Andy White, Senior Partner at CBW, explains what portfolio landlords need to know about the new buy-to-let tax rules and how to beat them.
This article was written for and published in the March 2018 issue of Property Investor News, a monthly magazine providing news analysis and professional research for the discerning private property investor/landlord.
If I had a pound for every article I’ve read, presaging the end of the buy-to-let market, I’d be rich enough, well, to acquire a buy-to-let investment.
This is unsurprising. The Government’s intention when it enacted recent changes to the legislation was to take the heat out of the housing market and make home ownership affordable. There can be little doubt that the public’s enthusiasm for buy-to-lets was a factor in increased house prices so it is self-evident that dampening down demand in that area should have the opposite effect.
So, since the changes were enacted, commentators have been offering varied opinions on how the changes will work, what clever tax steps can be taken to avoid the impact of the new rules and why there is no future in this market.
The legislation seeks to do three things. Firstly, there is now a 3% Stamp Duty Land Tax (SDLT) surcharge on what was already a very high levy. This is expensive, but not disastrous. 3% is not a great deal when one is considering the viability of what should be a 10 or 20-year investment and, in any event, much if not all that cost will be met by the vendor who has had to lower price expectations.
The second change was in relation to the well-known wear and tear allowance for furnished lettings. Although this has now been removed, replacement costs can still be claimed and, except in extreme circumstances, the change will not materially affect investors over the long-term.
The change that attracted the most attention was the restriction to tax relief on interest payments. From 6 April 2017 it is no longer possible to claim financing costs as a reduction in taxable property profits. Instead, the interest will attract relief at 20% only, albeit that the changes are being phased in over four years. The result is that taxpayers will pay tax on their income at one rate but receive tax relief on (some of) their expenditure at a lower rate.
In certain circumstances where the investor is highly-geared, not only will the tax liability increase but a situation could arise where the activity of property letting produces an actual loss but there is still a tax liability. And as interest rates rise, as they will, the situation is only going to get worse.
Since the change in the legislation was announced, I have been consulted by a stream of investors anxious to circumvent the new rules. All of them have the same idea of course: incorporate. Everyone knows that the rules do not apply to companies so transfer the properties into a company and all will be well.
What about the Capital Gains Tax (CGT) and the SDLT, I say? Well, I’m running a business so the CGT isn’t a problem and, as for the SDLT, I understand you can avoid that by using a partnership.
But you don’t have a partnership.
Can I go into partnership with my dog?
Although that wouldn’t be the first time a dog has featured in a tax case, I doubt this is a solution…
In most cases, the imposition of a dry CGT charge and a heavy SDLT liability make this an unattractive option.
So what can be done?
The problem is the gearing. The higher the gearing, the higher the interest as a proportion of the rents and the higher the restriction on the relief. And the obvious way to reduce the gearing is to sell part of the portfolio.
From a non-tax perspective, this may be a good move in any event. Interest rates are on an upward trajectory and unless rental yields rise proportionately, many portfolios may become unsustainable.
Consider the position of a gentleman who recently approached me for advice about his portfolio.
He had 10 properties yielding overall 3.75% p.a. (before interest) with a mortgage of 2.74% p.a. The value of the properties was around £4m and the outstanding borrowings totalled £3.2m.
The net rental yield after interest was over £62,000 yet while the tax under the old rules was around £28,000, by 2020-21 this would increase to nearly £50,000 (an effective charge of over 80%).
I advised him to sell most of the properties. Which ones depended on the relatives yields and the inherent capital gains. The CGT charge for taking my advice was £200,000. Was this madness?
By selling seven of the 10 properties and using the money to pay down the loan, Mike reduced the mortgage to just £300,000. The property values and the rental yields were decimated as was the net profit, which came down from £62,000 to £37,000, the percentage yield having increased slightly.
The prize was in the tax bill, reducing from £50,000 to £18,000 and boosting the after-tax return from around £12,000 to over £18,000. An increase of around 50%.
This is an extreme example of course but the principle remains sound. While it appears attractive to gear property portfolios for all the traditional reasons, the new rules require a new approach and a way of thinking that may appear anathema to most property people but could well pay dividends in the long run.
To discuss the content of this article further, please contact Andy White on the details below. You can also read more on CBW’s dedicated in-house Property team.