More and more property investors are turning to commercial property to diversify their buy-to-let portfolios. The main attraction is the secure income stream that comes from having high-quality tenants on long leases. However, investing in commercial property is a totally different ball game to investing in residential property and requires a certain amount of specialist knowledge.
If you are interested in taking the plunge you have to do some homework. The best way is to read as much about commercial property generally before you even begin to look at specific investment opportunities. And what about the tax benefits of commercial property investment? As you'll now read, the taxman certainly seems to have a soft spot for this type of investor.
One of the biggest decisions any property investor must make is deciding which legal structure to use. There are four ways, and the current tax implications of each are potentially enormous.
Buying personally
Most investors buy property personally/directly. The advantage of this is that when you sell you may qualify for special capital gains tax treatment - 'business asset taper relief'. This means three-quarters of your profits will be completely tax-free after just two years.
This makes commercial property one of the best capital gains tax shelters around. Effectively you can never pay tax at more than 10%. In many cases, thanks to the added benefit of your annual capital gains tax exemption, you will pay tax at an even lower rate.
Unfortunately when it comes to claiming the special capital gains tax treatment there is one big 'BUT'. You will not qualify if your property is let to a quoted (i.e. stock exchange listed) company. At least you can be sure a large high-street store will usually still be in business in five years' time and able to honour your lease. That's the whole reason people invest in commercial property after all - to earn a reliable long-term income.
If you let your property to a quoted company you will only qualify for the stingy 'non-business asset taper relief'. This type only exempts 5% of your profits after three years and 40% after a decade.
And what about the rental income? After all, many commercial property investors are more interested in income than achieving capital growth. Unfortunately there's no concession here. You'll pay income tax at 22% or 40% depending on your tax bracket. To protect your rental income you have to consider investing in a different way.
Using a company
More investors are using companies these days for the simple reason that corporation tax rates are much lower than personal tax rates. If you invest through a company you may be in the opposite position to the personal investor - you will pay less tax on your rental income but more tax on your capital gains. For example, your rental profits may be taxed at rates as low as 0%, which is great news for investors with high-yielding properties.
There's extra tax to pay if you extract dividends but if you can afford to keep reinvesting your profits for many years, a company could prove an extremely powerful tax shelter. However, it's important to remember that companies don't qualify for taper relief when they sell property so the generous business taper relief, which shelters three-quarters of a direct investor's commercial profits, will not be available.
Instead your company will qualify for an indexation allowance, which will protect you from paying tax on inflationary profits - about three per cent a year at most. You will personally qualify for taper relief if you sell your shares rather than the property itself.
However, this will be at the reduced non-business taper rates. The only way to escape income tax and capital gains tax (and corporation tax) is to invest through an ISA or self invested personal pension plan.
Using an ISA (Individual Savings Account)
At present you can invest £7,000 per tax year in an ISA and not pay any income tax or capital gains tax on your investment profits. A couple, married or otherwise, can therefore shelter £14,000 per year or £70,000 over a five-year period.
Most of us associate ISAs with shares and other potentially high risk investments but it is also possible to obtain exposure to commercial property through one. You cannot use an ISA to invest directly in commercial property but there are some excellent property investment trusts that do invest directly in bricks and mortar and that qualify for inclusion in an ISA. These funds invest in a broad spread of high quality commercial property and focus on earning you a high income that will, of course will be completely tax-free if you invest via an ISA.
Using a self-invested personal pension
ISAs are a fantastic tax shelter but your investment choices are extremely limited. One way of having greater investment choice and flexibility is to buy commercial property through a self-invested personal pension (SIPP). The advantage of investing through a SIPP is that you pay no income tax or capital gains tax on your rental income and capital gains. More importantly, however, you also receive tax relief on any contributions you make into your pension account. This effectively means that you will be able to buy property at a 40 per cent discount.
Commercial property SIPPs are extremely popular with business owners who use them to buy premises for their companies. Their company would then pay rent to their SIPP. The company would claim this expense as a tax deduction and the SIPP would pay no tax on the rental income it receives.
Nick Braun is the author of Retire Rich with a Property Pension and ISAs: The Definitive Guide , available from www.taxcafe.co.uk
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