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Changes Afoot

In July 2015, the former Chancellor George Osborne announced a series of measures that he proposed would rebalance the housing scales in favour of first-time buyers and away from landlords, much to their chagrin.  The measures announced, which started being phased in from April of this year through to 2020, included the introduction of a 3% surcharge on stamp duty payable on the purchase of buy-to-let properties and second homes, the scrapping of landlords’ wear and tear allowance and the phased reduction of tax relief on buy-to-let mortgage interest.  Prior to this, landlords had the right to claim full tax relief on their mortgage costs (being taxed on their profit as existing mortgage payments could be deducted from rental income before that income is declared) and could deduct all of their finance costs from their property income.  The impact of these changes will push up costs for buy-to-let landlords significantly.  However, there are some ways in which these additional costs might be mitigated.

Buy-to-let lending

Let’s start by looking at the mechanics of buy-to-let mortgages.  As with any mortgage, a provider will lend the landlord money to buy a property over a set term, the loan being secured by the property.  Apart from the property not being the landlord’s place of residence, there are some other key differences:

  • Most buy-to-let mortgages are interest-only which keeps the cost of repayments down. However, at the end of the mortgage term, the landlord will need to re-mortgage, sell or have another way to pay off the mortgage
  • Rather than reviewing the landlord’s salary or wages, lenders will typically look at potential rental income to decide whether they can afford the loan. If it’s a landlord’s first buy-to-let mortgage they may look at income from their job as well
  • Typically landlord’s need a larger deposit than for a residential mortgage – typically at least 25%, due to buy-to-let mortgages being riskier for lenders. 1

Tax implications

As buy-to-let tax breaks start to end, the market is seeing a profound shift in how buy-to-let properties are purchased, and by whom. This shift is due to widespread changes in the way buy-to-let investments are treated by the taxman. The 3 per cent stamp duty surcharge incurred as of April this year and the prospect of losing tax relief on mortgage interest as of April 2018 has led many landlords to hike up rents and move their buy-to-lets into limited companies. 2

Prior to the changes, landlords were being taxed on their profit because existing mortgage payments could be deducted from rental income before that income is declared.  This meant that a higher rate taxpayer paying 40 per cent income tax could deduct their mortgage costs (remember buy-to-let loans tend to be interest-only) and pay only income tax on their rental income above that. But as of April 2018, this tax relief – currently available up to 45 per cent for top tier taxpayers – will be reduced over four years down to 20 per cent.

Alongside this, the tax relief is being replaced with a tax credit, which must be claimed back. This means that 100% of landlords’ rental income is taxable, but they are in line for a credit payment of 20% back.

Conservative industry estimates predict that the changes will put half a million landlords into a higher tax band, hitting their profits hard. 3

Mitigating the tax increases

So what can be done to mitigate the looming tax increase and implications?  Many landlords with London buy-to-let properties are selling them and buying two or three properties via specifically set up limited companies in other places in the country.  This is despite the risk of them being liable for large capital gains tax bills.  For top-rate taxpayers, this is a potentially costly route to take, however, it can offer some protection so is seen as a sensible option.

For buy-to-let landlords with smaller portfolios or those who will not be so badly affected by the new taxes, focusing on costs is a more sensible option.  Options available include getting a lower mortgage rate.  For example, a buy-to-let offset mortgage would help to cut costs if savings or rental income was put into the offset account, thereby reducing the monthly interest bill.  However, in order for this to work, the landlord would need to be able to meet the criteria for buy-to-let offset mortgages, which being income dependent is not guaranteed.

Reducing the mortgage amount or raising rents to cover increased taxation are also options to be considered, though the latter will almost certainly be unpopular with tenants. 4

Does moving into a limited company structure make a difference? The pros and cons

As limited companies are not affected by changes, moving buy-to-lets into limited companies works well in some scenarios as it allows landlords to claim back expenses including the mortgage cost and pay a lower rate of corporation tax, currently 20 per cent but falling to 17 per cent by 2020. That being said, it also incurs a hefty stamp duty charge – as with everything, there are pros and cons to consider. 5 Let’s have a look at these in more detail:

There are a number of potential tax pitfalls that could erase any short-term savings:

  • Capital Gains Tax. If you transfer a property to a company, then this will be treated as if you’ve sold the property to the company. If the property value has increased since its purchase then you are liable to pay up to 28% capital gains tax on the difference, subject to any tax reliefs and allowances
  • Stamp Duty Land Tax. If the property is transferred from you to the company, then the company could become liable to pay stamp duty land tax. So while you may reduce your income tax liability, you may end up paying the same amount or more in stamp duty land tax
  • Once transferred, the company, not you, owns the property. Should something happen to the company then all its assets including the property will be exposed
  • If your company needs a mortgage to buy the property from you, in most cases the interest rate is higher for commercial or company mortgages than it is for individuals. This would mean that you end up paying a lot more over the full term of the mortgage
  • If you sell the property then the company will pay Corporation Tax on the profits and the balance of the money from the sale will remain in the company. To gain access to the funds you’d need to take it out of the company either as salary or dividends or other means. You’d then pay additional tax on that income.

When the above is considered it may seem that transferring buy-to-let properties into a limited company is not the best move. 2 However, there are some situations where transferring mitigates or removes some of the above and provides tangible benefits:

  • If buying a new property then a limited company could be a good idea as this wouldn’t trigger the tax implications that transferring would
  • If the buy-to-let is run through a partnership, then transferring into a limited company could reduce some of the tax burdens outlined above
  • Landlords who want to leave their buy-to-let properties to their children could consider the pros and cons of a Family Investment Company as an alternative to a Trust.

As with everything, options need to be carefully considered.  For the majority of small-scale property investors, higher interest rates mean that they remain better off operating on a direct or individual basis. However, there is a point when it will be cheaper to run as a company.  According to Private Finance, that tipping point is four buy-to-let properties. A landlord renting out that number of properties at the UK average will then make £274 more than an individual counterpart. 5

Unfortunately, there is no silver bullet available to mitigate the tax increases that are being phased in. Caution, due diligence and sound advice to a particular situation currently seem to be the best route to take.

Sources

1 http://home.bt.com/lifestyle/money/mortgages-bills/buy-to-let-mortgages-what-are-they-how-do-they-work-and-what-do-they-cost-11364192557574

http://www.telegraph.co.uk/property/buy-to-let/buy-to-let-many-properties-do-need-set-company/

http://www.thisismoney.co.uk/money/buytolet/article-3844788/Buy-let-mortgage-tax-change-push-440-000-landlords-40-tax.html

http://www.telegraph.co.uk/investing/buy-to-let/new-buy-to-let-tax-works-andhow-beat/

5 https://www.finance-monthly.com/2017/06/is-a-limited-company-the-way-forward-for-your-business/

Always seek independent advice. This blog has not been approved as a financial promotion by Cogress Limited. We are not responsible for the content of external websites. Potential investors must rely on their own due diligence prior to investing.

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2017-07-31T18:37:38+00:00