability is personal to the partners, it is unlimited and each partner is jointly and severally liable to the creditor for the whole amount owed and not just his share.
Nevertheless, a partnership vehicle has the advantage of tax transparency. This means the income and gains are treated for tax purposes as those of the individual rather than of the partnership even although, in Scotland, a partnership is a separate legal entity from its partners. This enables partners to benefit from the tax advantages of individual ownership referred to above, namely, BATR and avoiding a double charge on income and gains.
Historically, the alternative to a general partnership was a limited partnership. This enabled investors to limit their liability to the amount of equity they put into the partnership. There had to be a general partner whose liability was unlimited but often this would be a £100 company with little or no assets in it. This gave tax transparency to the limited partner investors. However there could be no active management on their part. This all had to be done by the general partner. If a limited partner did become involved, he lost the protection of limited liability.
Although less used now, limited partnership still have a role to play. Where the property portfolio is of a size that may be attractive to a pension fund or insurance company, it may still be advantageous to own it through a limited partnership. Exemption on income and gains which a pension fund enjoys through direct ownership of property is preserved in relation to interests it holds as a limited partner of such a vehicle but not as a member of the next vehicle to be considered, namely, a limited liability partnership.
Limited Liability Partnerships
Aside from this disadvantage, it would be reasonable to say that since they were introduced by the Limited Liability Partnerships Act 2000, LLPs have become many people’s collective investment vehicle of choice. As a separate legal entity from its members, an LLP offers limited liability broadly equivalent (but not identical) to that of a limited company. For tax purposes, until liquidated, an LLP is treated as transparent for tax purposes. There is no restriction on participation in its management.
Thus, individual members are taxed as if the income and gains of the LLP were their own. BATR can be available and for a non-resident, gains may escape UK tax altogether.
Property Unit Trusts
Mention of non-residency leads to another vehicle which has enjoyed increased popularity of late. Non-resident property unit trusts or PUTs, commonly based in the Channel Islands or the Isle of Man, have been used as relatively tax efficient property investment vehicles for a number of years because they can offer virtual tax transparency for income and capital.
More recently these have been popular as a vehicle to achieve SDLT savings where circumstances did not permit the property to be enveloped in an SPV tax efficiently.
Recent anti-avoidance legislation has, however, curtailed their efficacy.
The foregoing has been a brief run through of the choices available to a prospective property investor. Clearly, it is not intended to be specific legal advice as each case is different and should be considered on its own merits. Biggart Baillie would be happy to provide such advice to you. Please contact Ronnie Brown or Carol Goodwin to discuss further.
The information contained in this article is given for general information only and does not constitute legal advice on any specific matter.