Recent changes in property taxation
1. The political background to the recent changes in property taxation
For many years, the current government has promoted itself as the party that enables home ownership for all, but in recent years a combination of higher prices and much tighter lending criteria have made it more and more difficult for many people to get on the property ladder.
The government has therefore faced growing pressure to take corrective action in order to make the ‘right to buy’ a more realistic prospect for those who feel left behind.
Easing lending criteria was not really an option given the recent banking crisis, so the focus of attention has instead been on curbing house price inflation and using tax policy to try and discourage property investors.
Those new tax policies could be very bad news for the property investor who is uninformed and doesn’t take action to counter the effects, so we’ve outlined the main issues you need to consider below.
2. The reduced tax relief for finance charges incurred by unincorporated ‘property letting businesses’
Perhaps the biggest change facing residential landlords is that the new rules operate by requiring that the profits of ‘property letting businesses’ are computed without the benefit of a deduction for ‘relevant interest payments’ ( ITTOIA 2005, s 272A) – i.e, interest and finance charges.
They first take effect in April 2017, by blocking the deduction of 25% of the relevant finance charges, and that blocked deduction rises to 50% in 2018, 75% in 2019, then 100% from 6 April 2020.
Instead of a deduction against profits, the landlord will be allowed a ‘tax credit’, which is calculated by multiplying the disallowed finance charges by the basic rate of tax (currently 20%).
At first glance then, it appears that only higher rate tax payers are affected (thus appealing to the broader electorate who are basic rate tax payers and the same people who are struggling to buy). A deduction worth 40% of finance charge cost is lost, but a ‘tax credit’ worth 20% of that value is given in its place. That surely means net effect = 20% tax relief, so if you only pay tax at 20%, the new rules don’t affect you? And, if you are a higher rate tax payer, the restriction ‘only’ costs you 20% of the finance charges.
That is emphatically not the case; the carefully hidden reality is that the effects can be far more severe, and often affect the basic rate payer especially badly. The devil is in the detail, or more specifically in the mechanics of the tax calculation, and the following examples illustrate this point:
i). Impact on a higher rate tax payer:
Tom has earnings from employment of £60,000 p.a in the 2016/17 tax year.
He also has a property portfolio which generates a profit of £40,000 after deduction of £80,000 in finance charges.
His statutory total income (STI) is therefore £100,000, and his total tax liability is £29,200. If he didn’t have the rental income he would pay £13,200 in tax on the £60k income from employment, so in effect he pays £16,000 on his £40,000 rental profit and that equates to a 40% tax rate.
It might be expected that the effect of the new rules would be to increase Tom’s tax liability by £16,000 (£80,000 finance charges x the 20% apparent differential in tax rates). However, the new rules actually have the following effects:
– Tom’s STI has been increased from £100,000 to £180,000 so that means that he loses his tax free Personal Allowance (currently £11k p.a) , and it gives him an effective rate of 60% tax on £11,000 of his rental profits
– £30,000 of his rental profit will be taxed at 45% instead of 40%,
His total tax liability is now £51,100, or £21,900 higher than previously. In other words, tax attributable to the rental income is now £37,900 (£51,100 -13,200), or nearly 95% of his rental profits!!
To add insult to injury, the maximum amount he could put into a pension scheme and obtain tax relief (if he has any spare cash left after all the additional tax), is reduced from £40,000 to £25,000, thereby potentially costing him a further £6,000.
ii) Impact on a basic rate tax payer:
Ben has no income other than from his portfolio of ‘buy to lets’.
In 2015/16 he made a profit of £40,000 p.a after deducting finance charges of £80,000 a year. He paid tax on that profit of £5,880 (all at the basic rate) and his ‘net of tax income’ was therefore £34,120.
However, if the new rules had applied in full for 2015/16, Ben would have had a tax liability of £41,403 on a ‘notional income’ of £120,000 and obtained a tax reduction on the £80,000 in finance charges of just £16,000. He would therefore have paid £25,403 in tax, and his net income would have fallen from £34,120 to £14,597.
Ben is likely to struggle to make ends meet as a result. His ‘notional income’ is certainly not going to help.
Ben’s new tax bill is actually a staggering 63.5% (£25403/£40000) of his profits, yet he is a basic rate taxpayer with no other income to fall back on.
NB. ‘Relevant interest payments’ means finance charges on any amount that is borrowed for the purpose of generating income from dwelling houses, but does not apply to a business that deals in property or develops property.
It is not restricted to loans taken out specifically to acquire properties for letting (e.g, a loans taken out to acquire office accommodation from which a property business is run, or a vehicle, are also affected).
What can you do?
Property investors are currently cushioned from the full effect of the blocked deduction because a) it has only just been introduced, b) it is being phased in over 4 years, and c) interest rates are very low at the moment.
Nevertheless, interest rates are certain to rise sooner or later, and it won’t be long before the restrictions take full effect.
So unless you have no borrowing at all (in which case lucky you!), our advice is to make plans now…. especially those investors with a high loan to value ratio.
The first step is to quantify just how the new legislation is likely to affect your post tax income.
For some, the subsequent planning might be as simple as reducing borrowing, but not everyone has that option so what then?
The most commonly touted option is incorporation, but this option needs very careful consideration.
Advantages and dis-advantages of incorporation
The following are some of the advantages and disadvantages:
Advantages of incorporation
a. No restriction on your tax deduction for Finance Charges, so the owner(s) of a business with substantial borrowings could save significant sums of tax on income.
In fact, the UK’s rate of Corporation Tax is reducing. It was 20% last financial year, is 19% from 1.4.2017, and will be just 17% from FY beginning 1.4.2020.
So, the difference in tax payable on profits could be as much as 28% (45%-17%) in the future.
However, that level of saving can only be achieved to the extent that profits are not going to be withdrawn from the company. If you are likely to need to withdraw cash from the company (e.g, to live on), you will have to factor in additional personal tax payable on the distributions.
b. If the company sells a property it will benefit from ‘indexation allowance’, whereas individuals do not. If gains made are reasonably large this may be worth more than the CGT annual exemption (currently £11,100) which is received by individuals but not by companies.
c. A company ordinarily pays Capital Gains Tax (CGT) at the Corporation Tax rate (see a. above), which is lower than the 28% CGT rate applicable to individuals who pay tax at the higher rate, but broadly equivalent to the 18% CGT rate payable by basic rate tax payers.
Once again that saving can only be achieved to the extent that profits are not going to be withdrawn from the company. If you are likely to withdraw the proceeds from the company instead of reinvesting it, you will have to factor in additional personal tax payable on the distributions.
Disadvantages of incorporation
a. Capital Gains Tax (CGT) – If your properties have increased in value since you acquired them, transferring them into a company will ordinarily give rise to a capital gains tax liability, even though you don’t actually receive any cash in the process.
This outcome can be avoided if you are in ‘business’ for the purposes of ‘incorporation relief’, but until recently HMRC have routinely denied that a property rental business could ever be a ‘business’ in this context.
Since Ramsay v HMRC , they have had to revise that view in circumstances where the requisite level of ‘business activity’ can be demonstrated. However, relief is by no means a foregone conclusion and it is therefore essential to get expert advice before incorporating.
It is possible to apply for ‘informal clearance’ from HMRC, but costs will be incurred in doing so, and there is no guarantee of a favourable opinion. Ultimately, the matter may have to be decided by a Tribunal
b. Refinancing – You will need to establish if your lender is prepared to allow the proposed new company to take on the debt attached to your portfolio. If you have to refinance, rather than novate your loans, it may affect the availability of ‘incorporation relief’ so that a Capital Gains tax liability is crystallised.
There will also be various professional fees to consider, and your interest rates may increase.
c. Stamp Duty Land Tax (SDLT) – A transfer of properties by an individual to a company will give rise to an SDLT charge, but a transfer of properties from a partnership to a company may not.
If a genuine partnership exists it would be best practice to formalise it by way of a partnership agreement before transfer, but forming a partnership immediately prior to incorporation simply to eliminate the SDLT charge does not work and simple co-ownership does not qualify as a partnership in this context.
If SDLT is payable it may be possible to claim relief on transfers of multiple properties.
The SDLT liability on a property portfolio can be significant so once again you need expert advice.
d. A double charge to tax on sale of a property at a gain and subsequent withdrawal of profit – Corporation tax is payable on the gain, and income tax is payable in addition if the profits are extracted.
e. Estate planning – If your estate is liable for Inheritance Tax (IHT), broadly the same amount of IHT will be due whether your rental properties are owned personally or by a limited company you own.
However, incorporation could leave your beneficiaries with a very significantly lower inheritance if they decide to sell off part of the portfolio after they inherit.
Landlord A owns a ‘buy to let’ portfolio worth £1m. The portfolio is not held in a limited company. Landlord A’s Will leaves the portfolio to his son by means of a ‘tax bearing specific legacy’ and IHT is due at 40% on the full value of the portfolio.
The son pays the tax and takes possession of the whole portfolio, then immediately sells half the portfolio to realise £500k cash which he uses to buys a holiday home that he and his wife have set their heart on. There is no Capital Gain on the sale of the properties because his tax deductible cost is the value of the portfolio as at the date of death from proceeds, and there has been no increase in the value of the properties since that date (Proceeds £500k – costs £500k = No Capital Gain = No Capital Gain Tax).
The net benefit of the father’s £1m legacy is therefore £600,000. (500K in the remaining property portfolio + £500k invested in the holiday home – £400k IHT paid).
Landlord B also owns a ‘buy to let’ portfolio worth £1m, but his portfolio is held in a limited company. Landlord B’s Will also leaves the shares in the company to his son by means of a ‘tax bearing specific legacy’ and IHT is due at 40% on the full value of the shares (which equates to the value of the portfolio the company owns). The son pays the tax and takes possession of the company and its property portfolio. So far, Landlord A and Landlord B’s legacies appear to have achieved pretty much the same result. The IHT paid in both cases is £400k, and the son now controls the properties.
However, Landlord B’s son also needs to sell half the properties so that he can the extract some cash from the company and buy a holiday home that he and his wife have set their heart on.
The son’s first surprise is to discover that the company will have Capital Gain Tax to pay on the sale. This is because the company’s CGT ‘base cost’ is not the value of the portfolio as at the date of death. Instead, it is the original cost of the portfolio + an inflationary allowance since his father incorporated the business a couple of years ago (to try and minimise his Income Tax bills). The total cost available for offset against the proceeds of £500k (half the portfolio) works out at just £150k, so the company has made a Capital Gain of £350k, and has tax of £70,000 to pay (at current CT rates). The son then draws the remaining cash of £430,000 from the company and discovers that this lands him with an additional Income Tax bill of £163,830 (£430,firstname.lastname@example.org%). After tax he is left with £266,170 of the £500,000 proceeds, and finds he can’t afford the new holiday home.
The net benefit of the father’s legacy is therefore just £370,689 (£500k remaining property portfolio + £270689 cash from the company – £400k IHT paid), or £229,311 less than Landlord A achieved. And that outcome could be made even worse if the son decides to sell off some of the company’s portfolio!
f. Significant professional fees will be incurred in incorporating a rental property business (e.g, accountants, tax advisers, bankers, lawyers), and ongoing accountancy fees for a company once it is set up are also more expensive in most cases.
g. More changes to come? – If you are prepared to contemplate dealing with all of the above hurdles, it may (exceptionally) be worthwhile considering incorporation of your property business, but before you do so you might wish to consider the possibility of further new legislation which could undo any advantage you may gain. New legislation could make companies subject to the same finance charge restrictions as unincorporated businesses (there is no logic in allowing companies to remain unaffected by the new finance charge restrictions?).
The government has encouraged incorporation in the past only to then change legislation to remove the advantages – e.g, you may remember the special 10% CT rate and the CT Nil rate band, introduced between 2000 and 2005, which encouraged many small businesses to incorporate and incur extra costs in doing so, only to see the standard CT rate re-instated shortly afterwards.
It wouldn’t be the first time businesses have rushed to incorporate only to have to unwind things when the law subsequently changes, and that would be even messier and more expensive than incorporation!
In the vast majority of cases, we are able to offer a solution that is simpler, cheaper, and better than transferring your investment properties into a limited company.
3. The Stamp Duty Land Tax 3% surcharge
The second big change to taxation for property investors is the imposition of an additional 3% SDLT charge on individuals acquiring a second dwelling, as from 1.4.2016.
A dwelling is defined as a building or part of a building that is used or suitable for use as a single dwelling, or is in the process of being constructed or adapted for use as a dwelling.
It therefore applies to a second home, a furnished holiday let, and to a residential buy-to-let. It also catches ancillary land and outbuildings (such as garages) that are occupied or enjoyed with a dwelling.
The same principle applies to partnerships, companies and trusts.
Property in a partnership is treated as owned by the individual partners so has to be taken into account when considering if the partner has more than dwelling. However, property used by the partnership for the purpose of trading (such as a house used by a dental practice) does not count as a second dwelling and should not trigger the charge. (NB, a ‘buy to let’ partnership is not a trade for these purposes)
The higher rate applies to a company even if it is the first or only purchase of a dwelling regardless of the individual shareholder or shareholders personal situation(s) (except where it cost more than £500,000 and was acquired for owner occupation, in which case the 15% SDLT already chargeable is not increased).
However, an individual does not need to take into account his shareholding in a property owning company when considering if the surcharge applies to a purchase of dwelling in their own name.
If a trust is a ’Bare Trust’ or an ‘Interest in Possession Trust’ the higher rate charge applies to all other dwellings the beneficiary acquires an interest in.
A beneficiary of a ‘Discretionary Trust’ (who doesn’t have any specific interest in trust assets) does not need to take account of their trust interest if they purchase another property in their own name. However the trustees of a Discretionary Trust are liable to the 3% surcharge on all dwellings purchased as trust property, including the first and/or only such property (this treatment is similar to the company rules).
Married couples and civil partners who are living together are treated as ‘a single unit’ for the purposes of the higher rates. So if one half of a couple already owns a residential property in their own name, the purchase of a home in the sole name of the other partner will be subject to the surcharge.
However, if a couple separate in circumstances that are likely to be permanent, they are no longer treated as a unit and can each purchase a main residence without triggering the higher rate (assuming they have no other interests in residential property).
The surcharge also applies to a joint purchase by two or more individuals, where any one of them already owns or has an ‘interest’ in a residential property (and isn’t simply replacing their only or main residence).
The ‘interests’ taken into account can include trust interests, no matter how insignificant that trust interest may be.
A beneficiary has a right to 5% of the income from a trust which owns a holiday let generating £10,000 profit per annum. The beneficiary receives £500 income per annum from the trust. She acquires a holiday let with 2 other investors, paying £750,000, and her trust interest increases the SDLT payable by £22,500 (or at a cost of 45 years trust income!).
It may therefore be necessary to review and update family trusts and other interests in residential properties if the interest is likely to have a disproportionate effect on new acquisitions.
Exemptions from the charge
The 3% surcharge does not apply in the following circumstances:
– non-residential (e.g, office space, a B&B, a factory, or a hotel)
– mixed use properties such as a shop with a flat above;
– where the chargeable consideration is less than £40,000;
– when the dwelling is subject to a lease which has more than 21 years to run on the date of purchase;
– caravans, mobile homes and houseboats
– to a leasehold interest originally granted for a period 7 years or less (e.g, a leasehold originally granted for 100 years with only 5 years left to run is chargeable at the higher rate, but a leasehold originally granted for 7 years with 6 years 11 months to run is not subject to the higher rate)
It could therefore be worth considering property investments in these categories, provided you have the expertise and desire to do so, and the profitability is likely to be comparable, and the tax saving is significant enough to warrant a change in your business model.
Even though an individual may own several buy-to-let properties, the 3% surcharge is not due if he/she simply replaces their own main residence, provided the new residence is acquired after the previous main residence has been disposed of, and within 3 years of disposal.
– the charge will still apply if the old residence is retained – for example, if it is subsequently let out (because in that case it hasn’t been disposed of)
– if an individual owns a buy to let, but no main residence, then subsequently acquires a main residence he will incur the surcharge (so the first time buyer of a main residence is worse off than someone who replaces their main residence!)
Finally, if the purchaser buys a new main residence before disposing of the old main residence, but disposes of the old residence within 3 years of acquiring the new property he will have to pay the 3% surcharge in the first instance, but can reclaim it from HMRC when the disposal completes.
Inherited interests in property are generally taken into account when determining if a surcharge is due, but there is an exception where the inherited interest is 50% or less in the property, which allows the beneficiary to ignore the inherited interest for a period of up to 3 years after inheritance, or until a share exceeding 50% is acquired by the beneficiary within the 3 year period.
Multiple Dwellings Relief
If you buy more than one dwelling in one transaction, Multiple Dwellings Relief ‘(MDR) continues to be available.
MDR works by computing the mean average price of the dwellings, then calculating the SDLT due on that price and then multiplying that figure by the number of dwellings; however, if the mean average price would otherwise be charged at 0%, a minimum rate of 1% applies to the overall purchase price.
In addition, the surcharge always applies where 2-5 dwelling are purchased if 2 or more of those dwellings are worth more than £40k (valued on a just and reasonable basis) and are not subject to a lease with more than 21 years to run, so the minimum rate of SDLT where MDR is claimed will therefore be 4%.
By contrast, a purchase of 6 or more dwellings is charged at the non-residential rates (so there is no surcharge), unless MDR is claimed.
There are therefore various SDLT consequences and options when purchasing one or more dwellings in one transaction or a ‘linked’ transaction:
a) You can pay SDLT on the combined price at residential rates (+3%),
b) You can claim Multiple dwellings relief (MDR) which allows you to pay SDLT at the residential rates (+3%) that are applicable to the average price of one of the dwellings and then multiply the end result by the number of dwellings to arrive at total SDLT payable,
c) If 6 or more dwellings are purchased, the default position is that SDLT is charged at the non-residentialrates, unless MDR is claimed.
There is no hard and fast rule determining which option to take, because the circumstances and outcome will be different in every instance, but the difference in tax payable can be very significant.
A landlord buys 6 houses in one transaction at a cost of £2.4m to add to his existing portfolio. SDLT using each option works out as follows:
Clearly most people would prefer option c), but it is necessary to perform calculations to determine which option is best for any specific transaction.
Taking advice is essential!
4. Other tax changes affecting residential landlords
The removal of the 10% ‘Wear & Tear Allowance’ & the ‘statutory renewals basis’, and the introduction of ‘Replacement of domestic items relief’
From 6.4.2016 tax relief based on the old ‘Wear & Tear Allowance’ is withdrawn, as is any tax deduction on the ‘statutory renewals basis’.
The Wear & Tear deduction was broadly calculated as 10% of rental income, and was available regardless of actual expenditure. It was given to allow landlords a deduction for costs incurred when furnishing a property that would not otherwise have been tax deductible – e.g, moveable furniture or furnishings, white goods, carpets and curtains, linen, crockery and cutlery.
Alternatively, landlords could have used the ‘statutory renewals basis’ and would have claimed a deduction for actual expenditure on the replacement of tools used for the purposes of the property business.
It was not possible to claim both reliefs and HMRC’s view on what qualified as a statutory renewal was very restrictive, so this option was unlikely to be favoured if the landlords properties were furnished.
The new relief for ‘replacement of domestic items’ is very similar to the ‘non-statutory renewals’ basis (which applied in 2012/13 and previously), and allows a revenue deduction for the net costs of replacing:
– moveable furniture or furnishings, white goods, carpets and curtains, linen, crockery and cutlery etc. (similar to Wear & Tear Allowance),
– fixtures – e.g, integral parts of the building such as a new kitchen or bathroom, where the replacement can be regarded as a ‘repair’ and there is no ‘improvement’,
provided all the following conditions are met:
a) the taxpayer carries on a residential property business
b) the ‘domestic’ item is provided for use in the residential accommodation, and it replaces the old item, and is provided solely for use by the lessee (so no private use for the landlord)
c) the expenditure is capital expenditure, incurred wholly and exclusively for the purposes of the property business
d) the expenditure does not qualify for relief under the capital allowances rules
Owners of furnished holiday lets and rent a room properties do not qualify.
To maximise allowable deductions on any extensive renovation works you should consult so that you can plans things is such a way as to ensure that your expenditure meets the qualifying conditions and you retain supportive records to demonstrate your case.