Buy-to-Let Tax Changes and What You Can Do1st November 2015
Buy-to-let has been an effective way to provide additional income and save for retirement, helped by record low interest rates, the UK’s notorious housing shortage and favourable tax treatment. However, following the changes announced by George Osborne earlier this year, its best years might be coming to an end.
Interest Tax Relief Changes
The reform comes with many details and complexities, but the most important feature is the tax relief cut. Until now, buy-to-let investors have enjoyed full tax relief on mortgage interest paid. Going forward (the changes will be implemented gradually in 2017-2020), this will be limited to 20% (the basic tax rate) only.
As a result, higher rate taxpayers will pay 40% tax on their entire rental income and only be able to reduce their tax liability by 20% of interest paid (unlike 40% now). This will have vast consequences, especially for those with high loan-to-value ratios and paying higher interest rates. Some landlords may find themselves paying more than 100% tax on their profits.
Example: 120% Tax on Profits
With rental income of £25,000 and allowable interest of £20,000, a higher rate taxpayer would have paid £2,000 tax (40%) on his £5,000 profit until now (not assuming letting agency fees and other costs for simplicity).
Under the new regime, the entire £25,000 will be taxable income, with £10,000 tax (40%) payable. That will only be reduced by 20% of the interest, i.e. £4,000, making the final tax liability £6,000, or 120% of the profits. After tax, this landlord will be making a loss of £1,000.
What If Interest Rates Rise?
Being at record low levels, interest rates are widely expected to increase in the next few years. What will happen to the landlord from our example if his mortgage interest rises to £30,000? Making a loss of £5,000 before tax, he will still be liable to tax of £4,000 (40% of £25,000 less 20% of £30,000). After tax loss jumps to £9,000.
This is admittedly an extreme case, but it illustrates the dangers of the new system, where you may not only pay taxes greater than your profits, but even pay taxes on a loss.
Basic Rate Taxpayers
The damage is not limited to higher rate taxpayers. Basic rate taxpayers will find their taxable income going up, as their entire rental income will now be included (even though the actual tax will be reduced by 20%). As a result, some of them might end up in the higher tax bracket too.
The only buy-to-let investors unaffected by the reform are the wealthy ones, who don’t need a mortgage to buy the properties. The more you rely on mortgage financing and the more interest you pay, the more severe the implications.
What to Do about It?
A significant change like this has naturally triggered strong reactions. While some of the affected landlords have signed petitions and written letters to their MPs, property experts and financial advisors have come up with predictions and recommendations. Opinions vary both on the possible future impact on the property market and on the best ways to tackle the issues.
Some recommend buy-to-let investors to set up limited companies, which are unaffected by these changes. Unfortunately, this solution comes with other pitfalls, such as financing (access to mortgage lending), tax implications (e.g. capital gains tax issues) and increased complexity, costs and administrative duties of running a company.
Those with lower rate taxpayer spouses might consider shifting the property ownership to them, but this solution will only be possible for a small fraction of affected landlords. Besides, there may be costs and other difficulties.
To keep their cash flow positive, some buy-to-let investors will have to find ways to increase their rental income (for instance, by refurbishing the property or splitting it into a larger number of smaller units) or to reduce the interest payments (e.g. by remortgaging). Neither is easy or available to all affected landlords.
For some investors the best decision will be to actually leave the market and find alternative ways to invest and save for retirement. Depending on your particular circumstances, selling and reinvesting the proceeds in other assets may be more profitable in both the short and the long term.Share: