By Donald Parbrook, Head of Tax, Milne Craig, Chartered Accountants
Landlords may be forgiven for feeling like the new changes in tax rules were made up in La La Land. Certainly the changes are music to the ears at the Treasury. It seems both Scottish and English Governments have little or no interest in making the tax lives of landlords efficient. Buying property to rent is now seemingly socially unacceptable. Hikes in tax through Stamp Duty (LBTT in Scotland) and the removal of mortgage interest relief are pretty harsh.
The tax law is changing for private landlords who let residential properties from 6th April 2017. After that date only 75% of bank interest paid on buy to let mortgages will be treated as a deductible expense of the rental business. Over the following three years the deduction will be removed altogether. The deduction is replaced by a tax credit of 20% of the interest. For many landlords this change is quite profound and after four years the move to a tax credit relief will be harsh indeed for many highly geared landlords.
At an extreme, let’s take a landlord with a £43,000 salaried job (hovering below 40% tax) with a nice flat with rent of £10,000. If they borrowed to buy that rental flat they could currently be paying little or no tax. Let’s suppose their interest matched their rent and no profit was made and there were no other costs (to keep it simple). The individual will move from no tax at all (no profit) to having to add £10,000 to their income, pushing them into the 40% tax bracket. For simplicity, if all £10,000 was taxed at 40% the individual will have £4,000 of tax they didn’t have before with only £2,000 of tax to deduct. So a new £2,000 bill, even though they actually have no real profit on that property. Worse still, in my example, the individual could have a claw back of Child Benefit if they are in receipt as their income heads over £50,000. Don’t even start to think about what the true tax rate on actual economic profit will be for highly leveraged landlords who happen to be higher rate taxpayers (or become higher rate taxpayers). HMRC guidance can be found here.
So, what can be done?
Many landlords have been looking at whether they can start using a Limited Company structure. Companies continue to get a tax deduction for mortgage interest. The headache with this is that the transfer of existing rental properties to a company will usually attract Stamp Duty (LBTT), including the new 3% rate and crystallise capital gains tax. The amounts will very and may depend on whether the landlord has multiple properties, operates a formal partnership and whether there are capital gains. Refinancing will also be a serious issue for many. Often, the easier answer may be a gradual transition where properties are sold off, and new ones acquired inside a corporate structure. Corporation tax rates of 20% are falling to 17% over the next few years so the cash flow on a rental business may be considerably better than for a private landlord with other income on their tax return forced into higher rate taxes.
A company structure should be an obvious solution for many, particularly where several properties are involved and the additional compliance costs of a company can be justified. Companies also get indexation on property assets they hold so there is some inflation proofing for future capital gains. There are downsides to using a company and these include a more limited number of funding options, the cost of accounts and tax returns, the additional planning needed for cash extraction and the duplication of tax on exit (the sale of a property may create a corporation tax bill on sale but the cash still needs extracted).
Others are looking to obtain the continuation of interest relief by turning their rental business into a furnished holiday let business. If the HMRC criteria is met tax relief for interest continues. However, planning regulation, business rates, insurance etc. can limit the opportunity as will management of such a business.
Ultimately it sometimes feels like the increase in Stamp Duty /LBTT and the attack on interest relief are steps designed to force the market towards large corporate landlord companies and squeeze out some landlords who have one or two flats (e.g. their former main residence) let out with a mortgage underpinning the ownership.
One thing is for sure, living in La La Land will see landlords pay more tax. It’s time for specialist advice if you have a portfolio funded via bank debt.
Chartered Tax Adviser