Buy-to-let: make it pay

Posted on 18 March 2016

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This article, originally featured in Investors Chronicle on 18 March 2016, includes comment from Alistair Hargreaves on the cost of transferring a BTL portfolio to a limited company. 

With higher stamp duty on second homes starting in April, it's hardly surprising to see aspiring buy-to-let landlords and second-home buyers rushing to beat the deadline. The Bank of England reported 74,581 mortgage approvals in January, which represents the largest monthly growth for seven months and is up 21.9 per cent from a year earlier. On top of this, in the same month net lending picked up to £3.7bn; that's the second highest monthly reading since the financial crash.

Three-quarters of surveyors anticipate a rugby scrum for new instructions ahead of the April deadline.
The question is: what happens after the new tax regime comes into play? It would be tempting to conclude that buy-to-let lending will fall off a cliff, a trend that could raise difficulties for the aspiring renter, where demand will not be going away. In the three months to January 2016, there was an increase in interest from prospective tenants, with a third of surveyors reporting an increase in instructions in London.

And while that demand is there to underpin rental values, it may be premature to write off buy-to-let as an investment asset. Furthermore, there might be some mileage in playing a game of poker with prices, working on the premise that if buying collapses from 1 April, lower selling prices will more than make up for the rise in stamp duty. Also, in London at least, there is a big new supply element to consider as well, which could place a top on price inflation for the time being.

The small buy-to-let investor should rightly expect to make a reasonable return by putting capital to work. At the same time, it can be argued that by putting a property up for rent, the landlord is carrying out a social service in providing rental accommodation at a time when one in five households will live in private rented accommodation by 2018. But the government doesn't see it quite like that. In the light of new regulations, it appears that the government doesn't like the idea of landlords claiming tax relief on their costs. Removing this, the reasoning goes, will encourage landlords to sell up and that will place more properties on to the market.

However, it doesn't quite work like that because in many cases a couple both in full-time employment can afford to pay the rent on a property they have no chance of being able to buy. But it seems unlikely that the government will change its stance, not least because the new measures will generate revenue - or rather in some cases they won't, as can be seen by the way that the top end of the London residential sector has imploded, taking a big lump out of stamp duty revenue.

But, despite all the gloom and badly thought out legislation, there are some bright spots. A landlord with no intention of buying more properties and who has no mortgage is unaffected by the new rules. In fact, in a roundabout way he is likely to benefit because landlords will attempt to recoup some of the increase in costs by pushing rents higher. The effects of higher taxes will vary according to the size of any mortgage, but as a rule of thumb Capital Economics believes that in order to maintain after-tax returns, rents would have to rise by around 18 per cent. That's without the stamp duty increase on further purchases, which could add another £10,000 to landlords' transaction costs. Never slow to find new ways to plug the budget deficit, George Osborne cannot fail to have noticed that while home owners' mortgage debt has risen by £10bn over the past three years, the growth in buy-to-let mortgages over the same period has been four times as large.

So is it worth all the bother to become or remain a multi-home owner? The qualified answer is: yes. Scare stories abound, but if you are prepared to take a long-term view, perhaps as much as 15 years, the attractions start to show through. There is also support from the low interest rate environment. And this, perhaps, is one of the key influences in the buy-to-let market because if interest rates were to rise to historic norms, there would be less burdensome avenues for achieving a reasonable investment return. However, it could be argued that if interest rates were to rise to 6 per cent, it would imply strong economic growth and higher inflation, both of which would support the case for pushing rents higher. Assuming that interest rates stay at current levels, residential property is likely to remain one of the most profitable investment classes for this year at least.

This has certainly been true over the past few years. According to the latest buy-to-let index compiled jointly by Your Move and Reeds Rains, the average landlord saw total returns from rental income and capital appreciation of 12 per cent in the past 12 months. That equates to an average £22,000 before any costs. And there is room to boost this further because the gross yield on a typical rental property was steady at 4.9 per cent in January, down from 5 per cent a year earlier. Average rents in January were £790 per month, and that's already up by 3.6 per cent from a year earlier. On occasion, affordability issues could play a part in limiting the extent of any stronger increases, but with average earnings starting to grow this is unlikely to be the case right now.

One of the challenges, more of an inconvenience really, is that rental increases are now greater outside London. That's fine if you don't live in London because landlords will prefer to have their property portfolio in an area that they are comfortable with and relatively close to hand. Rent rises in the east Midlands and the east of England have now pushed London into third place. However, this throws up some geographical anomalies, for while rents actually fell in the less prosperous north-east, rents also fell in the prosperous south-east.

As an investment asset, the residential sector still seems to have the edge over other real estate asset classes. According to the British Property Federation (BPF), residential is expected to show the best financial return this year over six other asset classes, including office, industrial and retail. Residential also comes top of the pile when BPF members taking part in the survey were asked which asset class they were planning to increase their exposure to this year. What may raise a few eyebrows is the response to the question of where the greatest increase in investment would most likely be. The answer was London, which is probably less surprising when noting that uncertainty caused by a potential exit from the European Union came well down the list of factors considered likely to influence the market this year.

The jury remains out on what happens after April. A recent survey by the Royal Institution of Chartered Surveyors revealed that just half of the respondents believe that the new legislation will lead to an outflow of landlords; 31 per cent felt they would not, while 19 per cent were unsure. However, according to buy-to-let lender Shawbrook Bank, more than half its property clients are planning to make a purchase within the next 12 months, while around 40 per cent are looking to set up a limited company, and a third intend to increase rents.
As an investment class, buy-to-let in the UK is still far cheaper to get into than in other countries. And with a fast-expanding population's demand for rented property set to accelerate, that will put more upward pressure on rents. The only major change over the next four years is that more money will flow into the treasury.

Landlords will have to assess their commitments on a case-by-case basis. Anyone with a high loan-to-value mortgage ratio will find it the hardest because more of their rental income will become taxable as mortgage relief is tapered. For existing landlords with no mortgage, life carries on much as usual. Some will consider the burden of extra taxes as too much on top of all the other bits and pieces that a landlord has to attend to. Those with the highest level of gearing will feel the pressure the most. It seems unlikely that there will be a flood of previously rented properties finding their way on to the market, but landlords with cash will always be open to picking up a bargain. All the latest changes are likely to achieve is to deter would-be landlords with less than compelling financial strength to come into the market. Existing landlords are in the main likely to stay put.

Easy access, attractive tax breaks, physical assets, highly visible income streams, good yields and solid capital gains. It's not difficult to understand why buyto-let has soared in popularity over the past 20 years. But now those juicy tax breaks are being removed, the good times could be over for many buy-to-let investors as those with large mortgages could find they're making a loss.

But the profitability of buy-to-let depends on several factors - where and what you buy, how you fund the purchase and how you run your business - and it's up to you to turn as many of these as possible in your favour.

The first thing you should do is take what steps you can to minimise your finance costs ahead of the reduction in relief starting from April 2017. The options include:

  • Increasing the rent at the next tenancy renewal or change of tenant.
  • Putting your rental income into the name of a basic rate taxpaying or non-working spouse or civil partner. If they are not working they can earn up to the personal allowance tax-free (£11,000 in 2016-17 and rising thereafter). But note that how you fix it at the outset cannot be changed later. There will be a further tax advantage when you come to sell, though: two lots of capital gains tax relief will be available.
  • Remortgaging on a lower rate of interest - depending on the size of your mortgage, this could save you significant sums of money even after the arrangement fees, although possibly not if you are already locked into a fixed rate and face exit penalties.
  • Selling one property to reduce or even cancel debt on others.
  • Taking the hit for the next few years until the mortgage is paid off or shrinks
  • There is another option that many landlords are already using and others are considering and this is to run your business as a limited company rather than as a private individual. We look at the pros and cons of this in the boxes on pages 29 and 30.

How the tax relief rules will be applied

The new tax year starting on 6 April will be the last in which landlords can claim higher and top-rate tax relief on all their finance costs. Finance costs include mortgage interest and fees paid when taking out mortgages. Under the current relief rules, a 45 per cent taxpaying landlord can claim relief of £45 for every £100 of interest they pay.

From April 2017, some of this relief will be restricted to the basic rate of tax - 20 per cent. So the top-rate landlord above will get back £20 in relief rather than £45 on part of his/her costs. Note that the relief will be applied as a tax credit rather than the landlord deducting costs from his rental income. The change will happen in phases. In 2017-18 the permitted deduction from rental income will be restricted to 75 per cent of the landlord's finance costs. The remaining 25 per cent will be given relief at the basic rate of tax, even for 40 per cent and 45 per cent taxpayers. In the following year, 50 per cent of finance costs can be deducted and 50 per cent will be given lower-rate relief, and so on until in 2020-21 all financing costs incurred by a landlord will be given relief at the basic rate.

All other costs remain allowable as before, although these are typically tiny compared with the finance ones.

Nonetheless, you should claim for everything you are entitled to claim for. These non-finance costs can be deducted as before from the gross rental income.

From 6 April, allowable costs include the replacement of furniture and furnishings even if the property is not fully furnished. This is a new rule that replaces the wear and tear allowance of 10 per cent of rental revenue on furnished property only and it applies whether the landlord is a private individual or a company. "Landlords thinking about a kitchen or bathroom refurbishment might wish to delay the cost until the new tax year to be able to enjoy their 10 per cent deduction in full this year and the whole actual replacement costs next year. Contracts should be made after and not before 6 April," says Frank Nash, tax partner at Blick Rothenberg.

If you are a new landlord, you can claim for some of the costs of getting a property ready for letting. Costs that have been incurred up to seven years prior to the letting can be included as expenses - just don't get your capital expenditure and running expenses mixed up. That's because you may not claim for Frank Nash: What landlords can do to absorb the impact of tax changes Residential property is in short supply. Demand remains high. Until the supply of housing is corrected, these relationships of supply and demand will support the capital investment made by landlords. They can, however, make some changes to absorb the impacts.

Specific measures

George Osborne's plans attempt to create 'barriers to entry' by uplifting the purchase cost of a residential investment property by 3 per cent from 1 April in the form of a stamp duty land tax (SDLT) surcharge. Many landlords invest for a considerable period of time, often as a means of a long-term informal pension and will not be put off by the extra 3 per cent SDLT cost. It will be factored in as a cost of investment and may well be partly or wholly absorbed by the vendor adjusting the price, for example in a stalling market. There is little a landlord can do, except factor it into their decision to invest in new rental property.

What may change behaviour is the graduated restriction to income tax relief on interest paid, which will start to bite from April 2017. To work out the annual cost to the 'bottom line' from April 2020 landlords who are exposed to the higher rates of income tax should apply the following formula: B x N x r Where: B = the total amount of borrowing; N = a number represented by the interest rate; R = a value expressed as either 0.0025 for a top-rate taxpayer or 0.002 for a higher-rate taxpayer.

Using an example, Mia has a £58,000 annual salary and is clearly a higher-rate taxpayer, with some way to go before breaching the top rate of income tax, which kicks in at £150,000. Mia has three residential property lets, producing £60,000 a year of rental income and, other than nominal running costs, Mia pays interest to Abercorn Bank at the rate of 3.69 per cent on a mortgage of £775,000. Mia makes about £30,000 per year before tax. The extra annual income tax cost to Mia in 2020/21, all things equal, is: £775,000 x 3.69 x 0.002 = £5,720 What can Mia do? Firstly, these rises in interest rates are gradual. Mia could gradually pass on the cost to the tenants in the form of a slightly higher annual rent. This would be around £158 per property per month, in real terms if Mia is to fully recoup the extra tax cost.

Secondly, the interest tax relief restriction does not apply to companies. They are liable to corporation tax at 20 per cent, reducing to 17 per cent by April 2020. Mia could form a company and transfer her properties to it. The interest would be fully offset against the rent at the company's tax rate.

Forming a company Mia would be taxed at the additional personal tax rates when she took the profits out of the company, either in the form of a salary or a dividend on her shares. This would achieve no tax saving at all if the whole profits are taken out each year. However, assuming Mia does not need the income, a company is a tax-efficient way to acquire rental property. The tax savings create greater working capital in the company to repair existing property or accumulate funds to purchase new ones.

There are problems with getting there though. A transfer of real property to a company is a disposal for capital gains tax purposes. A form of rollover relief is available provided the whole of the property business is transferred to the company and shares are issued in return. An investor cannot avoid the tax by simply asking the company to issue repayable debt. Neither will passive residential investment activities qualify for the transfer - the business must have some scale and depth to it. Mia is unlikely to qualify, but if she had more properties and was involved for many hours a week the relief may be due.

The other problem is that the transfer of a property portfolio to a company creates an SDLT charge. This is not so bad given we are now on a graduated SDLT rate, and the average property value can be used to lower the tax if there are six or more residential properties. Where there is an existing partnership, 100 per cent relief from SDLT may be due, but forming a new partnership with the aim of securing SDLT relief on transfer to a company will probably not work as legislation has been introduced to prevent this. These tax costs need to be factored in to Mia's decision to operate through a company, as does any risk of changes to tax legislation, for example if the chancellor were to tax residential property companies at rates higher than the standard corporation tax rate.

The lender will also need to be on board, and this is likely to lead to a remortgage and higher interest costs. Frank Nash is tax partner at Blick Rothenberg 'capital' expenditure such as improvements or material alterations to the property as expenses. Relief will only be given for expenses incurred wholly and exclusively in order to produce the rental income. For example, building an extension to the kitchen isn't allowed as an expense. If it's an enduring asset, it's considered capital expenditure, and these costs should be deducted instead from your capital gains when you sell.

You might need to install a central heating system if there isn't one, but you cannot claim for this cost (although you can claim when you sell the property). But you could claim the cost of repairing a heating system that isn't working properly and for replacement of radiators. It's important that you are only replacing and not improving, though. Other allowable repairs/replacements made prior to letting include decorating and replacing carpets in a poor state, for example, or a boiler that failed a safety check.

You can't claim for buying furniture or furnishings in order to let a property - these initial costs are not allowed, only the replacements of such items when they need to be renewed.
If the property is acquired in a rundown condition then the cost of putting the asset into a useable condition is capital expenditure and not an allowable deduction.

For further details on what you can and cannot claim when getting your property ready, visit:

Once the property is let, ongoing repairs and renewals of fixtures such as a bath or shower, or getting rid of mice or fixing guttering are allowed. You can claim for the cost of replacing an old kitchen with a new one, but you will run into problems if the replacement kitchen is of a much higher specification than the old one.

You can also deduct unpaid rent - where there is no realistic hope of payment. If the rent is subsequently paid, it must be included in the tax return for that year. You can claim for cleaning and gardening, accounting and legal services and costs that you run up in the course of letting and managing the property, such as travel, advertisements, agents' fees and buildings insurance.

For more detail on allowable expenses, visit

Capital gains tax

Landlords who have never lived in their rental property have to pay capital gains tax (CGT) on any gains made when they sell up. The taxable gain will be the sale price less the cost of purchase plus the cost of improvements.

However, if the landlord has lived in the property at some stage - without any tenants - they will qualify for private residence relief (PRR) for the years they live there. And they can also claim the last 18 months of ownership as if they had lived in the property during that time.

If you have let part or all of your main home, you may be given Letting Relief. This is given where a property or part of a property has been let and will be the lowest of either £40,000, the amount of the capital gain arising or the amount of PRR given. The relief is only available to landlords who have used the property as their home.

If you can live in the property for a time, you should, as this will bump up the amount of relief given. A landlord who buys a house, never lives in it and sells at a profit after five years will create a gain that is 100 per cent unsheltered. If he lived in the property for one year before letting it, 50 per cent of the gain in this case would be sheltered (12 months plus 18 months out of 60 months).

Married couples and civil partners who jointly own the property can use additional allowances and relief to soak up even more of the tax bill. Each spouse can claim letting relief and their own annual exempt allowance.

Is there an alternative?

As an investment, property has a lot of plus factors right now, although some people may not like the idea of having to manage a property and deal with a tenant. They might not even like the idea of owning a second or subsequent property, so it's not surprising that alternative ways of investing in property have been devised. One typical scheme is run by Property Partner. Investors can put in as little as £50 and as much as £50,000. This is invested in one of the selected properties within the portfolio; you make the choice. There is a one-off 2 per cent charge, but no annual fee. Property Partners does take 10 per cent plus VAT of the rental income to cover the letting, maintenance and management. Realising your investment can be done at any time with no costs, but you're unlikely to come near to market value. Alternatively, Property Partners offers an option whereby once every five years investors can exit their investment at full market value. The rental income is paid as a monthly dividend, and after April investors will have a £5,000 annual dividend allowance on which no tax is payable. There is, however, a capital gains tax liability if you sell you investment for more than you paid. There is a tax-free allowance of £11,100 for the 2015-16 tax year, and gains after that are taxed at 18 per cent for basic-rate taxpayers and 28 per cent for higher-rate payers.

Private investors interested in commercial property opportunities could look at specialist syndicate schemes such as that run by Connection Capital. Its model enables investors to invest in £25,000 chunks and to choose the deals they back. Recent additions to Connection's portfolio include properties tenanted by Travis Perkins.

Should you switch to a limited company? Right now, there are significant advantages to holding your buy-to-let assets through the structure of a limited company. The first is that your profit will be taxed at a rate of 20 per cent and this rate will fall to just 17 per cent by 2020. As an individual, your rental income can be taxed at 45 per cent. A second big advantage is that your mortgage interest will continue to be fully deductible, so the amount you pay tax on will be reduced, too.

Alistair Hargreaves of mortgage broker John Charcol explains how this adds up: "If a client had a rental income of £7,200, and interest of £3,000, this leaves them profit of £4,200, and then tax paid at the relevant level - if 40 per cent this would be £1,680. Under the new rules you cannot deduct the interest so tax would be payable, at 40 per cent, on the whole rent. Therefore the liability would be £2,880 - you can deduct 20 per cent of the interest costs, so in this case the tax payable would be £2,280.

"Compare that to a limited company where the tax liability will be 17 per cent by 2020, as well as having the ability to deduct all of the interest costs from the pre tax profit and you can see that it's far more tax efficient."

And, he points out, in terms of income tax you can also hold retained profit in the company year on year, if you do not need it while you are working; you can draw down on this as dividends in the future when your income drops as you get older. You can also use the retained profit to buy further buy-to-lets within that limited company.

From an inheritance tax point of view, a limited company can also make it easier to pass on the business.

However, it's not all plain sailing.

There is the high risk that the chancellor will amend the tax treatment of buy-tolet in a limited company. You will have to consider how you take income out of the company: if you pay yourself a salary, this will be taxed in the normal way, but could mean you end up in a higher tax band. A more tax-efficient way to withdraw an income from the business could be via dividends - the first £5,000 of which will be tax-free, but draw out more than this and you will pay tax on payments over that threshold at 32.5 per cent if you're a 40 per cent taxpayer and 38.1 if you are in the 45 per cent tax band.

Once again it's important to use more than one set of tax allowances where possible.

Bigger obstacles include the fact that the costs of moving properties you already own into the company structure could be horrendous, which means it would only make sense for new buy-to-let purchases. When you transfer ownership to the company, a capital gains tax liability will be triggered, and then stamp duty will have to be paid.

Accountancy firm Price Bailey crunched some numbers for us to show the costs of transferring a portfolio of four properties worth in total £2.16m, which had been purchased for a total of £1.36m. Moving the properties into a limited company over a four-year period using two sets of capital gains tax allowances and assuming no change in either tax rates or the couple's income, the cost of such a move would be well in excess of £190,000.

"Each individual case must be taken on its merits and discussed with accounting and legal professionals and a mortgage expert," says Mr Hargreaves.

If you sell a property in your limited company, corporation tax will have to be paid on the profit and later if you close the company, that money when extracted could incur capital gains tax (CGT). You would also pay CGT as an individual but at a higher rate (28 per cent). The CGT rate on a sale of shares in a company owning residential property would be 20 per cent.

To read the original article please visit the Investor's Chronicle's website here.


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