It can sadly be said with certainty that the buy-to-let is one of those sectors which has been hit hardest by the recent tax changes over the last few years such as:
- 10% wear and tear allowance now replaced with actual repairs
- Introduction of 3% stamp duty on second property
- Phasing out of higher rate tax relief on mortgage
According to the National Landlords Association (NLA), the loss in higher rate tax relief may result in pushing around 440,000 basic rate taxpayers into a higher tax band.
Phasing out of higher rate tax relief:
The higher rate higher rate tax relief is going to be phased out and reduced to 20% over the coming 4 years period of 2017-2021. Previously, the landlords could claim full tax relief on their mortgage interest payments, meaning, they could offset the cost of the mortgage interest from the rental income when they calculated their profits. Following is a (before and after) example of tax due with rental income of £20,000 and mortgage interest of £18000;
Before the change:
Income after deduction of mortgage interest: £20000-£18000 = £2000
Tax for basic rate taxpayers: £2000*20% = £400
Tax for higher rate taxpayers: £2000* 40% = £800
Tax for additional rate taxpayers: £2000* 45% = £900
Explanation:
So, if a landlord received rental income of £20,000 a year and paid mortgage interest of £18,000, the profit would have been £20000-£18000 = £2,000. Accordingly, a basic-rate taxpayer would pay 20% tax on £2,000, or £400. The higher rate taxpayer in a 40% tax bracket would pay £800, while the additional rate taxpayer would pay £900 at the 45% tax rate.
After the change:
Cap on mortgage interest relief = £18000*20% = £3600
Tax for basic rate taxpayers: £4000-£3600 = £400
Tax for higher rate taxpayers: £8000-£3600 =£ 4400
Tax for additional rate taxpayers: £9000-£3600 = £5400
Explanation:
With the cutting back of mortgage interest relief by 2021, the basic rate taxpayer in the above example would have to pay tax on the full amount, less a 20% credit on the mortgage interest. That would be £20000*20% = £4000 less £3600 or £400, so there will be no change in tax for them. But this may push the basic rate payer to a higher rate when his/her total income is added up. The higher rate taxpayer would end up paying £20000*40% = £8000 – £3600 which is £4400 as compared to £800. For the additional rate taxpayer, it will be £9000-3600= 5400 instead of £900.
From the above, we can see that tax liability of basic rate taxpayer remains unchanged but it could push them to the higher rate if they have enough other income, plus child benefit may have to be partly/wholly repaid.
So what are the options available? There are two broad options:
1. Limited Company Structure:
One way to minimize the impact of upcoming changes in the tax regime is to buy property as a resident limited company as that may be more tax efficient. This way corporation tax which is lower is payable rather than income tax on rental income. Limited company landlords can subtract mortgage interest costs from their rental income before calculating their corporation tax.
However this in not a solution for all the buy to let landlords. It depends upon the individual circumstances, and each case has to be analysed separately. There are many downsides that ought to be kept in mind. It is comparatively difficult to get mortgage lending for companies than it is for individuals. The mortgage costs, therefore, can be substantially higher.
If a property is transferred to a limited company, keep in mind the stamp duty and capital gains tax that may have to be paid.
First time buyers may find it as a viable solution but again all the factors need to be taken into account.
2. Transfer to spouse:
The second major option is to transfer the property to the spouse if they are in a lower tax bracket. However, make sure it does not push them to higher tax bracket.
Whatever you decide, it is a good idea to take a look at the whole picture and keep in mind the impact of the following on your decision:
- Capital Gains Tax
- Stamp Duty
- Mortgage cost
- Inheritance tax
- Income tax
- Other costs
Blog originally published here.