Using a simple partnership combat the effect of Section 24 mortgage interest restrictionsFirst Published: May 2018 | Available in: Property Articles Your Property Network
Tax year 2018 sees the start of the new ‘Section 24’ residential mortgage interest relief restrictions, which phase in over tax years 2018 (25%), 2019 (50%), 2020 (75%), 2021 (100%), with only a flat-rate 20% tax credit allowed for mortgage interest / fees paid, regardless of the tax rate of the investor. However, using a ‘simple’ partnership can be useful in allocating property profits in the most beneficial way to ensure that each individual’s tax status is fully-utilised.
What tax problem would having a ‘simple’ property partnership solve?
Many residential landlords own their properties with a spouse or business partner, and historically may have accounted for the rental income and expenses for each property according to who actually owns the property – which is the start-point for accounting for any property rental business.
Until Section 24, because mortgage interest was fully-allowable against rental income, there often simply wasn’t a need to change this basic position because the income tax rate of each owner was the same – so changing the structure would simply shift a tax bill from one person to another, but the total amount due wouldn’t change.
However, with the phased removal of mortgage interest / fees as Section 24 starts in 2018, many more landlords will see their taxable incomes ‘pushed’ into the Higher Rate (40%) of income tax (2018: £45k), which will therefore mean a tax increase, as the tax credit for mortgage interest / fees is only at 20%. (Note: if mortgage interest is removed from the ‘taxable income’ calculation and the investor’s taxable income is still below the Higher Rate income tax threshold, there is no impact of Section 24 at all).
So, how can a ‘simple’ property partnership help with Section 24 tax-planning?
A property partnership allows all the income and expenses for the properties included within the partnership to be accounted for as one total, and then the total split between the partners in whatever way the partners wish (e.g. 50-50%, 60/40%, 99/1%. This allows a more flexible allocation of rental profits between the portfolio owners than the alternative i.e. simply accounting for each property according to who owns each property.
Note that it is the partners who pay tax on their share of the rental profits (and pay capital gains tax), not the partnership itself (unlike a company, where the company itself pays tax, and the shareholders may also pay tax on their income from the company) i.e. a partnership is ‘transparent’ in tax terms.
This means that each of the investors full Basic Rate band can be used, subject to all partners agreement (which should be documented within the partnership agreement).
What exactly is involved in setting up a ‘simple’ partnership?
A ‘simple’ partnership can be set up by applying to HMRC to form the new partnership (there is an online process to do this, which your accountants should be familiar with). The partnership needs a name (most of our own clients use their surname, plus the words ‘Property Partnership). A separate bank account isn’t necessary (unlike for a company) although it’s course good practice to have a dedicated rental bank account anyway.
HMRC will then issue a partnership tax reference, and a tax return will be required for the partnership itself, which will include the usual totals for a rental property business i.e. rental income, finance costs, repairs, etc.
How do partnership accounts work – and how does this affect my SA302 Tax Calculation?
The basic process and ‘rules’ (known as GAAP: Generally Accepted Accounting Principles) for the production of property partnership accounts is in most ways the same as for ‘basic’ rental accounts. All of the properties held by the partners in the partnership are accounted for together, and then the total split between the partners in whatever way the partners wish (e.g. 50-50%, 60/40%, 99/1%.
One major difference between a jointly-owned property rental business and property partnership is that a simple partnership is an ‘entity’ and so only one ‘Annual Investment Allowance’ (a type of capital allowance) can be claimed by the partnership – however as the AIA is £200k, it is rare for landlords operating as a partnership to be affected by this).
Each partners SA302 Tax Calculation would then simply include a single line for ‘Income from partnerships’, rather than ‘Income from property’, however the tax treatment of the income would remain the same e.g. National Insurance isn’t charged on rental property partnership income as the income is treated as ‘investment income’.
I also have a property management company – how is that affected by operating as a partnership?
Many landlords also have a property management company, which usually would charge property management fees into the property rental accounts – operating the property portfolio as a partnership has no impact on this arrangement.
Why is using a simple deed of trust not preferable to using a partnership like the old days!
For many jointly-held property portfolios, only a small number of properties may need the ownership structure changing to achieve the desired income split for the portfolio owners. However since the reduction in the SDLT threshold to £40,000, and the introduction of the 3%+ additional SDLT for 2nd homes, in many cases an unwelcome SDLT charge can result from the use of a deed of trust, based on the proportion of mortgage that is also deemed to transfer from one person to another. Also, if the joint owners are not married, a CGT charge could also result from a beneficial interest transfer via a deed of trust.
How can involve family members in the partnership if they don’t own any rental property?
It is possible to involve family members, or trusted friends / business partners, if those individuals also contribute property to the partnership. Crucially, the partnership’s overall profits don’t need to be split in the same proportion that each individual partner has contributed properties to the partnership.
This therefore provides useful flexibility in terms of allocation of income between partners, ideally to ensure that each partners Personal Allowance & Basic Rate income tax band is used, to the benefit of the owners in total (so, this is especially useful where the partners are all family and are so happy to allocate income tax-efficiently to the benefit of the family as a whole).
If there are adult (18+) potential partners who don’t have any rental properties, it may also be possible to allocate some beneficial interest ins some partnership properties, via a deed of trust transfer (taking care not to trigger SDLT / CGT tax charges by calculating carefully how much interest in each property to transfer).
How is a ‘simple’ partnership different to an LLP (Limited Liability Partnership)?
A ‘simple‘ partnership is effectively a tax-reporting entity – rather than a legal entity in its own right. So, it isn’t possible for a ‘simple’ partnership to itself own property (which is why there are no ‘partnership mortgages’ available).
The main downsides of an LLP are that:
- Annual LLP accounts need to be filed with Companies House, just like for a company (“Companies House” should really be called “Companies and LLPs House”), which incurs typically similar or higher accountancy / tax-planning fees as for a company
- And, the property portfolio balance sheet (property values less mortgages, plus cash at bank etc) is also reported on the public record (which isn’t a requirement for a personally-owned property portfolio, as reporting is only required to HMRC via the annual tax return filing). So, tenants, family, nosey-neighbours, can all see what the portfolio net worth is…
Given that the tax treatment of a ‘simple’ partnership and an LLP is identical, in most simple cases a ‘simple’ partnership is preferable to an LLP (there are some limited cases where this isn’t the case, but this is rare for property investors.
In summary …
However, using a ‘simple’ partnership can be useful in allocating property profits in the most beneficial way to ensure that each individual’s tax status is fully-utilised. Mortgage lenders don’t need to be informed about the formation of a ‘simple’ partnership (unlike where beneficial interest in a personally-mortgaged property is transferred to a company), and so using a ‘simple’ partnership can enable many landlords to significantly reduce their exposure to Section 24 mortgage interest relief restrictions (possibly in conjunction with an add-on property management company, depending on profits and Section 24 exposure).