Musings: Budget-busting…beating the tax hikes to BTL investors

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The Property Voice Podcast - Musings: Budget-busting…beating the tax hikes to BTL investors

As a property investor with buy-to-let property, there was probably only one thing on your mind over the past week or so…tax hikes from the Budget! In the Emergency Budget, one or two bombshells were dropped onto us property investors. What were they, what are the implications, what can we do about them and is it as simple as we may think to fix? These questions are addressed this week, so higher rate taxpayer or not, this is for you!

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Resources mentioned

• Property Investor Toolkit – here is the book link on amazon.co.uk & amazon.com in case you would like to get yourself a copy to accompany this serie
• Shout Out – Kylie’s Blog

Today’s must do’s

1. In a word - seek professional advice to get an idea of how the Budget tax hikes could affect you...and then decide what steps you need to take as a result
2. Subscribe to & review the show in iTunes…and while you are at it please help us to spread the word by telling all your friends too!
3. Send in your property stories, questions or moans to podcast@thepropertyvoice.net and we will try and feature YOU on the show too!
4. If you would like to, grab yourself a copy of the book: Property Investor Toolkit (link in Resources above)

Get talking!

• Join in the discussion, either here in the comments section below, or anywhere else on the Blog
• Start a conversation on Twitter with us @PropertyVoiceUK or on our Facebook page

Transcription of the show

Hello and welcome to another edition of The Property Voice Podcast, my name is Richard Brown and as always it is a pleasure to have you join me again today.

Now then, what has been on your mind during the past week or so I wonder? Could it be the implications onto your property investments as a result of the recent tax hikes Budget? Yep, me too! So, that’s why today’s episode is aimed at addressing some, not all, just some of the key changes that will affect many of us as property investors as a result. A special word of thanks to one of our listeners called jay, who kindly suggested the topic for this week’s show – thanks for that Jay 🙂

OK, let’s just get on with today’s musings with Property Chatter – how the budget will affect us and what we can about it.

Property Chatter

OK, so I really do expect many of you to be aware of some of these changes, but I thought I would share my own take on some of the main changes from the budget that affect us as property investors. There are some more that I won’t be discussing too, such as inheritance tax, the living wage and employer tax changes for example. However, here is what we will be discussing in today’s show…

Main changes affecting property investors

• Mortgage interest & finance charges tax relief capped
• Withdrawal of wear & tear allowance for furnished properties
• Increase in Rent-a-Room Scheme allowance
• Changes to how dividend income will be taxed

Taking them in turn, let’s just recap what the changes will be.

Mortgage interest & finance charges tax relief to be capped

Starting from the 2017/18 tax year, the amount of tax relief we can claim against rental profits in respect of finance-related charges, including mortgage interest but also broker fees and mortgage arrangement fees for example, will be capped at the basic rate of tax regardless of what tax bracket we are in.

It will be phased in gradually over 4-year period with the full impact being felt in the 2020/21 tax year.

What does it mean in practice?

Higher rate and highest rate taxpayers, so 40% and 45% taxpayers will have this tax relief at least halved from what it is today.

I would like to refer you to a property investor that I know by the name of Kylie, who writes a really great blog called www.diytopropertyinvestor.co.uk as she has undertaken a financial assessment of the changes on her actual portfolio. Kylie illustrates that as a 40% taxpayer, her retained after tax profit from two of her rental properties would fall from around £1230 to around £730 on one property and from £1260 to around £534 on another one. That’s a £500 or 41% reduction in her after-tax profit on one property and £726 or 58% reduction on the other.

So clearly, for higher rate taxpayers it will result in lower retained profits as Kylie illustrates.

However, it doesn’t end there…

If, or rather, when interest rates increase, the reduction in profit will be felt even more severely with a double-whammy effect if you like. Firstly, the increased interest payments will obviously reduce our rental profits, however due to the restriction in the tax relief, we may find ourselves in a position where aside from a reduced profit, that we also have insufficient cashflow to pay for the resulting tax charge as well. So lower profit and further out of pocket from a cashflow point of view. Ouch!

I will discuss some of the wider implications or ‘what if scenarios’ in a minute, suffice to say that this change will hit some investors quite hard. However, for now let’s move onto the next big change.

Withdrawal of wear & tear allowance

Currently, landlord investors that let furnished property can opt to claim this allowance, which equates to 10% of the annual rental income by way of a tax deduction. The aim was to help to provide some relief for depreciation, repair and replacement of the furniture and so encourage good standards of furnishing in rental properties. The change announced would mean that this allowance will be replaced by a claim of the actual expenditure on furniture instead.

For example, I have an HMO, which is furnished, where the annual rent is around £34,000 per annum. Under the current rules, I can claim £3,400 against my rental profits as a tax deduction, regardless of how much I spend on furniture each year. This meant that some years I win and others I lose when I am replacing items periodically as you might expect.

In all honesty, the arbitrary 10% per year rule was open to abuse, for example, if an investor does not spend much money on furnishings and so the change actually seems to be a fair one…even if it may prove unpopular among some that saw a greater return than outlay on furnishings.

Next…

Increase in the rent-a-room scheme allowance

You may be wondering how a tax-break aimed at homeowners is relevant to property investors…allow me to explain.

Firstly, what is it?

The rent-a-room scheme is an allowance provided by HMRC that allows a homeowner to let out one or two rooms to lodgers tax free. The allowance was £4,250 per year, meaning a homeowner could earn this amount from a lodger or taking in guests from say Airbnb and similar before paying any tax at all. Anything above that would then be subject to tax based on their tax rate.

In the Budget, this allowance was increased to £7,500 for homeowners. This is a massive boost to a household income, equivalent to something like a pay rise of around £11k a year or more if you are a higher rate taxpayer.

The reason why the Government is supporting this is to provide further assistance to homeowners living in expensive areas and also as one way of reducing to the housing shortage by encouraging more people to live in a fewer number of properties.

In truth, I think this is an excellent tax break that anyone owning a property could do well to look into. The obvious downside is sharing our home obviously. I will discuss how this could affect property investors later.

Changes to how dividend income is taxed

As a property investor owning and renting property personally, this change may not at first seem to concern you. However, given some of the changes discussed earlier, many investors will now be considering investing through a company and receiving at least some of their income in dividends…in which case, it becomes highly relevant.

So what is changing?

Currently, dividend income is free of further tax liability for basic rate taxpayers. Higher and highest rate taxpayers are then subject incremental tax at a marginal tax rate of 25% higher and taxpayers. This is better than paying straight income tax as if it were PAYE earnings but it is still incremental tax to pay.

The changes made mean that only the first £5,000 of dividend income will now be free of tax, even if we are a basic rate taxpayer. After this amount there will be an additional dividend tax at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers. So, tax on dividend income has been increased by 7.5%.

Dividend income earned through tax-efficient savings plans such as ISAa will not be affected by this change.

How is this relevant?

As I mentioned, many property investors either do already, or if not, are now considering putting their property business into a company structure leading to the more preferential dividend tax regime when compared to straight income tax. However, it is by no means a simple choice to do this as we shall see!

Implications and consequences

Here are just some of the potential implications and consequences that I can see resulting from these changes and tax hikes:

Capping of mortgage interest and other finance charges tax relief

It will probably impact investors that are both higher rate taxpayers but also using higher levels of mortgage borrowing the most. For these investors, it will lead to:

• Lower profits
• Potential for some investors to be left with a cash shortage to pay their tax bill
• Some particular investors being trapped, particularly if they have been refinancing above the original purchase price, or would be left with insufficient funds to pay any capital gains tax on a sale.
• Some investors having difficulty with refinancing due to the consequential changes that lenders will need to make to their lending criteria

Loss of wear & tear allowance for furnished properties

There will be winners and losers here in terms of the after tax position. However, the changes will mean a return to a more normal or fair record of actual costs and profits for investors with furnished properties. We should have no complaints in principle with this, unless we are just being selfish that is! I have not understood how the transition will affect us between the two systems, so this needs closer examination.

Rent-a-room scheme

Indirectly this does not affect us. However, if we are a homeowner, then it provides us with another opportunity to increase our income from property as I mentioned a couple of episodes ago in considering our home as a tax-efficient asset.

In the medium-term, I do wonder whether this will attract more homeowners into the room rental market. If it does, then this could lead to greater competition to HMO landlords.

Dividend income tax

Again, at the surface, this may not affect us. However, if we already receive dividend income for example as a shareholder in listed companies or through our self-employment businesses say, then this will lead to a higher tax bill than is currently the case. If we add this to the other tax changes and in particular the loss of finance charges and interest relief, it will be a tough one to take no doubt.

What are our options?

So, when we hear of these changes, we naturally go through a process don’t we. We may be shocked or surprised, then possibly angry or at least worried. But then we will start to look at what are we going to do about it and plan going forward. That’s the stage I want to cover off a little now briefly.

Following a Budget with higher personal tax hikes, we are faced with a few basic choices:

• Increase our income to cover the tax position – this could be by increasing rents or by growing our portfolio to cover the tax increase
• Reduce our costs to cover the increased cost – this could be by reducing our borrowing levels, or by addressing the overall costs of running our property business. It is certainly my view that one part of the Government’s aim here is to encourage reduced levels of debt for BTL investors.
• Switch to more favourable tax environments – this could mean considering investing through a company to move from income tax to dividend tax, switching strategy to potential replace income tax with capital gains tax, or even more elaborate tax planning approaches that I would not wish to venture into here.
• Exit the market – sell up and move on is certainly going to be an option that some may consider, and to be honest in some situations I can see why this might be attractive. For smaller portfolio investors or accidental landlords with high levels of borrowing and a higher tax rate, other forms of investment will start to look more compelling when compared with BTL for example. ISAs, pensions and even investing in our own home with the tax-incentives associated with inheritance tax and rent-a-room scheme could move further up the radar. As indeed could the idea of converting our home to a BTL and then selling it at a gain later, repeating the process every few years or so perhaps. However, if the intention is to develop a larger portfolio of say 6 or more properties, then other options do exist and it may well be worth pushing through the pain barrier and / or considering some of the other options available.

There are some challenges we may face when considering some of these options of course, for example:

• We may not be able to simply increase our rents, especially when only some people are affected by these tax changes and not all and where the market sets the rents based on supply and demand.
• We may not have the capacity to grow our portfolio due to financial considerations say
• We may have a limited ability to reduce our costs, especially if we are locked into long-term fixed rate mortgages and already manage our own properties say.
• We may also find ourselves in an equity trap of sorts, for example if selling was not an option due to a capital gains tax bill we could not cover, or if lending criteria meant we no longer qualify for a remortgage based on harder affordability measures.
• We may find that even if we do manage to get a tax benefit by switching to a limited company, that we then find ourselves with a stamp duty and / or capital gains tax bill to pay on our way in or at a later stage. Tax is a complex area and there are so many different tax rules and environments to navigate around that sometimes when we fix one issue, we end up creating another one somewhere else instead.
• We may well be tempted to call it a day, however if we already have a good pension in place, take advantage of our ISA allowance and are concerned that just as this Government has made changes to the tax rules, so could subsequent Government, meaning having a balanced investment portfolio seems to be ever more appealing. In this case, as I said earlier, perhaps there are a range of options open to us and any pain could be short-lived with careful planning…it is time to adopt a professional approach to this business of property investing now more than ever I would say.

This is about as far as I wanted to take the discussion today in truth. Whilst I have more ideas in my own mind, I would like to suggest that the best piece of advice overall is quite simply to: seek professional advice. That way you can consider things from your own positon and not simply plough into a change just because it sounds like the right thing to do. I am hearing of many people say they are going to switch into investing via a company, however it might not always be the best option and it really does depend on our personal circumstances and our overall objectives.

One thing is for sure…the accountants, tax planners and general financial advisory professional is about to get a whole lot busier as a result of this Budget!

My overall conclusion is this: adopt a professional approach to what is a business operation. This means, we need to plan carefully, seek the right advice and then structure our affairs that provide safeguards and contingencies against short-term changes such as those we heard about in the Budget.

I did originally have another musings episode in mind for this week, however, the Budget really did set the cat among the pigeons and as Jay, one of our listeners, asked me so nicely, I decided to do a Budget special episode instead. I hope you found it useful.

And please remember…there are never any unsurmountable problems, only opportunities and obstacles for us to overcome…let’s keep moving forward!

The show notes are available at our website www.thepropertyvoice.net and we have added some additional aspects to our website recently as well; it includes our new Investment Partner offering, so perhaps check it or, if you just want to know more about that you can simply drop us an email to: partner@thepropertyvoice.net and start a conversation.

OK, so another week over…where do they all go? Thank you very much for listening to another in my Musings mini-series. A special & final word of thanks to Jay for suggesting today’s episode and also for Kylie for her transparent sharing of her portfolio financial performance too.

Until next time on The Property Voice Podcast…ciao-ciao