The Government has clearly stated that its policy is to increase the availability of housing for first time buyers and that it is aiming to achieve this by making buy-to-lets far less appealing as an investment. It is doing this via the tax system.
First to mention: the stamp duty land tax additional rate. This was covered in our article last month and will add 3% onto the bill of anyone buying a property that does not replace a main residence.
Second is the phasing out of the availability of deducting mortgage interest as an allowable expense against rental income for individuals and trusts. From 2017/18 this will be phased out and the deduction as a tax reducer at basic rate will be phased in. By 2020/21 the only deduction for finance will be as a tax reducer at basic rate.
This will mean that an individual who has a mortgage financing their rental property and is a higher rate tax payer, or is only a basic rate tax payer because of the availability of a deduction, could find themselves in an extremely different situation in the coming years.
This will not apply to companies or loans for the purchase of furnished holiday lets.
Bob owns a portfolio of UK residential properties which generate gross rental income of £40,000 per annum. Non-finance cost expenses are £5,000 per annum and Bob borrowed money on an interest only basis at a fixed rate where the annual cost is £20,000. Assuming Bob is a higher rate taxpayer, the income tax payable on the property profits over the next five years will be:
|2016/17 (£)||2017/18 (£)||2018/19 (£)||2019/20 (£)||2020/21 (£)|
|Gross rental income||40,000||40,000||40,000||40,000||40,000|
|Finance costs allowed||-20000||-15,000||-10,000||-5,000||0|
|Tax at 40%||6,000||8,000||10,000||12,000||14,000|
|Les: Tax reducer at 20%|
|2017/18 20% x 25% x 20,000||-1,000|
|2018/19 20% x 50% x 20,000||-2,000|
|2019/20 20% x 75% x 20,000||-3,000|
|2020/21 20% x 100% x 20,000||-4,000|
|Net tax liability||6,000||7,000||8,000||9,000||10,000|
|Rental profit net of interest||15,000||15,000||15,000||15,000||15,000|
|Effective rate of tax||40%||47%||53%||60%||67%|
The figures are worse if an individual is a basic rate taxpayer as a result of the interest deduction.
Annie runs a residential property business and has no other income. Gross rental income is £60,000 with finance costs of £35,000. Net profit before tax is therefore £25,000. In 2016/17 taxable income after the personal allowance is £14,000. Therefore tax payable at a rate of 20% is £2,800. That is an effective rate of 11.2%.
However, in 2020/21 (using 2016/17 rates), there will be no relief for finance costs so net profits before tax will be £60,000. Taxable income after the personal allowance will be £49,000 and tax will be:
(32,000 x 20%) + (17,000 x 40%) = £13,200
Less the tax reducer (35,000 x 20% = 7,000) = £6,200 tax payable.
This gives a marginal rate on a net rental profit of £25,000, of 24.8%! Put another way, the tax payable has increased by 221%!
When the numbers get larger, an individual may even end up paying more in tax than they receive in rent less finance costs!
These sorts of marginal tax rates will mean that property investment financed by loans, will no longer be tax-efficient.
Some businesses will look to incorporate, however, with the dividend regime now having changed, a question over whether banks would transfer the loans and at the same rate, SDLT issues, potential Capital Gains Tax issues and running fees for companies, it may not be an attractive solution.
The easiest solution for many, may be to sell some properties, however, this also has Capital Gains Tax issues.
There is also an option of changing the ownership between spouses.
In all cases we can advise on the pros and cons of each available option and help you to reach a decision over which avenue would be the most tax efficient for your desired overall outcome.
The third change to the rules relates to the way the replacement of domestic goods are dealt with and the abolition of wear and tear allowance. Until 5 April 2016, fully furnished, residential, rental properties, but not furnished holiday lets, were able to claim a 10% wear and tear allowance (10% of rental income less expenses paid by the landlord that are usually paid by the tenant e.g. water rates) each year instead of capital allowances. Capital allowances were claimable on items used in communal areas of flats and if an item is used within a ‘business’ i.e. for the upkeep of the property e.g. a lawnmower, but these items are few and far between plus property rental is only classed as a business if you have more than one property that you rent out and you are running the rentals as a business and not as an investment whilst working another job. There was also a renewals allowance for small tools.
As of 6 April 2016, wear and tear allowance was replaced by a new relief for the replacement of domestic goods. This relief is available to landlords with furnished AND unfurnished residential properties. This means the landlord gets a deduction for the actual amounts spent but, in years where nothing is replaced, no deduction is obtained. The renewals allowance for small tools was also scrapped.
Full tax relief will be available against rental income for the cost of the replacement item, less any cost associated with an improvement to that item (but not if the item bought is a modern equivalent), less any proceeds received from selling the replacement item plus any costs for disposing of the old item.
The ‘Domestic items’ must be used solely in the residential property by the tenant and includes:
- Moveable furniture, TVs and household appliances,
- Furnishings including carpets, curtains, bed linen, towels
- Kitchenware such as cutlery and crockery
The relief is not available if rent a room relief is claimed and applies to companies, individuals and trusts.
A tax return needs to be completed if you are renting out a property where rental income is between £2,500 and £9,999 after allowable expenses or £10,000 or more before allowable expenses. If the rental income is below £2,500, HMRC still need to be contacted but a self-assessment return does not need to be completed.
At Gander Tax Services, we can prepare tax returns, advise on CGT implications, SDLT implications, reliefs available against taxes, planning with regard to changing your structure or sale.
Please contact us on firstname.lastname@example.org.