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How to fund your new property investment company tax-efficiently using borrowed funds

First Published: July 2020 | Available in: Property Articles Your Property Network

By specialist property accountant Stephen Fay ACA

Due to the ‘Section 24’ mortgage interest restriction for ‘private landlords’, investing in residential property via a property company is now a mainstream investment approach for the landlord community.

However, given that a new property company won’t already have it’s own funds to invest with, it is normally the company’s owner that provides funds – but how could this be done, using borrowed funds, and in a tax-efficient way?

Why can’t my company just raise it’s own finance – why does it even need me, it’s owner?

Most property investment companies (“PICs”) in the post-Section 24 era are newly-formed ‘SPV’ companies, and so as a brand new company it won’t have any assets or cash to invest with.

‘SPV’ means a ‘Special Purpose Vehicle’ – a company (in most cases) that has a ‘special purpose’ – for a PIC, to buy & hold rental property. This is distinct from a company that may already exist and have an existing trade (e.g. a contractor-type company, or a company that has an existing trade, such as a retailer, café, etc).

The vast majority of mainstream BTL lenders won’t lend to a company unless it is an SPV, and so usually this means that a new company needs to be formed to invest in residential property.

Of course, on ‘Day 1’ of the new company’s life, it has no assets or cash, and so, like a child is reliant on a parent in its early years, the company is reliant on its Director-Shareholder for funds with which to invest.

This then leads to the key question … how can a property investor fund a new PIC, using borrowed funds, tax-efficiently?

Back-to Back Loan via a main residence

Probably the most common way that most landlords get started in their property investment career is to borrow against their main residence.

This is often the cheapest way to raise funds, as interest rates & fees for main residence borrowing tend to be lower than BTL lending (whether in personal or company name), and many lenders these days are more sensitive to borrowers with high levels of unsecured borrowings (unlike the ‘Wild West’ old days of BTL when many landlords had a myriad of cheap personal loans and no/low interest credit cards!).

Fortunately, tax relief is available for interest on loans used to lend to a PIC, assuming the company is a ‘close company’ and the owner owns more than 5% of the shares (a ‘close company has 5- or fewer shareholder generally).

The interest is known as ‘qualifying loan interest’ and allows the PIC to pay the Director-Shareholder’s personal mortgage interest, without creating a tax charge, in return for the use of the funds. This is sometimes known as a ‘back-to-back’ loan i.e. an indirect way for the company to borrow investment capital, since there are few sources of unsecured loan finance for new companies.

For example:

Mr Smith has an unencumbered residence worth £250k and realises how cheap 60% residential mortgages are (currently less than 1.5% for most borrowers!). So, Mr Smith borrows 60% of £250k (so, £150k), on which the monthly interest is £187/month.

Mr Smith then transfers the £150k into his PIC bank account, as a Director’s Loan (labelling the transfer as ‘LOAN’ when doing the transfer via internet banking).

The company balance sheet now shows a £150k cash balance, and an equal and opposite Director’s Loan balance of £150k. The company’s net worth remains nil, as Mr Smith is a creditor of the company (the company owes him back the £150k he has lent to the company).

After a month, the first mortgage payment is due on the £150k borrowed. The Direct Debit for the payment is via Mr Smith’s personal bank account, however all the funds have since been lent to the PIC. So, Mr Smith transfers £187 from the company bank account – before the Direct Debit is taken – to fund the mortgage payment from his own bank account.

As the loan is a ‘qualifying’ loan, and so the interest is ‘qualifying’ interest, the £187 income received by Mr Smith from his company is offset by the £187 mortgage interest charged i.e. no tax arises as no profit arises, and Mr Smith’s Director’s Loan to his company remains at £150k.

Mr Smith then realises that he can set up a Standing Order from his PIC to his personal bank account, to automate the process (he can’t simply transfer the mortgage direct debit from his personal account to the PIC bank account, as the mortgage lender is expecting to see a monthly mortgage payment made from his personal bank account).

A few things to note:

Repayment mortgages

For repayment personal mortgages, the capital part of the mortgage payment will reduce the Director’s Loan account accordingly – for example:

If Mr Smith’s capital repayment mortgage payment was £687 (of which £500 was capital repaid, and £187 interest), the PIC would pay Mr Smith £687 to cover the mortgage payment in full, however the £500 capital element would reduce Mr Smith’s Director’s Loan to £149,500 (of course Mr Smith hasn’t ‘lost’ anything, as the amount owed to the lender has also reduced to £149,500).

Practically, payments can be made from the company bank account through the year to cover the mortgage payment, and then the amount to be treated as interest paid vs capital paid can be calculated using the year-end residential mortgage statement.

Part-business, part-private mortgage borrowings

Interest can be claimed from the PIC to the extent that the personal mortgage was used to fund the company. For example, if Mr Smith borrowed £150k and used £75k to fund the company, and £75k to fund a new home extension, then he would simply claim 50% of the mortgage interest from the company (the remainder would be a private expense).

Of course, as a repayment mortgage is paid, the capital part being repaid in this case would allocated to the non-business capital amount owed i.e. after Mr Smith’s first repayment mortgage payment of £687, he would owe £149,500 in total, split £75,000 business element, and £74,500 personal element. In this way the maximum possible amount of interest would be tax-deductible as the mortgage balance (and therefore interest) reduces over time.

Sometimes the maths can get a bit tricky for cases where there are multiple tranches of borrowings, over several years, over several companies … but doing the maths is worth it!

Other types of loans

Property investors are an inventive breed! Having enough investable funds is usually the constraint in the growth of a PIC – but an interest-bearing loan from any source can be transferred to a PIC and the interest would be ‘qualifying interest’ just as personal mortgage interest would be.

So, personal loans & credit cards, loans from friends, family, Joint Venture partners etc can all be transferred to a PIC and the PIC would then pay the company’s Director-Shareholder as outlined above i.e. although the most common way to fund a new PIC is via a personal residential mortgage, ANY type of personal borrowing can be treated as a ‘back-to-back’ loan.

Section 24 position

Finally, note that as it is the company that is effectively bearing the cost of the interest, the ‘Section 24’ mortgage interest restriction is not relevant, as Section 24 does not apply to PICs – neither does Section 24 doesn’t apply to SASS & ISA loans …

Other sources of investment capital are …

SASS loans

Many company property investors will choose to convert their pension to a SASS pension (Small Self-Administered Scheme) – which then allows the SASS to lend up to 50% of it’s value to the PIC.

The PIC pays interest on the loan to the SASS, which is tax-deductible for the PIC, & not taxable in the SASS. This can be a good way for younger investors to access their pension for residential property investing before they reach retirement age (now 55, but age 57 from 2028 onwards).

The main issue with taking a SASS loan is the cashflow impact of taking a short-term (typically 5 years) repayment loan i.e. if a new company property is purchased with a 25% capital repayment loan from a SASS, the cashflow generated by the property purchased might be used to fund the SASS deposit loan repayment i.e. the property might not make much cashflow due to the short SASS loan repayment period (albeit at the end of the 5 years the company then has a significant boost to cashflow having cleared the SASS loan).

ISA loans

It is possible for a PIC to borrow from the ISA (Individual Savings Account) of it’s owner. For investors with substantial ISA funds this can be another source of new investment capital into the PIC, while also being able to pay tax-free interest to the ISA (i.e. this achieves the tax benefit of reducing the company’s corporation tax, but without creating taxable income in the ISA).

Crucially, a key benefit of taking an ISA loan is that the ISA ‘tax wrapper’ remains in place around the ISA funds – so the tax-free status isn’t lost, which would be the case if the ISA was simply closed and the funds invested into the PIC as a simple Director’s Loan.

An example of a platform that facilitates ISA Director’s loan lending is:

https://www.rebuildingsociety.com/

Conclusion

Generally, corporate BTL lenders prefer to lend to ‘SPV’ companies, however this means that usually the company won’t have it’s own investable funds, and so will need to borrow from it’s Director-Shareholder, in one way or another.

Many landlords start their property portfolio by borrowing from their main residence … and in the new ‘post-Section 24’ world where residential property investing is commonly via a limited company, this remains a common way to fund the company’s need for purchase deposit funds (along with a company BTL mortgages).

‘Qualifying loan interest’ tax relief allows for borrowed personal funds to be lent to a PIC, and for the PIC to then pay the company’s director / shareholder’s interest charge, so that the company effectively bears the interest cost of the borrowed funds.

Finally, the main constraint to the growth of a PIC is investable capital … borrowing from a SASS pension and Director’s ISA are new ways for a property company to grow using it’s director’s overall assets … a case of ‘necessity being the mother of invention’!

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