By Kevin McDaid, Jun 28 2016 01:17PM
Two major changes to the taxation of residential property will put a squeeze on both the purchase of property and rental profits landlords receive.
On 01/04/16 the Stamp Duty Land TAX (SDLT) 3% hike came in to play in England & Wales (or Land & Buildings Transactions Tax [LBTT] in Scotland) for the purchase of additional residential property valued at £40,000 or higher.
Comparing the impact of the new rules with the old ones, a purchase of a £250,000 2nd residence from April 2016 would incur SDLT of £12,500 compared to £5,000 if purchased in March 2016; an increase of 150%.
So purchasing additional properties has become more expensive. No surprise then that, according to the Council of Mortgage lenders, the purchase of BTL mortgages was up by 226% in March 2016 compared to the same month in 2015, as landlords rushed to beat the hike.
The second major change to the taxation of residential property landlords does not commence until April 2017. (However, when you read on, you will see that all landlords should be considering their options now.) This is the restriction to 20% in income tax relief for loan interest, being phased in as follows:
Case studies 4 & 5 at http://www.propertytaxadvisers.co.uk/case-studies/4591698202 provide in depth commentary on the effects of the restriction but in very simple terms an individual who is a 40% taxpayer and had interest of £5,000 on a mortgage would receive £2,000 of tax relief pre April 2017. By the time we get to April 2020 the same £5,000 mortgage interest will only receive £1,000 tax relief. This would result in an additional £400 in tax becoming due.
You can imagine for a landlord with a larger property portfolio, say with £100,000 in interest payments instead of £5,000, this restriction could be devastating.
The case studies clearly show that it is not just landlords who are currently paying tax at 40% who will be impacted upon by these changes. The way the restriction is to be applied from April 2017 will mean that some landlords who are currently 20% taxpayers will become 40% taxpayers even though their income may not increase. The change could also impact on the repayment of student loans and entitlement to child benefit and tax credits.
All in all, not great for residential landlords. Consequently, BTL investors should seriously be considering their future choices now.
If they decide to sell up and there is an increase in the price that they receive for the BTL over the price paid for it, any such gain will be subject to Capital Gains Tax (CGT). For the current 2016/17 tax year there is an annual CGT exemption of £11,100 but if the gain exceeds this amount it will be taxable at either 18% (on any part of the gain falling within the individual’s 20% income tax bracket) or at 28%.
If you have a spouse/civil partner who has not used up their annual CGT exemption consider taking advantage of this by transferring part of the property into their name but be aware of the SDLT implications outlined in the blog dated 25/04/16.
I have highlighted annual CGT exemption because one of the options open to residential landlords is to reduce the size of the property portfolio over a period of years to take advantage of multiple annual exemptions.
Imagine a scenario with Simon, a landlord who earns £38,000 P/A from his full time employment. He has a row of 5 terraced rental properties each earning him £5,000 less £3,000 interest and £1,000 in other expenses. This leaves him with net rental profits of £1,000 P/A per property under the current interest regime. He falls just inside the 20% tax bracket for 2016/17 and so pays £1,000 tax on his total net rental profits.
He anticipates getting promoted at work inside the next 2 years (this will immediately increase his salary to £44,000). This, coupled with the loan interest changes, leaves Simon pretty certain that he will be a 40% taxpayer on the full amount of his rental profits by the time the interest rate changes are fully implemented by 2020. This would mean that pre interest rental income per property would be £4,000 taxable at 40% = £1,600 less interest of £3,000 x 20% = £600, i.e. he would pay £1,000 in tax per property on the £1,000 profits he makes! Unsurprisingly, Simon decides he must concentrate on his career and sell up his rental properties.
Each of them is standing at a £10,000 gain in 2016/17(£50,000 in total). If he was to sell all the properties in one go his gain (after the annual exemption of £11,100 and allowing for legal costs of £5,900 in total) would be £34,000. The majority of this would be taxable at the higher rate of 28% (say £30,000) with the balance of £4,000 being taxable at 18%. The total tax liability would be £9,120 leaving Simon with just under £35,000 from the sales (taking the legal costs into account).
If Simon was to spread the sale of the properties over 4 years, all but a fraction of the gains would be covered by his annual CGT exemptions leaving a negligible amount of tax payable. Even just spreading the sale over 2 years to gain the benefit of a 2nd annual exemption and an extra £4,000 taxable at the lower 18% tax rate would reduce the overall tax liability down to £5,300, a saving of £3,800.
NB in the March 2016 Budget, the Chancellor announced a reduction in the CGT rates mentioned above to apply from April 2016. The top rate is now 20% (from 28%) and the standard rate is 10% (from 18%). Good news! Unfortunately, these rates do not apply to gains on sales of residential property where the old rates will continue to apply. Landlords, can surely now see that the Chancellor sees you as his golden goose as far as tax revenue is concerned.
It should be noted that, subject to HMRC/Treasury denying this to be the case, it appears that sales of shares in a property investment company will also qualify for these lower CGT rates so if you can sell the shares rather than the underlying property you can save CGT at the rate of 8%.
This moves us nicely on to, potentially, using a company for your property investments if you decide not to sell up. The main reason you would be likely to do this is because the loan interest restriction does not apply to companies. Also, bear in mind that from April 2020 companies are only due to pay tax at the rate of 17% and, thus, via incorporation, it seems that all landlords tax worries just melt away. If only!
Let us go back to Simon, our promotion seeking basic rate taxpaying landlord with the 5 properties currently generating £5,000 net rental profits. If he decided to incorporate in 2016/17 he would be faced with a CGT bill of £9,120 for selling the properties to his newly formed company. CGT arising in 2016/17 becomes due for payment by 31 January 2018.
We then have to consider SDLT. Let us assume that each property is valued at £150,000. Transferring these properties to a limited company would create an SDLT liability of £37,500. SDLT becomes due and payable within 30 days of the transaction.
Even assuming the legal fees would be considerably down on the £5,900 he would incur if selling them outright, let us assume he would owe at least £2,000 - Simon would have to fork out £39,500 immediately with a further £9,120 CGT payable by 31/01/2018. In total, he would be £48,620 worse off if he transfers his properties to a limited company to take advantage of the loan interest restrictions not applying to companies.
Yes, there are certain reliefs that could exempt Simon from both CGT and SDLT and if he could obtain these reliefs, incorporation could well be beneficial. For CGT relief, Simon’s rental income would need to be accepted as being a business rather than the default position of being an investment. With Simon being in full time employment, it would seem unlikely that he would be putting sufficient time and effort into looking after the 5 properties to be regarded as operating a business. For SDLT, relief applies on incorporation of a partnership. Clearly, this is not the case.
Consequently, Simon needs to make savings in the long term of almost £49,000 in order to make the short term pain of incorporation worthwhile.
Let us fast forward to 2020 when the loan interest restrictions are in full effect. Via the company Simon’s rental profits are £5,000 at 17% = £850, net income of £4,150 compared to nothing if he continues as an individual landlord. Under the new dividend rules applying from April 2016, Simon could pay these post tax profits to himself tax free. This would mean that it would take him 12 years to recoup the costs he incurred via incorporation.
N.B. it is assumed that the rental income and expenditure remain the same under the company as it would operating as an individual although, in reality, it is likely that mortgage interest rates within a company would be slightly higher and, certainly, administration costs would be higher.
If Simon decides not to incorporate due to the high initial costs, he knows that he will have no rental profits after tax but he may be prepared to live with this because the property values are steadily increasing.
In 15 years he intends to retire and sell a property each tax year to take advantage of his annual CGT exemption. Each property will sell for £200,000. The mortgages are paid up so he will have net proceeds of £1m before tax and legal costs. Each property cost £140,000 and so is standing at a gain of £60,000. After the annual exemption is deducted he would be liable to pay CGT on gains of say £45,000 per property, at 18% on the first £20,000 and 28% on £25,000. The CGT payable would be £10,600 leaving him with £49,400 profit per property (pre legal costs). Over a 5 year period he would receive £947,000 net.
If he went down the company route his taxable gains would only be £50,000 per property because, of course, he had gains of £10,000 on each when incorporating in 2016/17. There is no annual exemption in the company but the tax is only payable at the rate of 17%. The CGT would be £8,500 per property (£42,500 total), a saving of £2,100 per property if selling as in individual.
Of course, it is the company that has sold the property not Simon. Consequently, he has to extract the post gains profit out of the company to enjoy it. Extracting profits means more tax!
If he decides to liquidate the company this will create a personal capital gains tax liability for Simon as follows:
£207,500 is available to distribute. Annual CGT exemption = £15,000 leaving £192,500, taxable (£20,000 x 20% = £3,600 and £172,500 x 28% = £48,300). Total personal tax due = £51,900. Net proceeds £905,600.
This compares to £947,000 via Simon selling as an individual (admittedly, over a 5 year period to take advantage of his annual CGT exemptions and 20% tax band). However, a saving of over £41,000 clearly makes this an option that cannot be disregarded.
Conclusion – the change in the rules for loan interest deductions makes operating via a company an attractive proposition for any landlord likely to be liable to 40% tax on rental profits. However, unless you are currently operating as a partnership you will be hit with an immediate SDLT charge. Unless you are deemed to be operating a business you will, potentially, also have a CGT liability to pay.
The income tax savings you may make via operating as a company have to be compared to the upfront tax charges of becoming a company in the first instance. Of course, there will be additional costs of the incorporation such as legal and accountancy fees and, in the longer term, the administrative costs of operating as a company will be certainly be higher than operating as an individual/partnership.
Even if the company route is chosen you have project forward to the date when you, ultimately, anticipate disposing of the properties. Getting the money out of the company could create a CGT liability far in excess of any income tax savings made.
Knowing the full facts enables you to make the right decisions.
See http://www.propertytaxadvisers.co.uk/pricing/4592100439 -‘A huge tax bombshell’ as to how we can steer you through the murky waters.