Buy to Let Taxation
Today’s post is about Buy to Let Taxation.
Buy to Let
Regular readers will know that I am not the world’s biggest fan of directly-held property as an asset class:
- It’s lumpy (hard to trade in small amounts)
- You need enormous sums to diversify properly
- It’s closely correlated with equity returns
- Returns are lower than on stocks (but flattered by leverage)
- Most of us own too much of it already (through our homes)
- Transaction costs are very expensive
- The tax treatment is unfavourable
- Prices are high, which means that expected future returns (and rental yields) are low.
Buy the place you live in (it’s tax-efficient, and the lower expenses help to protect against sequencing risk in retirement), but leave it at that.
But twenty years ago, I was all set to become a property baron.
- I had a partner, and we each had crazy profits from the dot com boom to reinvest.
But then he bought his mother a flat instead, and I got cold feet about going it alone.
- I think my regret at missing out on the easy money so long ago has blocked me from writing much about buy-to-let (BTL) on the blog to date.
But now a coaching client needs to work out whether he should keep a leveraged flat, so I’d better get into it.
BTL has worked well for a lot of people for a long time.
- So well, in fact, that the government decided to do something about it.
They added more stamp duty to second homes, but the big change was to the tax treatment of income.
- Under what has become known as Section 24, landlords will only be able to claim basic rate tax relief on their mortgages.
Previously, all the interest could be offset against the rental income, at your marginal tax rate.
- The change has been phased in over four years (perhaps to mitigate the impact of a mass exodus of small-scale landlords) and will be fully in place from 2020/21.
But there’s a sting in the tale:
- The way that the income and relief are processed has also changed.
Instead of directly offsetting the interest against the income, the gross rental income is now added in whole to your income.
- A 20% tax credit on the interest is added back at the end.
So a landlord’s tax allowances will be used up by the gross rental income – and this could push him into a higher tax band.
- There also used to be a percentage allowance for wear and tear, but now only actual spend can be reclaimed.
Let’s look at an example – a 3-bed flat in London worth £1M and rented out for £25K pa.
- Let’s assume a mortgage of £600K, with an annual interest charge of £18K.
So that’s a gross yield of 2.5% (on the full property price) and a net (but pre-tax) yield of 0.7%.
- But on the equity of £400K, the net yield would be 1.75%
Here’s the old tax calc (let’s assume a £40K salary for now, and ignore NICs):
Salary = £40K Rental Income = £25K Mortgage Expense = £18K Total income £47K Tax = 20% * (£47K - £12.5K) = £6,900
The marginal tax on the rental income is £1,400, and your after-tax profit is £5,600 (admittedly, only a 1.4% yield on the equity).
Here’s the new calc:
Salary = £40K Rental Income = £25K Total income £65K Basic Rate Tax = 20% * (£50K - £12.5K) = £7,500 Higher Rate Tax = 40% * £15K = £6,000 Mortgage Tax Credit = 20% * £18K = £3,600 Total tax due = £9,900
The tax on the rental income is now effectively £4,400 (63% of the net income).
- The after-tax profit is now £2,600 – a 0.65% yield on the equity.
That’s less than you’d get from a savings account.
- Voids, management fees and maintenance would reduce this yield further, but a lot of small landlords will do much of their own work.
What can be done?
Landlords have four options:
- Suck it up and take a lower return on their properties
- Attempt to pass the extra tax on to their tenants
- Of course, it’s not easy to increase the rent unless everyone else in the area does so
- Pay down their loans so there’s no interest to offset
- But this increases your equity in the property, reducing the after-tax yield through a different method.
- Incorporate (move their properties into a limited company).
- This will involve higher interest rates on your BTL loans and some paperwork (and possibly expenses, like an accountant) to get used to,
- You’ll also be liable for GCT – and your company for stamp duty – on the transfer transactions.
- And there may be fees if you need to pay off your mortgages and arrange new ones.
Alternatively, small landlords might accept that they have enough property exposure through their homes.
- And if not, there are dozens of listed vehicles (REITs) that can provide that exposure.
Please stay away from unlisted property “opportunities”.
- Most of these involve equity risk for debt levels of return and often come with a worthless “guarantee” from the developing company.
Now let’s look at my client’s situation – it’s not that far removed from the example we used above.
- One small wrinkle is that he’s a freelancer, earning £100K through a limited company.
He doesn’t want to stack up too much cash in the firm, so his annual income statement looks like this:
Income = £100K Expenses @ 5% = £5K Pension contributions = £40K Salary = £50K Profit = £5K Corporation tax @ 19% = £950 Retained profit = £4,150
Tom has a flat worth £500K and a mortgage against it of £377K.
The £22K is a gross yield of 4.4% on the £500K that the property is worth.
- Which is very high for London – the flat my mother in law rents around the corner from me has a gross yield of 3%.
This used to be Tom’s tax situation:
Salary = £50K Rental Income = £22K Mortgage Expense = £9K Total income £63K Basic rate tax = 20% * (£50K - £12.5K) = £7,500 Higher rate tax = 40% * £13K = £5,200 Total tax = £12,700
The marginal tax on the rental income is £5,200 and his after-tax profit is £7,800.
- That’s a 6.3% yield on his £123K of equity – very nice.
And now here’s his new situation:
Salary = £50K Rental Income = £22K Total income £72K Basic Rate Tax = 20% * (£50K - £12.5K) = £7,500 Higher Rate Tax = 40% * £22K = £8,400 Mortgage Tax Credit = 20% * £9K = £1,800 Total tax due = £14,100
The tax on the rental income is now effectively £6,600 (51% of the net income).
- The after-tax profit is now £6,400 – a 5.25% yield on the equity.
This is much higher than I was expecting, due to the high gross yield of 4.5% pa.
- Plugging in a more typical London yield of 3% (increasing the value of the flat to £733K and therefore the equity to £356K) would produce an after-tax yield of just 1.8% pa.
So the lesson here is that the gross yield is the key driver.
- But whatever the reason, it looks like Tom can keep his rental flat.
Until next time.
Photo credit: Images Money on Flickr, Creative Commons licence
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Article credit to: https://the7circles.uk/buy-to-let-taxation/