Welcome to the April 2018 newsletter from Chamberlains

 

So we’re into a new tax year! I’ll forgive you if you’re not as excited as I am. .. OK, am I really excited?! Probably not, on the normal Richter scale of excitement, but, as we start to do some tax returns and we talk to new clients, there are always surprises for them and for us. Things to keep us on our toes… I thought I’d mention a couple of things about the new tax year, but I want to concentrate on buy-to-let landlords and the changes that are happening.

 

As I said last month, there are various things that need to be done within the relevant tax year, notably payments into ISAs and pension schemes. So let’s just say that now you’re in good time to start thinking about the current tax year. Investment advisors encourage you to pay into your ISAs early in the new tax year to benefit from as long as possible for the investments to grow – and yes, there’s a fresh £20,000 allowance for the 2018/19 ISA. We’re also into a new year for capital gains tax allowances, so you have a tax-free profit of £11,700 to play with.

 

PROPERTY RENTING – WHO’D BE A LANDLORD?!

 

Over the last few years the government has been attacking landlords, particularly the buy-to-let sector, but it’s still an attractive idea for many people. Our local MP, Jeremy Hunt (the long-serving Health Secretary), has recently been in the news because of his investment in seven flats in Southampton. Interestingly, he did this through a company with his wife. The media commented that he might not have notified the right people at the right time about this investment (politicians are supposed to disclose this sort of thing) and that he might have got a good deal for the package from someone he knew through politics – but they may be being over-harsh. The point is that people who are perhaps “in the know” are still investing in residential property.

 

As is well known, there are two sides to property investment: income and capital. For many people, the expected long-term increase in capital value is the main interest, but in the meantime they hope to get some useful income. From what I’ve seen (and I have quite a number of clients with rental properties) the income side is often disappointing, although it’s still normally a better rate of return than leaving money on a deposit account. From a longer term perspective, the project is seen to be worthwhile, so long as the income covers the expenses, including interest. However, recent changes make things a little harder for the landlord.

 

Before I talk about taxes, it’s perhaps worth mentioning other responsibilities of landlords. There’s quite a bit in the press about creating a “hostile environment” for foreigners to discourage immigration and to encourage people to “go home”. As part of this, landlords now have to check the residence status of potential tenants. Details can be found here: https://www.gov.uk/check-tenant-right-to-rent-documents . It’s an onerous duty for the landlord, and he can’t just assume that someone with an obviously English accent is eligible. If they don’t check proper ID and the tenant turns out not to have the right to be in the UK, the poor landlord can be fined or even sent to prison.

 

INCOME MINUS EXPENSES EQUALS TAXABLE PROFIT (more or less)

 

Back to basics for a moment: If you buy a residential property (let’s call it a house or a home, rather than the technical term) and rent it out, you can claim various expenses against the rent – management fees, repairs, accountancy, etc. – and this reduces the amount of tax you pay. If you took out a mortgage to help with the purchase, you can also claim some of the interest. There are three basic types of mortgage, but only the interest element of payments is allowable.

 

  1.  An interest-only mortgage is simplest – the payments are allowable against the income.
  2.  A repayment mortgage is a bit more complicated – only the interest element of the payments is allowable. It can be a bit awkward to work this out, but the mortgage provider will normally provide some sort of statement for us to use. Trap for the unwary (it catches quite a few) – the loan repayment element of the payments is definitely not tax-allowable – in other words, you can’t offset the whole payment against the rental income.
  3. The third main type is an off-set mortgage, where the loan account is linked to another bank account where you have some money, and interest is just charged on the net loan. Given that you can get virtually no interest from a positive bank account, this can be a good system – you save paying interest on part of the loan, so this is equivalent to getting interest at a higher rate. Note: you can still only claim the interest that you’re paying,

 

So that’s the starting point – only the interest element of your mortgage payments is tax-allowable. But what if you extend your mortgage against the property in a couple of years time when it’s gained some value? You might want funds for something else, perhaps to buy another property, or you might need to get a new mortgage at the end of a fixed term interest rate period. Would the extra interest still be tax-allowable? Well yes, so long as the total loan is not more than the original cost of the property. If it’s more than the original cost, only a proportion of the loan interest can be claimed.

 

However, the system for allowing interest against rental income is changing – the 2017/18 tax returns are the first to be affected, and future years will be worse. Until recently, the full interest helped to reduce the taxable rental income, but not from 6 April 2017. The new idea is that your rent account will start by showing rental income minus rental expenses excluding interest. The tax computation will work out how much tax is due, including any other income and taxes paid, and there’ll then be a “tax-reducer” for the interest, at the basic (20%) rate of tax. So in principle you don’t lose unless you’re a higher (40%) rate tax payer. But, the way that the calculation works, you may be pushed into higher rates. Higher income = time to celebrate? Not in this case…

Let’s look at an example:

 

 

      AAAAA                                                                                              2016/17                2017/18                 2020/21
AAAAA                                                                                                                £                              £                                 £
Rental income                                                                                          40,000                  40,000                    40,000
Loan interest                                                                                          (20,000)                (15,000) (75%)                      (0%)
Other expenses                                                                                       (5,000)                   (5,000)                    (5,000)
Taxable rental profits                                                                          15,000                    20,000                   35,000

Tax at 40%                                                                                                    6,000                       8,000                    14,000
Less: 20% of £5,000 loan interest                                                                                     (1,000)
Less: 20% of £20,000 loan interest                                                                                                                      (4,000)
Tax liability                                                                                                  6,000                      7,000                       10,000

Rental profit net of interest                                                            15,000                  15,000                       15,000
(stays constant)
Profits net of tax                                                                                        9,000                    8,000                          5,000

Effective rate of tax                                                                                     40%                      47%                            67%

 

We’ll assume that our landlord is already a higher rate taxpayer, due to his other income. He gets £40,000 rental income, but he has to pay £20,000 loan interest and £5,000 other expenses each year. His net rental income before tax is £15,000. Until the 2016/17 tax year, the full £20,000 loan interest was allowable against income for working out the tax, so the net income was taxed at 40% – tax of £6,000. His net income after tax was £9,000.

 

However, from 2017/18, a new system is being phased in. Only three-quarters, £15,000, of the loan interest (marked as 75% in the table above) is deducted to reach taxable rental profits – so these now increase to £20,000. Tax on this is £8,000 at 40%. There’s a deduction (a “tax reducer”) for the remaining £5,000 of loan interest – but only at 20%. So this reduces the tax by £1,000 to £7,000 – but this is at an effective tax rate of 47% (ie. £7,000 tax on income of £15,000) and his net income has gone down to £8,000.

 

The situation gets worse over the next few years until the new system is fully functional in 2020/21. Then the loan interest is only deducted by the “tax reducer” – so that the £20,000 is given an allowance of only 20%. On this basis, the poor landlord pays tax of £10,000 on net income of £15,000 – an effective tax rate of 67% – and his net income after tax is just £5,000, down from £9,000 in 2016/17.

 

It’s possible to think of even worse scenarios, and people with large property portfolios and big borrowings can even make a net loss. They will probably need to consider selling some properties, or perhaps to transfer them into a company.

 

But that’s probably enough for the moment. I’ll talk about investments through companies and other property-related matters next month.