Over the last year or so there have been several major changes in the way landlords are taxed. Here, property taxation expert Nick Braun, founder the highly respected Taxcafe.co.uk, gives a comprehensive summary of the main changes affecting buy-to-let landlords, and gives some valuable tips on how to deal with them:

Stamp Duty Land Tax – Non-Residential Property

From 17 March 2016 new rates for non-residential property (typically commercial property) have been introduced. Instead of paying tax at a single rate, you now pay tax at a combination of rates.

The new rates are as follows:

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£0 to £150,000                   0%

£150,001 to £250,000             2%

£250,000 +                       5%

If you pay £300,000 for a non-residential property, you will now pay nothing on the first £150,000, 2% on the next £100,000 and 5% on the final £50,000 – £4,500 in total. Under the old system you would have paid 3% on the whole amount – £9,000.

Stamp Duty Land Tax – Additional Residential Properties

From 1 April 2016 higher rates of stamp duty land tax apply to purchases of “additional” residential properties (typically rental properties and second homes) in England, Wales and Northern Ireland.

Higher rates of land and buildings transaction tax also apply to purchases of additional residential property in Scotland. Note, the rules are different in some respects to those that operate in the rest of the UK.

The higher SDLT rates are 3% above the standard rates:

£0 to £125,000                   3%*

£125,000 to £250,000             5%

£250,000 to £925,000             8%

£925,000 to £1.5m                13%

Over £1.5m                       15%

*Only applies if total price is over £40,000. For purchases at £40,000 or less no stamp duty land tax is payable.

For example, if you buy a second home for £300,000, you will pay 3% on the first £125,000, 5% on the next £125,000 and 8% on the final £50,000 – £14,000 in total. That’s £9,000 more than someone who pays SDLT at the normal rates!

The higher rates are payable if at the end of the day of the transaction you have more than one residential property and you are not replacing your main residence.

The higher rates do not apply if you are simply replacing your main residence, even if you own other residential properties. So someone who owns a big portfolio of buy-to-let flats will not have to pay the higher rates when they replace their main residence.

When replacing your main residence, however, timing is everything. If you buy a new main residence before selling your old one you will have to pay the higher rates of stamp duty land tax. Thankfully, as long as you sell your old home within three years, the additional SDLT can be refunded.

Nevertheless this is a cruel rule for a couple of reasons. Firstly, from a cashflow perspective, someone who buys a new main residence for, say, £500,000 before selling their old one will have to stump up an extra £15,000 at a time when their finances could be under enormous strain.

The new rules may also prove cruel to landlords and second home owners who sell their main residence and rent before buying a new main residence.

If you own any other residential property and wait more than three years to replace your main residence, you will have to pay the higher rates of stamp duty land tax and the extra tax will not be refundable.

Married couples are treated as a single unit and therefore cannot avoid the higher rates by purchasing one property each. If either of them owns more than one residential property at the end of the day of the transaction they may pay the higher rates.

For example, if the family home is owned solely by the wife, the husband cannot avoid the higher stamp duty rates if he alone buys a holiday home.

Initially, the Government considered an exemption for companies and funds making “significant” investments in residential property. In the end it was decided that all investors will pay the same stamp duty land tax. The higher rates will apply to all companies purchasing residential property (including their first purchase of a residential property).

Capital Gains Tax Rates

The main rates of capital gains tax were reduced on 6 April 2016 as follows:

  • From 18% to 10%       Basic rate taxpayers
  • From 28% to 20%       Higher rate taxpayers

Where the individual is entitled to Entrepreneurs Relief, the gain is taxed at 10%. Entrepreneurs Relief is generally only available when you sell or wind up a trading business.

Sadly, the 18% and 28% rates still apply to gains arising on disposals of residential property.

The lower rates do, however, apply to sales of commercial property (except where a business owner disposes of his trading premises and Entrepreneurs Relief is available).

CGT Payments – Residential Property

In the 2015 Autumn Statement it was announced that, from April 2019, capital gains tax due on disposals of residential property will have to be paid within 30 days of the disposal.

Main Residence Exemption

Two key changes have been made in recent times:

  • The final period of ownership exemption for principal private residences has been reduced from three years to 18 months.
  • Non-resident individuals are subject to CGT on UK residential property gains arising after 5 April 2015.

Changes have also been made that will affect those who want to make main residence election for overseas homes and non-residents with UK homes.

Replacement Furniture Relief

From 6 April 2016 the 10% wear and tear allowance has been abolished and replaced with a new ‘replacement furniture relief’.

This allows all landlords to claim the actual cost of replacing furnishings (movable items) in fully or partly furnished residential properties, including furniture, electrical equipment, white goods, carpets and other flooring, curtains and kitchen utensils.

Interest & Finance Costs

In utter defiance of the basic principles under which businesses are taxed, the Government has decided to restrict tax relief for interest and finance costs paid by individual landlords who own residential properties.

The new rules will not apply to commercial property or furnished holiday lettings or to properties held inside companies.

Higher-rate tax relief for interest and finance costs will be phased out over a four-year period commencing in 2017/18, as follows:

  • 2017/18           75% deducted as normal, 25% at basic rate only
  • 2018/19           50% deducted as normal, 50% at basic rate only
  • 2019/20           25% deducted as normal, 75% at basic rate only
  • 2020/21           All relieved at basic rate only from this year on

Example

Oz has a salary just in excess of the higher-rate tax threshold each year. He also receives rental profits of £40,000 before deduction of interest costs which amount to £20,000 each year. Oz will pay tax as follows on his rental income:

 

2016/17

2017/18

2018/19

2019/20

2020/21

Profit before interest

40,000

40,000

40,000

40,000

40,000

Less: Interest

20,000

15,000

10,000

5,000

0

(100%)

(75%)

(50%)

(25%)

Nil

Taxable profit

20,000

25,000

30,000

35,000

40,000

Tax @ 40% (A)

8,000

10,000

12,000

14,000

16,000

Basic rate relief on

0

5,000

10,000

15,000

20,000

Equals: (B)

0

1,000

2,000

3,000

4,000

Tax payable (A-B)

£8,000

£9,000

£10,000

£11,000

£12,000

 

By the time we get to 2020/21 the tax Oz pays on his rental income will have increased by £4,000.

However, the extra tax payable in the intervening years is less because the interest deduction is only partially withdrawn.

The purported objective of this reform is to make the tax system “fairer”, reducing the tax benefits enjoyed by landlords with “higher incomes”. However, the change will affect many ordinary landlords.

Example – Old Interest Rules

It’s the 2020/21 tax year and Katerina is a full-time landlord who owns a portfolio of rental properties producing net rental income of £125,000 per year. This is after deducting all the expenses of the business except her mortgage interest.

Her portfolio is heavily geared and her interest payments are £75,000 per year. Thus her true rental profit is £50,000 per year. We’ll assume Katerina has no other income but does receive around £2,500 in child benefit and is the highest earner in her household.

Assuming there was no restriction to her mortgage tax relief, Katerina would have taxable income of £50,000 in 2020/21 (if she had any more income she would be a higher-rate taxpayer). The first £12,500 would be tax free thanks to her personal allowance and the final £37,500 would be taxed at just 20% producing a total income tax bill of £7,500. (The Government has promised to raise the personal allowance to at least £12,500 by 2020/21 and the higher-rate threshold to at least £50,000.)

Furthermore, because her taxable income would not exceed £50,000 she would not have to pay the child benefit tax charge and would keep all of her £2,500 child benefit.

Her total after-tax disposable income would therefore be £45,000.

Now let’s see how Katerina will fare under the proposed new restriction to mortgage interest relief.

Example – New Interest Rules

Because her mortgage interest will no longer be a tax deductible expense she will have a taxable rental profit of £125,000. With this much income she will lose all of her income tax personal allowance. Thus the first £37,500 will be taxed at 20% and the remaining £87,500 at 40% resulting in tax of £42,500.

Against this she will be able to claim a tax reduction of 20% of her mortgage interest (£15,000) leaving her with a total tax bill of £27,500.

She will also have to pay the full child benefit charge and will effectively lose £2,500 of income, so her final after-tax disposable income will fall from £45,000 to £22,500:

£125,000 net rent – £75,000 interest – £27,500 tax = £22,500

With her after-tax income falling by 50% it is unlikely that Katerina will be able to cover her household expenses and she will probably have to take drastic action to shore up her finances.

As you can see, the main victims of this change will not be high income earners, but landlords who have big buy-to-let portfolios with fairly modest amounts of equity, i.e. those who earn significant amounts of gross rental income but have fairly modest rental profits because most of it goes in mortgage interest payments.

They will end up being forced to pay tax at 40% (and possibly 45%) on profits they haven’t actually made and may face other tax penalties, e.g. the loss of their income tax personal allowances and child benefit.

It’s a populist but ill-conceived tax reform.

Strategies for Minimising Your Property Tax Bill

Taxcafe has published a brand new guide called Landlord Interest which explains how you can beat the tax increase by:

  • Postponing tax deductible expenses
  • Increasing tax deductible expenses (without suffering real economic loss)
  • Accelerating finance costs
  • Making pension contributions
  • Reducing buy-to-let mortgages
  • Selling properties
  • Investing in other types of property
  • Converting properties to a different use
  • Using alternative investment structures
  • Transferring properties to your spouse/partner
  • Using a company

Taxcafe publishes a wide range of property tax and business tax guides see www.taxcafe.co.uk

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