Spiralling costs and recent tax changes are forcing ‘Buy to Let’ landlords to review their property portfolios but there are tax planning tips to consider.
The country faces a number of economic issues with energy supply, labour shortages and inflation being just three recurrent headline topics. A further area of concern is housing, with both prospective buyers and renters finding themselves priced out of suitable opportunities.
Looking at the rental sector, there are already signs of a reduction in properties available to rent with buy to let landlords looking to sell and exit from the residential rental market.
Spiralling costs and recent tax changes are very much behind this trend.
Increasing costs
Costs are increasing on many fronts. Many of these will hit the tenant, for whom heavier energy bills and other living costs are taking a further chunk out of disposable income. Then, of course, is the spectre of a sizeable rent increase which may not be affordable. That brings us on to the landlord.
Possibly the biggest headache for landlords is recent interest rate rises. These are already giving rise to finance costs which may be a multiple of the amounts being paid just 12 months ago.
With the impossibility of subjecting tenants to rent increases anywhere near the level that may now be required, landlords are faced with finance costs that may not be covered by rental income.
That is, of course, quite a problem for landlords. It is a problem exacerbated by the tax situation.
Income tax
Focusing on the landlord that owns residential property personally, either on their own or with co-investors, we can see that the recently changed income tax treatment for finance costs is compounding an uncomfortable scenario.
Since 2021, no deduction has been allowed for finance costs against rental income. Instead, the landlord receives a credit against their income tax liability at a rate equivalent to the basic rate of tax. This is applied to the lower of the interest costs incurred or the level of rental profit (before interest).
As an example, take an individual letting out residential property whose earned income alone is sufficient to use his or her annual personal allowance and the basic rate band. That individual’s gross rental income is £25,000, out of which there are £10,000 finance costs and £3,000 of other expenses. Note that the tax position analysed below is likely to differ in Scotland.
In tax year 2016–17 – which was the last year that a full income tax deduction was available for finance costs in relation to let residential property – the individual would have paid 40% tax on the rental profit of £12,000 (ie, £25,000 less £13,000). The related tax would have been £4,800.
In 2022–23, when only a basic rate tax credit was allowed for finance costs, tax at 40% would have been charged on £22,000 (£25,000 less £3,000) and then a credit given for 20% basic rate tax for the £10,000 finance costs. The resulting tax would have increased to £6,800. The pre-tax return is still £12,000 but the landlord has to find a further £2,000 tax compared to 2016–17.
If, in 2023–24, the finance costs double to £20,000, the pre-tax rental return would drop to just £2,000 if there is no rent increase. However, the income tax liability only reduces to £4,800 because the extra £10,000 finance costs attract just a £2,000 tax credit at basic rate. The landlord is now actually losing £2,800 after tax.
The position would be even worse if finance costs increased further to, say, £25,000. The basic rate tax credit would be restricted to the actual rental profit (before finance costs) of £22,000.
So, the tax liability would only come down by another £400 (that is the £2,000 at 20%), leaving the landlord a further £4,600 out of pocket (by having to pay the extra £5,000 finance costs with only £400 tax relief).
Where effect cannot be fully given to the tax credit in a year, as with the £3,000 just mentioned, the ‘excess’ unrelieved tax credit can be carried forward. However, that can only be relieved if and when future rent increases generate sufficient taxable rental profit for both the brought forward credit to be offset as well as the credit due in that year.
In this example, the landlord’s income is in the 40% tax bracket. The impact is, therefore, even greater for landlords with rental income that take them into the 45% income tax bracket.
Capital gains tax
The residential landlord also suffers when a property is sold at a gain by being subject to a higher rate of capital gains tax (CGT) than applies to a non-residential property gain – or indeed a capital gain on any other asset.
Once the annual CGT exemption is exceeded, the lower CGT rate for residential property is 18% (compared to 10% on other assets). This rises to 28% (as compared to 20% on other assets) if the seller would be exposed to higher rate income tax if the taxable gain were added to taxable income.
The capital gains exemption is £12,300 in 2022–23 but following the Chancellor’s Autumn Statement in November 2022, this is due to fall to £6,000 in 2023–24 and then to £3,000 from 6 April 2024.
With non-property gains, these only need to be reported in the seller’s usual self-assessment tax return and any related tax paid by 31 January after the tax year-end.
This is not the case with a taxable real estate gain. In that case, the landlord must report the disposal to HMRC within 60 days of the sale completion date and any tax due must be paid at that time.
Stamp duty land tax (SDLT)
Apart from direct taxation, the landlord or prospective landlord buying residential property will also be faced with a stamp duty land tax (SDLT) surcharge unless in the exceptional circumstance that the individual owns no other property.
Purchases of second properties by individuals in England and Northern Ireland are subject to a 3% surcharge over and above the normal SDLT liability. There are also surcharges payable in Scotland and Wales under their separate land tax regimes, albeit at slightly different rates.
If the landlord is not a UK tax resident, there is also a further 2% surcharge.
Personal v company ownership
Some landlords may now opt for owning investment properties through companies rather than personally.
Operating via a company means rental profits will be subject to corporation tax rather than income tax. For profits of £50,000 or less, that rate will be just 19% compared to 40% or even 45% at the margin for higher earning individuals.
For annual profit over £50,000, the corporation tax rate from April 2023 will be 25% which is still better than the higher income tax rates although few private landlords will be enjoying that level of rental profits.
There is a further advantage of the company route for residential landlords, since finance costs would normally be an allowable expense against rental income for corporation tax purposes.
The disadvantage of using companies is that there is either an income tax or CGT charge when cash or assets are taken out of the company. There is, often, also extra admin involved.
Transferring properties, which are already owned personally, into a company can result in a CGT charge as well as SDLT (or the Scottish or Welsh equivalents).
In conclusion
These are testing times for buy to let landlords. It remains to be seen how all this impacts on the availability of rented accommodation going forward.
If you want to find out more about this or have any questions you want to chat about further, please feel free to get in touch on 07799 435 922 or email info@capoaccounts.co.uk