Musings: Home as a tax efficient property investment ASSET!

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The Property Voice Podcast - Musings: Home as a tax efficient property investment ASSET!

The Property Voice Musings are one-off episodes designed for an opportunity for us to share what is on our mind at the moment. Today we will be talking about using your home as a very tax efficient property investment asset. This is controversial, as some people suggest that your home is actually a liability and not an asset at all. Add in a bit of spice with some tax benefits and we might just start to see our home not only as our castle, but also as our goldmine!

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Resources mentioned

• Property Investor Toolkit – here is the book link on co.uk & amazon.com in case you would like to get yourself a copy to accompany this series
• Home Tax Bonus materials - drop us an email: podcast@thepropertyvoice.net and we will send you the cheat sheet and spreadsheet of how you can turn your home into one of the most tax efficient property investments you will ever make!

Today’s must do’s

1. Consider turning your home into a rental property and make it one of the most tax-efficient property investment deals you could ever make!
2. Subscribe & review to the show in iTunes…and while you are at it please help us to spread the word by telling all your friends too!
3. Drop us an email for the listener only bonuses (Own Home Tax Bonus cheat sheet & spreadsheet to podcast@thepropertyvoice.net and we will add you to our bonuses list!
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

Note: Budget July 2015 Update - On the day this recording was released, the Chancellor made two changes that affected what I discuss here. First, the Rent a Room Scheme tax threshold was increased from £4,250 to £7,500. Second, mortgage interest relief for BTL investors was capped at the basic rate of tax (20%). This reduces the tax relief available to higher and highest rate taxpayers on rental profits. Capital gains tax looks to have been left alone. If anything, this probably makes the conversion of a home into a rental property even more attractive, given the benefit is largely based on capital gains tax relief.

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. We are preparing the next series right now, which will be released soon. In the meantime, we had the option of taking a break, which was very tempting, or alternatively, of doing something a little different instead. You may have picked up from me by now that I like different…not outrageous, just a little different! So, I plan to share with you a few of my musings as I like to call them. Topics that have grabbed my attention and occupied my mind a little. I guess it is a mini-series of musings that we shall be sharing over the next few episodes as we prepare ourselves for series 2. So, sit back, relax and join me as I share the first of these musings today. I would be interested to hear your thoughts and reactions to these personal musings as we go.

So, let’s get cracking with Property Chatter…or perhaps it should be retitled Property Musings?

Property Chatter

Do you know how sometimes a certain subject seems to crop up all over the place? I guess you would call it ‘trending’, however today’s topic has probably been trending for quite some time in truth, and stimulated me to talk about it on this week’s show, in what I am calling The Property Voice Musings.

As well as this topic being discussed on at least two other property podcasts that I listen to: The Property Podcast with the Two Robs and The Property Investor Podcast with Anna Harper & Damien Fogg quite recently. I also came across a forum post over at The Property Hub (that’s two plugs now Rob & Rob!), where a poster by the name of Noel had a decision to make. His dilemma centred on whether or not it was worthwhile converting his existing home into a rental property and remortaging to release funds to invest in a different one instead. His main concern was the after tax ROI on the former home…let’s share some of Noel’s situation to set the scene a little bit.

His home is currently worth £165k and after the remortgage would have a loan of £92k secured on it with additional cash released to the tune of £31k. The rent would be £650 per month, which puts the gross yield modestly at 4.7%. The ROI that Noel calculated was 7.34% from the year 2 onwards (after getting rid of some of the refinancing charges in year 1) and an after-tax ROI of 4.4% at that time (note: he is a higher rate taxpayer).

His big questions were…what sort of ROI do property investors seek and was the deal worth it at all with these lower single digit returns?

In response, let’s start by looking at the ROI question…

ROI is a very personal criteria...some people would be happy to 'beat the bank' at something like 3% to 5% or so, whilst others may be looking at a significant risk / reward approach, like a developer who would be seeking 20%, 30% or possibly more. The first thing to do, therefore, is decide what the right ROI level for you personally is. For me, it varies depending on the project...for a long-term buy and hold it has to be double digit BUT...

There is often more to it than this, for example:

ROI usually only looks at income as a % of the cash invested - don't forget that the total ROI also includes capital appreciation, whilst recognising that capital appreciation is only a paper number until it is realised.

Noel mentions taxation and usually I only look at a pre-tax position to evaluate a deal. However, if you are prepared to do the digging and fully understand the tax implications, it can indeed change one deal from another. Beware of the procrastination trap however, when looking too deeply into this area…it can stifle you into the equivalent of a dog chasing its tail I can tell you!

So, here’s a quick look at the normal personal tax position of property would mean the following:

Own home - With our own home we would have no capital gains or income tax liability, providing we do not rent it out, which we will look at in a minute, or use it for business purposes in whole or in part, which is too complex for this discussion. However, whilst there is no tax, there could also be no rental income or profit on sale depending on the state of the market when we sell…as I have said, capital appreciation is speculation.

Rent-a-room scheme – with our own home, whether we actually own it, or rent it, we can earn up to £4,250 per year before paying any tax…remember my words here, ‘whether we own it or rent it’ as I will return to the definition of an asset later? However, this scheme does mean that we could take in a lodger to at least create some income from our home whilst potentially waiting for a profit on sale.

BTL taxation – simply speaking, we pay income tax at our highest rate on net rental profits and then capital gains tax if we sell a BTL at a profit.

Property Trading – here the business changes so that buying and selling property becomes the business, rather than rental income. This means profits on sale are instead subject to income tax and not capital gains tax. As a higher rate taxpayer, this would make property trading less attractive after tax when investing personally. This explains why a lot of property traders do so through company structures but again that’s a different topic…

One home, rented out at some point – as the owner, we get PPR or private residence relief for the time that we own the property, plus the last 18 months of ownership if rented, plus lettings relief for the time it is rented out, plus an annual capital gains tax exemption to offset against any profits on sale. I think you will agree, that’s a lot of plusses there!

Rental income is subject to income tax as with BTL. However, the profit on sale is classed as a capital gain and not income, after deducting all the allowances mentioned. Oh, I should also mention that CGT is taxed at 18% for a basic rate taxpayer or 28% for a higher rate taxpayer, so it is a lower tax rate than for income tax…again worth noting.

In Noel’s example, he has a distinct advantage with his property beyond many standard BTLs...it used to be his home! As it used to be his home, he will qualify for PPR relief whilst he lived there and then any gain will be subject to CGT at 28% rather than income tax at 40% as he is a higher rate taxpayer. That’s one advantage when compared with property trading say.

Next, there is what is called lettings relief of up to £40k on any residual sum if his home was ever rented out. There are some rules of how this is calculated, which we will share with our listeners – check out the cheat-sheet & spreadsheet listener offer mentioned in the Shout Out section later on or just drop us an email right now to podcast@thepropertyvoice.net to receive the bonus material.

Then, he would also get an annual CGT exemption, or even one per joint owner, if he co-owned the property with someone else. This would be something like £11k per joint owner. Note this annual exemption can only be used once and not for each year, nor can it be carried forward when unused say…it is a ‘use it or lose it’ allowance. Strictly speaking, there are ways to use it more than once but that’s a more sophisticated topic beyond the realms of this discussion…

Finally, he can offset buying, selling and capital improvement costs against the gain before any CGT liability is calculated.

This effectively means that as a couple who jointly own their own home and then let it out, they could afford to make a minimum of £62k profit on sale for the time attributed to when it was rented out before we will have to pay any capital gains tax! The time when it was used as our own home plus the last 18 months is a tax-free gain as mentioned. This could mean living in our own home for quite a short time, then renting it for longer and still paying no CGT…that’s pretty neat I think.

We would not get such a tax boost from owning a standard BTL, so it may be worth doing the sums and calculating how long to hang onto this property until the tax effect is at least neutral (no financial advice offered you understand right?).

Next, we should not ignore the fact that the cash released from remortaging the property will be reinvested elsewhere. There will be an ROI on this reinvested cash that should also be taken into consideration when evaluating the go/no-go decision on the deal.

My conclusion was that Noel could afford to have a very modest rate of return on what was his former home, even if it means simply 'washing the face' of this particular investment, capitalising on the unique capital gains tax advantages available, plus using it as a springboard for further investment by releasing the £31k of equity to reinvest. That makes it very compelling from a tax-efficient investment point of view I have to say. In fact, I would go as far as to say that it looks like a tax-efficient cash-cow to me!

This area of taxation led me to come up with the idea of using our home as a form of 'tax arbitrage'. The basic definition of arbitrage is “the simultaneous trading of assets to take advantage of different pricing in different markets”. Tim Ferris made this observation in his book, The 4-Hour Work Week, where he earned his income is US Dollars but his lifestyle costs were spent in lower cost economies, such as Asia & South America. Tim called this idea ‘geo-arbitrage’, in this case, I am implying trading different tax rules to arrive at a better overall after-tax result, which I am calling ‘tax-arbitrage’. This is the idea of switching how an asset is utilised to take advantage of different tax structures, leaving us with more money in our hands after tax.

However, let’s pause for a moment and look at the definition of an asset, which is part of where the controversy of this idea of your home being considered an asset or not, comes into play.

Many property investors will be familiar with Robert Kiyosaki’s book: Rich Dad, Poor Dad. In fact, it is one of my personal favourites. In the book, he defines an asset as: “something that puts money into your pocket (each month)” or as he spun it as being: “a liability takes money out of your pocket each month”. A home that is not rented out will only mean outgoings each month by way of mortgage, maintenance, repairs, taxes, insurance and so on.

So, by the RDPB definition, our home cannot be an asset, even if it grows in value over time.

That’s the RDPB definition, how about the International Accounting Standards Board…they know a thing or two about assets and liabilities don’t they? Here is their definition:

“An asset is a resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity.”

Using this definition, I think it is clear that a capital gain on the sale of a property in the future could make our home fit the description of an asset. The only issue really is that this is speculative until the sale is actually made and the profit or gain is realised. In truth, this should really be more a question of timing, but there are no absolutes for sure.

The point about control is actually a very, very interesting concept I think, but we shall have to leave it there for now at least.

My own definition of an asset is:

“Something that we own of value”

Short and sweet, but again it leaves the possibility there for a capital gain, or indeed the equity to be classed as an asset for sure.

So, for met at least, our home is potentially & quite possibly the most tax efficient property investment we will ever have (whether or not we say it's an asset). However, for me this does really mean turning it into a rental property at some point. As mentioned, there are certain reliefs that come into play with it being a home that is subsequently let. PPR relief for when you live in it, CGT annual exemption and lettings relief when it is let and sold at a profit.

I have undertaken a bit of number crunching to illustrate a number of scenarios where owning and then renting our home could turn into a very tax-efficient investment. However, rather than run through all of the numbers here on the podcast; I shall be making a cheat-sheet and spreadsheet available as an email subscriber-only bonus. That means, if you are not already on our mailing list, you had better get yourself on it. The easiest way to make sure is to send us an email to: podcast@thepropertyvoice.net, along with your name and the subject title ‘Own home taxation bonuses and we will add you to the list and send you the bonus materials by return.

Just to whet your appetite a little; I was able to use Noel’s example to demonstrate how he could make a whopping £129k capital gain by renting out his former home and then selling it after around 3 and half years of renting and yet pay no capital gains tax at all. As Paul Daniels used to say, ‘now that’s magic’. I would have to agree!

As for Noel, he could take that £129k tax-free sum and re-invest this into further investment properties and / or, could consider 'rinsing and repeating' the process every few years.

The 'tax arbitrage' taking place when we convert our own home into a rental property is a unique benefit in property investment.

That’s why, for me at least and under the right circumstances, our home can indeed be a very tax efficient asset indeed! I would like to hear what you think about this idea too.

OK, so that’s another week of The Property Voice Podcast with this musings episode. We are in between series and that’s why the format is a little different. The next series will be available soon, but in the meantime, I hope you enjoy a couple of my musings episodes.

The show notes and details of the listener bonus materials offer will be on our website, or by sending us an email to podcast@thepropertyvoice.net instead. Meanwhile, thank you very much for listening to the first in my Musings mini-series.

For now and until next time on The Property Voice Podcast…ciao-ciao