BTL Tax Changes Are Here!
Tax. A small word, large implications. We all want to pay less of it, or avoid it. But, as my accountant likes to point out: Paying tax is good news, it means you are making a profit and doing something right.
However, the recent budget changes announced by George Osbourne changed the parameters of what constitutes taxable profit.
Up until last year, your taxable profit on residential buy-to-let was calculated as:
Taxable Profit = Gross Rent Received – Allowable Expenses – Mortgage Interest – Wear & Tear Allowance
The wear and tear allowance applied to properties that are let fully furnished. For such properties, you could offset 10% of your rents received for that property to allow for depreciation (wear and tear) against your supplied furnishings. In properties with high rents, such as in London and the South East, this was a considerable allowance. This allowance has already been removed for 2016-17 tax year onwards.
Allowable expenses included items such as letting agency fees. Crucially, mortgage interest, usually an investors largest expense, was subtracted in full to arrive at the Taxable Profit.
Once you subtracted these from your gross rents, you paid tax on what was left, at your marginal rate (i.e. on top of any other earnings, such as a salary from your job).
Let’s take a simple example: You have a job, paying £55,000 per year. You have two BTL’s, grossing £15,000 in rent. Allowable expenses total £2,000 and you let both furnished, so you enjoy £1,500 (10% of gross rent) as a wear and tear allowance. Finally, your mortgage interest is £9,000 per year for both properties.
Currently, your taxable profit is worked out as:
Taxable Profit = £15,000 – £2,000 – £9,000 – £1,500 = £2,500
So you would pay tax at your marginal rate on £2,500. Given you are a higher rate payer (salary = £55,000), then you would pay £2,500 x 40% = £1,000 in tax on your buy to let business.
However, the budget of 2015 changed this significantly. It was announced that it was considered unfair that higher rate taxpayers were given mortgage interest rate relief at 40%, to the detriment of owner occupiers who didn’t get the same benefit. Therefore, starting from the 2017-18 tax year, the amount of interest rate relief would be reduced in stages, capped to a maximum of 20% by 2020, as follows:
- 2017-18: Tax relief limited to 75% of mortgage interest costs
- 2018-19: Tax relief limited to 50% of mortgage interest costs
- 2019-20: Tax relief limited to 25% of mortgage interest costs
- 2020-21 onwards: Tax relief limited to 20% (basic tax rate) of mortgage interest costs
Cue much gnashing of teeth by landlords, most of whom probably voted Conservative in the last General Election. There is plenty of discourse on various forums about these changes and the motivation, so I won’t go into them here. Suffice to say I think this is more of a governance issue than a revenue raising attempt, as regulating and taxing large players in the form of corporate entities is much easier than thousands of individual landlords.
As property investors, the key questions to understand the answers to are:
- How it affects your portfolio
- How does it affect your decision making going forward
In this blog post I will address the first question, with a follow-up blog post looking at the second question and help you understand if you should be adding another purchase to your portfolio and under what terms.
Redefining Taxable Profit
What makes this tax change particularly painful, is the way it is being calculated. Now, taxable profit will be calculated as:
Taxable Profit = Gross Rent Received – Allowable Expenses
There is a double whammy here. Mortgage interest is not discounted up front. In addition, another change announced in the budget was the removal of the wear and tear allowance.
Once the tax has been calculated at the marginal rate, only then can you offset a proportion of the mortgage interest, which by 2020 will be capped at 20%.
To take our example from above (salary of £55,000, two BTL properties grossing £15,000 in rent and £2,000 allowable expenses), then then taxable profit is:
Taxable Profit = £15,000 – £2,000 = £13,000
Quite a big difference from the taxable profit of £2,500 under the old rules!
You will now pay tax at your marginal rate on £13,000. With a salary of £55,000, this would be at 40%, i.e. £13,000 x 40% = £5,200.
By 2020, you will only be able to subtract 20% of your mortgage interest costs against this tax bill. With mortgage interest of £9,000, you would be able to claim £9,000 x 20% = £1,800 to offset your tax bill of £5,200. There is no longer any wear and tear allowance. This would result in a tax bill of £5,200 – £1,800 = £3,400. This is considerably more than the tax bill of £1,000 payable under the current rules.
Paying More In Tax Than You Actually Made In Net Profit!
One consequence of this is that, for highly geared and/or low profit landlords, it is entirely possible to have a tax bill greater than the actual net profit you are banking. Clearly, this can make such portfolios unsustainable unless you have other sources of income from which you can pay the increased tax.
If you are a lower rate taxpayer, whose combined property income and other income is below the higher rate tax threshold (which will be £45,000 for 2016-17 tax year), then there is no change to your tax position.
However, if you are a lower rate taxpayer in your day job, but by adding your property income you are taken into the higher rate band, then you will now pay 40% tax on some of your property income as you can no longer deduct mortgage interest before calculating your taxable profit.
BTL Tax Calculator
In order to help you assess the impact to your own portfolio, I have put together a BTL Tax Calculator below.
To use it, all you need to know are the following input parameters:
- Total Gross Rental Income across your portfolio, minus allowable expenses.
- Total Mortgage Interest across your portfolio.
- Total Other Income, e.g. your salary from your day job. If you are full-time landord, leave this as zero.
The BTL Tax Calculator will then work out your current tax position and the impact by the time the changes are fully phased in by 2020. It assumes that the tax bands will change as previously announced by the treasury, with the target for the 40% tax barrier expected to rise to £50,000.
As always, you need to think rationally and consider your own tax position before making any large scale decisions – it might not have as bad an impact as the wailing on the property forums would have you believe. If the tax bands rise as forecast, then it is perfectly possible to be paying LESS tax than currently, despite the changes to interest relief.
Disclaimer: Tax is a complicated business ... please seek professional advice before acting on any information given in the BTL Tax Calculator above!
What Can I Do?
If you find yourself facing a tax bill greater than your actual net profit by 2020, then you have some time to rectify the position. The options are:
- Sell a property and use the proceeds to reduce your LTV on other properties in your portfolio. You can model this in the BTL Tax Calculator by reducing the Gross Rental Income and Mortgage Interest amounts for the property (or properties) you are considering selling.
- Use other income or savings to reduce your LTV on properties in your portfolio. Again, you can model this in the BTL Tax Calculator by reducing the Total Mortgage Interest amount by the amount of interest you will save by paying down your mortgage(s). Note that most BTL lenders will allow you to overpay by at least 10% per year with no penalty, but check your terms and conditions to be sure. The amount of mortgage interest saved by overpaying can be worked out using the following formula:
Tax Interest Saved = Overpayment Amount x Mortgage Interest Rate
- Increase the rental income. Rents, particularly in London and the South East, continue to rise. If you have long standing tenants who are still on the same rent when they took up residence, then it is possible they are now paying a rent less than the going market rent and there may be scope for an increase. However, you need to consider an increase against the backdrop of affordability for the tenants and the probability of them leaving your property as a result. You can model this using the BTL Tax Calculator by increasing the Total Gross Rental Income figure by the annual amount any rent increases would result in.
- Change the rental model. Do you have any family homes that might make good Houses in Multiple Occupation (HMO’s)? Such properties might yield a larger net cash flow than a single let, although this has to be balanced by the changes required to meet HMO regulations and possible licensing requirements, your local council’s regulations on amenity space, the extra management overhead required, the local demand for room lets, any mortgage restrictions (you may need an appropriate HMO mortgage) and the fact that is usual for the landlord to pay the costs of utilities and council tax. You can model this using the BTL Tax Calculator by adding the additional net rent to the Total Gross Rental Income figure.
- Incorporation of your portfolio. Properties held within a Limited Company structure are still able to fully offset mortgage interest costs and pay corporation tax on the net profit. However, moving properties from your personal name into a limited company entity is classed as a sale and purchase. This means you may be subject to Capital Gains Tax on the sale of the property and the limited company will have to pay stamp duty on the purchase. In addition, limited company mortgages tend to have interest rates higher than BTL mortgages held in a personal name.. There is also the ‘known unknown’, of whether the current or future Chancellor of the Exchequer will turn his sights on such arrangements. I would suggest seeking specialist tax advice if considering going down this route.
Are These Changes a Good Thing?
On first glance, that seems like a stupid question.
With the additional tax burden, the removal of the wear and tear allowance and the recent introduction (as of 1st April 2016) of an additional 3% stamp duty surcharge on any second property purchase above £40,000 (so this would cover holiday homes for personal use, holiday lets and BTL purchases), it is clear that any property investor is facing strong headwinds moving forward.
But is it all doom and gloom? Remember, these are taxation changes. What does this mean for a property investor?
Consider the impact of these changes on the supply side of property rentals:
- Likely reduced investment in BTL as such changes act as a deterrent and require more liquid cash to purchase (lower LTV to cover tax changes, increased capital required to afford the 3% stamp duty surcharge).
- Some landlords will exit the market. Accidental landlords, or those highly leveraged with smaller cash flow will likely have to sell up if they face a tax bill greater than their net profit.
The net result: Less competition for new purchases and less competition for existing landlords as rental stock is reduced. Generally in any business, a reduction in competition is considered a good thing!
Now consider that the demand side for property rentals hasn’t changed. These are taxation changes imposed on landlords. There is the same tenant demand as before these changes, only going forward the supply of rental properties is likely to be reduced and the current rental stock also reduced. This increases pressure on rents and so we are likely to see increases in rents being achieved by landlords and more tenant choice for landlords.
For those landlords able to position themselves to absorb the changes, the future looks positive.
Let me know if you find the BTL Tax Calculator useful. If you have any suggestions for enhancements, let me know in the comments below.
Don’t let your friends and fellow landlords get caught out by these tax changes – share this calculator with them using the sharing icons below or directing them to this blogpost.