From April 2017 small buy-to-let investors will be hit by gradual tax changes set to slash their profits and increase their tax bill.
From April next year the Treasury will start phasing in changes which will eventually see landlords pay tax on the entire rental income they generate from their properties.
They will not be able to deduct the cost of mortgage interest. Instead, they will benefit from a tax credit equal to 20pc of the interest cost. It will mean higher-rate and additional-rate taxpayers will pay considerably more tax - and in some cases even pay tax where they make no profit.
But landlords structured as companies are exempt, and will continue to pay corporation tax on their profits.
It’s true that you can circumvent these charges through setting up a business. But this is a far from simple process, and there are several pitfalls that need to be avoided along the way.
"Corporations are looking really attractive at the moment," said Simon Collins, of broker John Charcol. "But they only work for certain types of investors, and people have to be aware of the implications further down the line."
How to get started
Most landlords will need to set up special purpose vehicle in order to buy the property. This can be done online for as little as £20 but David Whittaker, of Mortgages for Business, recommends spending a little more - around £75 - to make sure you get all the right paperwork.
Then select the appropriate SIC (Standard Industry Classification) code which relates to letting property. Alternatively an accountant can do it for a small charge.
Buying a buy-to-let property through a company is a similar process to buying it as an individual. Be aware that the 3pc extra stamp duty levied on people buying second properties from April will also apply to people buying through a company.
If you’re already a buy-to-let owner, transferring property into a company has its own tax implications.
The property has to be sold at market value. This has capital gains tax implications as well as potential stamp duty costs when the property is bought through the company.
If the property has increased in value since it was bought, capital gains tax may be payable on the sale, though after a landmark case in 2013 landlords may be exempt from this if they can show that the property is a "business" as opposed to an "investment".
This depends on the amount of work the landlord does on the property, including day-to-day maintenance and direct management of tenants. If they have another job or employ a letting agent to do the work, it’s likely to be categorised as an investment as opposed to a business.
Chris Springett, a director at Smith Williamson, said that for landlords who do not meet the latter criteria "it's probably a sign that incorporating is not worth it".
Getting a mortgage
Specialist lenders offer buy-to-let mortgages for companies, and it’s easier to get a mortgage with a special purpose vehicle, which only holds properties, than a trading company, which can carry out other business. This is because special purpose vehicles are regarded as less complicated and easier to underwrite.
Ying Tan, managing director of the Buy to Let Business, said: "When you set up a company to buy a company, there's lots more options open for landlords in a SPV. If you already have a business, that's fine, except that most banks won't lend to a trading company. You have access to better funding and better rates."
Mortgages for incorporated companies used to be significantly more expensive because the underwriting costs are higher due to the more expensive process of checking out the company and the individuals involved.
However, David Whittaker of Mortgages for Business said that costs have dropped in the past year, partly due to demand. “Increasingly lenders are not charging much more for limited companies than they are for individuals."
Average rates are still 0.7pc higher, though.
What happens next?
Once you’re incorporated, you have some responsibilities that you did not previously have as an individual buy-to-let investor.
Instead of simply doing self-assessment, businesses have to complete annual returns and accounts, so a limited company may have to factor in the cost of an accountant. However, Mr Springett said it's perfectly possible to do this yourself.
"Plenty of people run their own businesses on their own and this is no different."
This should be where the real benefit of incorporating kicks in, as investors pay less tax on their rental income, and the removal of higher-rate interest relief does not apply. Corporations currently pay a flat rate of 20pc, which will drop to 19pc in April 2017 and 18pc by 2020.
Things to watch out for
Doing this is really only useful for higher and additional-rate taxpayers, as the changes to tax relief are only likely to affect them. It might also be relevant to basic rate taxpayers who when the new rules come in will have combined rental and other income over the £40,000 threshold for higher-rate tax.
What the profits from buy-to-let will be used for is also important. Consider whether the money is needed now or to use as a pension or extra income at a later date. Removing profits from a company as a dividend will get more expensive in April for most people as dividend tax rates change.
Basic-rate taxpayers will have to pay 7.5pc tax, higher-rate taxpayers will pay 32.5pc and additional taxpayers will pay 38.1pc. This represents an increase for all three bands. There will be £5,000 dividend tax relief, but any amount above that will be taxed at these levels.
Therefore incorporating is a better option if you’re planning to “roll up” your income, and leave it to accrue without withdrawing it, for example to use as a pension later.
When you do come to dissolve the business and close the company, you could take a double tax hit. Your profits will be taxable within the company, at 20pc, and then when you take the money out you will have to pay tax at either your dividend rate or as capital gains tax, depending on how you extract the money.
Mr Springett said it's important for investors to be aware of this. "If it's only a short-term plan you have got to remember that those two levels of tax are payable. It's about what they are looking to acheive with their property portfolio. If it is long term or they are looking to grow, then a corporation could make more sense."
Are you thinking about incorporating your buy-to-let? Let us know: olivia.rudgard@telegraph.co.uk
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