What is a director’s loan account and why is it useful?First Published: November 2017 | Available in: Property Articles Your Property Network
Following the introduction of the new ‘Section 24’ mortgage interest relief restrictions, many property investors are now using a company to invest in property. Generally, the most tax-efficient way to fund a property investment company is via a Directors Loan Account – but how do these work & why are they useful?
What is a Director’s Loan Account (DLA), exactly?
Simply, a director’s loan account (DLA) is a running balance between the director of a company, and the company itself. In the early stages of a company’s life, the company itself won’t normally have any funds of its own, and so the director will normally fund the company initially. This creates a directors loan account (DLA) i.e. the cumulative total of all the funds the company receives from the director to get started.
Crucially, it is important to keep a good record of the total of the DLA because, once the company has funds of its own, the DLA can be repaid to the director tax-free. Given that dividends above £5,000 are now taxable for everyone, it’s now more important than ever that the DLA is maximised and preserved for as long as possible – as tax-free extraction of company profits can’t be beaten!
This is where a DLA becomes useful – money can be taken out of the company and NOT treated as income to you as the director.
What goes into a Directors Loan Account (DLA)?
Typically, a DLA will initially be made up of:
- Cash transferred to the company bank account e.g. director transfers £50k cash into the company bank account – therefore the company has a debt (DLA) back to the director for £50k
- Properties transferred at value (not a gift – see later) to the company e.g. director transfers legal title of an unencumbered personally-owned property to the company valued at £100k – therefore the company has a debt (DLA) back to the director for £100k
- Equity transferred to the company e.g. a personally-owned £100k property with a £70k mortgage is transferred to a company, and the company takes a £70k mortgage (i.e. simply replacing the personal mortgage £ for £) – therefore the company has a debt (DLA) back to the director for £30k
When a DLA in credit (meaning, the company owes the director back for all funds & property transferred to the company), the director can extract those funds from the company tax-free by having the DLA repaid – rather than take a salary or dividend, which would be taxable.
This means that when introducing money into a new company, it is almost always better to ‘loan’ the company money, rather than pay any more than (say) £100 in share capital – since share capital cannot be extracted easily and tax-free from a company.
A note on property ‘gifted’ to a company
Note that an unencumbered property can be transferred to a company ‘at value’ (say, for £100k), or as a gift (meaning, for zero consideration).
The tax treatment of the two options is very different – for a gifted property, the company hasn’t actually paid the director anything for the property, and so there is no corresponding credit to the DLA – the benefit of a gift is that there is no SDLT to pay, and so if SDLT on a transfer at value would be significant then gifting the property may be a better option than a transfer.
However, with a transfer at value, there is SDLT to be paid by the company on the transfer, and a corresponding large credit on the DLA. Depending on the circumstances, it may therefore be beneficial to pay the SDLT on a transfer at value, to get the potentially significant benefit of the large DLA credit e.g. on a £100k transfer at value, £3k of SDLT would be due, but the director could then potentially avoid paying £32.5k of income tax in dividends (if the director is a Higher Rate taxpayer and has used up any in-credit DLA).
Ideally, once a property investment company has been formed, the director would then promptly set up a company bank account (directors: prepare yourself for some admin hassle when doing this!).
The director would then ‘seed’ the company with funds for general expenses, and label such transfers as ‘DLA’, or ‘Loan’, or similar, so that it’s obvious what the receipt into the company bank account is, when the company’s accounts are being prepared at year-end. Obviously, it wouldn’t be ideal for receipts into the company bank account to be treated as rental income, and therefore taxed!
Preserving the DLA…
During the accounts year-end process, the DLA will typically be increased by the value of:
- Any dividends declared – e.g. currently there is a £5,000 per shareholder tax-free dividend allowance (typically a director would also be a shareholder)
- Any interest charged by the director on the DLA – Basic Rate taxpayers can received £1,000 per annum of tax-free interest (Higher Rate taxpayers: £500/annum) – though there is no requirement to charge interest on an in-credit DLA
- Any expenses that the director has incurred on the company’s behalf i.e. costs incurred that did not get paid through the company bank account (travel, computers, professional fees etc)
- ‘allowances’ to be claimed – home office allowance, vehicle expenses via a business mileage claim, and any expenses paid for personally by the director
- Any additional cash funds that the director wants to store in the company bank account – this can be beneficial as this means the director can charge the company interest on the increased DLA, which may be beneficial
And, the DLA will typically be reduced by the value of:
- Any funds taken from the company during the year – for whatever reason
- Any company assets taken from the company by the director e.g. the transfer out of the company to the director of a property
- Any expenses paid through the company bank account that are not the company’s expense e.g. if the company bank account (or debit card) is used to pay for the directors personal expenses
A note on transferring a DLA to another company…
A fairly common scenario is for a director to have a non-property company (e.g. a contracting company), which is used to funds day to day expenses, and also a property investment company. There may then be an undesirable scenario whereby the director has an overdrawn DLA in one company and an in-credit DLA in another company.
The solution to this problem in many cases is to simply transfer enough of the in-credit DLA to the other company, in order to eliminate the overdrawn DLA, via an ‘intercompany loan’ (which isn’t a taxable transfer).
Watch out for … a lender’s ‘deed of postponement’
Lenders usually prefer a scenario where the director has loaned a company the deposit funds to purchase a new company property – quite rightly, lenders see this as a sign of the director’s commitment to the company. However, as with any investment, there is risk involved even in property investing, and many investors subsequently prefer to re-finance their company in order to repay their own DLA, effectively leaving the lender as the company’s sole lender.
However, since the new Section 24 mortgage interest relief restrictions have made corporate property investment more popular, lenders are keen to avoid this potentially risky scenario, and so will often put a ‘deed of postponement’ in place, as a condition of any finance.
This deed restricts what the director can take from the company as a repayment of the DLA – it will normally be set at a particular £ value, and be assessable at each year-end. Most lenders word a deed prohibitively, so that the financed property can be repossessed if the director takes more funds from the company than is specified in the deed – this is serious stuff!
In summary …
Using a company to invest in property makes tax sense for many property investors who would otherwise suffer an excessive tax charge because of mortgage interest relief restrictions, if investing personally.
Having a company repay a directors loan account enables company profits to be accessed without having to extract the funds as taxable income (salary or dividends). This avoids dividend tax (for dividends above £5,000, currently) of 7.5% (for Basic Rate taxpayers) or 32.5% (for Higher Rate taxpayers).
For many property investors, drawing a small salary dividend with the remainder of any funds taken as a directors loan repayment, can mean that profits are earned in the lower-tax (19%, currently) company, and a full tax deduction for mortgage interest paid is available. Of course, all good things come to an end however, and once the directors loan account has been fully-repaid, company profits then need to be extracted as salary / dividend – but often that point can be many years after the company was formed.