In it together: Property ownership for partnerships

Investment in UK commercial property was seen as a good thing prior to the financial crisis: it provided tangible, bricks-and-mortar security and the perception of almost certain capital appreciation. Now, however, the banks have retreated, licking their wounds after fuelling a leveraged property boom, and risk committees are carefully reviewing loan covenant obligations.

Those who are overstretched are being forced to realise some of their assets to meet their obligations. At the same time, banks are approaching property lending cautiously, favouring only the strongest transactions and borrowers, and demanding higher equity input while they rebalance their loan books.

For those with their own financial resources, distressed sellers can provide an opportunity ripe for the taking, and bargains may be found in the commercial property sector.

In addition, partners whose pensions are in a self-invested personal pension (SIPP) arrangement, or who move their fund into a SIPP, are able to direct their SIPP to invest in individual commercial properties. A SIPP is, of course, a tax-efficient investment vehicle. Equity funding (through the contribution to the scheme) is tax-deductible, and investment income (rental income in the case of property assets) and capital gains realised within the SIPP are tax-free.

This creates opportunities for partners in professional services firms to purchase not only other commercial properties, but also the space that they currently occupy. Indeed, when looking simply at annual cashflow, why would firms consider paying rent on premises when this may be comparable to the cost of purchasing the freehold lease for their office? After all, over a period of time, the property owners should benefit from capital appreciation (particularly if buying during a downturn in the market) and rent reviews will no longer apply.

Ownership of its own property is an interesting and potentially appealing route for a firm to go down. However, partners must think carefully about all of the implications of property ownership before they rush out and buy, as a number of potential complications can arise where a partnership or LLP owns its own premises or invests in property as a group.

Revaluation considerations

If the property is held in a moving profit-sharing ratio by a number of partners, a revaluation is required each time a partner joins or leaves or there is a change in profit-sharing ratios.

In most firms, this is going to be at least an annual event. Professional valuations must be obtained and complex capital gains tax (CGT) calculations made on each profit-sharing change for every partner, since disposals for CGT will have taken place.

In reality, the tax payable may not be significant, and modest incremental annual gains for each partner concerned might be below their annual CGT exemption. Beyond that, a CGT rate of 28 per cent now is not unattractive to partners facing 47 per cent tax and national insurance on their profits for 2013/14 onwards. However, it is a complex process and, of course, no cash has been generated to help meet any tax due on revaluation gains.

To avoid such complications, a firm could hold the property for the benefit of the partners for a period of, say, ten years. There would be no revaluations during that time and outgoing partners would not receive any uplift for appreciation when they leave.

After ten years, the property would be revalued and effectively refinanced by the ongoing partners. If the property has increased in value over the ten-year period (as one might expect if acquiring at a low point), additional capital or borrowings may be required for the refinancing. Anyone who was a partner at any time during the ten-year period would share the capital appreciation according to their profit-sharing percentages through that period.

This longer-term method avoids the need for external valuations each time there is a partnership change and will smooth the appreciation over the ten-year period, rather than reflect short-term changes in the property market.

However, retiring partners will crystallise a disposal at the date of leaving, even though their ‘profit’ may be received several years later and the amount of profit can only be estimated at their date of leaving.

Partners as landlords

Another – and less complex – alternative is for each partner to individually have an interest in the property, either personally or through an individual or group SIPP. The firm would pay rent on a commercial basis to the owners, just as it would to a third-party landlord.

Although this strategy will work well at the outset when the business partners and the property-owning partners remain the same, complexities can arise if, after a period of time, some of the property owners retire or join a rival firm.

If a property-owning partner is required to sell when he leaves, then a buyer must be found, and this may lead to complications if there are too many or too few prospective purchasers.

Many other issues will also require attention where the opinions of the business and property partners diverge. For example, regular rent reviews should be required to take place, but should be on an arms-length basis. Likewise, arguments can arise if there is a desire by either group to refurbish or extend the property.

Break clauses

Perhaps the biggest conflict a partnership or LLP will face with a group of partners (and perhaps former partners) owning its premises is the decision whether to exercise a break clause in the lease.

The business partners will wish to ensure the continuing suitability of the premises for the firm’s business requirements. However, the property partners may be reluctant to lose the firm as a tenant, even if the premises are relatively easy to re-let.

Inevitably, there will be costs – including inducements – on a change of tenant and the property may no longer be considered prime. Secondary or tertiary property can be difficult to let and locations can rise and fall in their desirability.

Different needs

The fact that different partners will be at differing stages of their lives and careers must also be a consideration. Each of the partners will have different financial needs, depending on their personal circumstances.

Pressures such as large mortgages and paying school fees will be felt by some; others will be focused on saving for retirement in a variety of structures and asset classes. Unfortunately, over a period of time, a number of the property-owning partners are likely to go through a divorce, reeking havoc on their finances and financial planning. So, it may well be impossible to have an investment strategy that is constantly suitable for everyone.

Inevitably, a tension will be introduced into the partnership between the property-owning partners (typically the senior, financially-established partners) and the non-property owning partners (typically the younger financially-stretched partners). Over time, you could end up with a clear division between the ‘haves’ and the ‘have nots’, which is rarely a healthy dynamic to have in intergenerational partner relationships.

In addition, potential problems will emerge when the property-owning partners want an exit, particularly if they have had a rewarding investment which other equity partners have not participated in.

If there is a desire to sell the freehold because the property-owning partners wish to realise their investments and draw pensions, they will wish to have the benefit of as strong a covenant as possible to make the freehold attractive to an institutional investor. This is likely to conflict with the business partners’ desire for a more flexible lease commitment.

 

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Capital allowances for law firms

By Jeanette Edmiston, technical manager at Portal Tax Claims

Capital allowances provide tax relief for capital expenditure on plant and machinery within a commercial property.

The intricate details of capital allowances are not widely understood by law firms. Being people-centric businesses, considerations about tax and plant and machinery claims often take a back seat. However, where a law firm owns its own offices, it can, potentially, benefit from substantial relief.

The confusion surrounding capital allowances may be due in part to the complexity of the rules and case law that define the notion of ‘plant’, a term much broader than a simple reference to the more obvious mechanical items used within a business.

Items on which businesses can claim tax relief include heating and lighting systems, normal and special power supplies, mirrors, fish tanks, statues, CCTV systems and artwork, air conditioning systems, lifts, carpets, door ironmongery and other ordinary fittings often found in modern office spaces.

The result of making the claim can be considerable tax relief to set against profits. In some cases, firms can reduce their tax burden to the extent that some ‘overpaid’ tax in prior years can be refunded – a clear cashflow advantage.

The legislation relating to fixtures contained in the Finance Bill 2012 has, since April of this year, introduced regulatory changes in respect of capital allowance claims for fixtures. These changes will have a significant impact on commercial property owners, as they present a real opportunity to achieve cost savings.

The practical implications of the new rules are fourfold.

1. Mandatory pooling of expenditure on fixtures will be a legal obligation in order to keep capital allowances alive. This will be phased in between April 2012 and April 2014, depending on whether the property has been in the same ownership prior to April 2012 or is sold within this timeframe.

2. The seller is required to pool any expenditure prior to the sale of the property. In cases where no prior claims have been made, it is advisable to make a capital allowances claim prior to the point of sale. This will ensure that a correct audit trail is in place and that an equitable agreement on the allocation of the claim is reached between the seller and the purchaser.

3. A time limit of two years for the buyer and seller to agree on the value and apportionment of the allowances within a property will come into effect from the date of the sales transaction. However, the agreement on the allocation is best reached prior to completion as part of the sales process.

4. An election by the seller and the buyer as to the apportionment of capital allowances will have to be made using the current Section 198 (owners) and Section 199 (leaseholders) election processes. As before, this process has a time limit of two years from completion of the transaction for submission to HMRC.

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Weighing options

When opportunity knocks at the office door, think carefully before opening it. Firms may be tempted to purchase their own freehold during a market downturn, but thoughtful consideration should be given to the potential joint ownership pitfalls and internal acrimony that may follow.

Even if the partners elect not to purchase the firm’s offices, there are plenty of other properties they can buy either jointly or individually – without mixing personal investment with professional business.

Louis Baker is the head of professional practices at UK accountancy firm Crowe Clark Whitehill (www.crowehorwath.net/uk)