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Fundamentally flawed: Why the optimum tax-free cash property investment strategy’s reality is the elephant in the room
There is allegedly a beautiful little property investment strategy that allows us to receive a ‘tax-free income replacement’ for life from just a couple of investment properties. Spoiler alert: the problem is that it is fundamentally flawed! Join me as I lift the lid on the realities of this optimum tax-free investment strategy and why it is in fact extremely risky, unpredictable and ultimately doomed to fail. Or, then again, perhaps I have got it all wrong, in which case, you can correct the error of my thinking. Either way, you will want to hear what I have to say this week…it could save you a whole heap of trouble when you need it the least a couple of decades into the future. Best you find out now though I say…even if it means coming last in the Mr Popular in Property awards this year!
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Today’s must do’s
If you are thinking of following the ‘hold forever-refinance-spend the tax-free cash’ strategy…then think again! Revisit this show and take a look at the show notes to see what perils may await you, decades down the line. Do some digging to see who has been caught out by the recent tax changes that scupper this refinance and spend the cash strategy. Whatever you do, do it deliberately having weighed up all of the options…before it’s too late and can’t be undone!
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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 on the show today.
On a recent trip to south-east Asia, I did manage to get up-close-and-personal to an elephant or two. As an aside, the video footage did suggest a slight wariness on my part, at least to begin with, when I attempted to feed one a whole pineapple and wondered if I would see my arm again! But, this only serves to illustrate that we really should respect the elephant…whether in nature or in the corner of the room in the case of the metaphorical one!
So, today I want to talk about the elephant in the room that surrounds what many describe as an optimum tax-free property investment strategy…the buy, hold forever and refinance merry-go-round for tax-free cash that is.
If you are tempted to give this strategy a go, then let me share with you some of the potential realities associated with this ‘tax-free income approach’ right now…
Property Chatter
I have heard it said in some quarters, of late and of old, that there is a beautiful little property investment strategy that allows us to receive a tax-free income for life from a couple of investment properties!
Sounds terrific doesn’t it?
Firstly, how does it go…well, I am happy to share the model with you freely as follows:
Step 1 – Buy an investment property, probably using a mortgage to maximise the leverage benefits
Step 2 – Wait around 10 years, which is around the historic long-term average for property prices to double
Step 3 – Remortgage the property based on the higher value to release some of that in-built equity…tax-free!!
Step 4 – Spend that tax-free cash released on your lifestyle: a car, a holiday, new clothes or even your weekly grocery bill…basically in whatever way you want to
Step 5 – Rinse and repeat every ten years or thereabouts
Step 6 - Add in additional properties along the way to create more regular tax-free income replacement piles of cash
Step 7 – Ride off into the sunset without a care in the world 😉
Sounds good doesn’t it? Perhaps, almost too good?
The secret is this:
Debt receipts are not a taxable source of income. So, the proceeds of the remortgage, of course being debt, are not subject to any form of taxation, as they are neither income, nor a capital gain. In fact, it kind of gets better, as the debt also helps to reduce our Inheritance Tax bill as well…but that really is stretching the concept a little…
OK, so a bit of a spoiler alert for you in case you are too busy for the next ten minutes or so to keep listening:
It doesn’t work out quite as well as some might suggest and I would go as far as to say…it is fundamentally flawed!
Controversial eh?
OK, so having made that bold statement; let’s take a quick look at a worked example that we can refer back to.
Let us buy that notional buy-to-let property we always see for £100,000 and see the model in action.
At the start we have:
A single property with a purchase price £100k
Let’s assume a mortgage of £75k using a 75% LTV loan
As an important aside, mortgage interest relief is allowed on interest payments on the full £75k loan here but are limited to the basic rate of tax from 2020 as per the recent changes in policy from the Chancellor.
As a basic rate tax payer we would feel largely unaffected by the tax change at face value. However, our rental income will also be growing over time and this could eventually help put us into a higher rate tax bracket on its own. Let us not forget that if property prices are doubling every 10 years say, then so too are rents generally speaking.
Similarly, rental profits will now be calculated before allowing a relief equating to the basic rate of tax on the mortgage interest payments. The implication of this being that our total income has just been bumped up for tax bracket purposes equivalent to our mortgage interest payments and that could also push you into a higher tax bracket as a result!
So, make a mental note of these few points for later:
- Mortgage interest relief is only allowed if the proceeds are reinvested into the property business and are also capped at the original property purchase price
- Rents will increase over time adding to our taxable income
- Mortgage interest is going to be excluded from our rental profits when calculating your total taxable income, thus inflating out total income and potentially also our tax bracket
OK, so returning to the model, it would continue as follows.
In around about ten years’ time, the property is revalued at say £200k, which assumes it has now doubled in value
We then remortgage at the same 75% LTV, so a £150k loan
Therefore, a non-taxable 'income' replacement of £75k is released – this is the difference between the new mortgage of £150k and the original mortgage of £75k
However, remember what I said earlier about mortgage interest relief being capped on interest payments on up to the original purchase price? So, we can only offset £100k of the new loan against our tax bill if we have taken it out of the rental property business, or in other words, we have spent it! Of course, it will be limited to the basic rate of tax from 2020 as well.
This means we need to factor the tax cost on the interest we are unable to offset into our calculations - it gets complex I know but at this stage it will probably still sound appealing on the income tax side of things alone. But let’s carry on…
As an aside, our average annual tax-free 'income' equivalent here would be £7.5k in today's value…happy days…apparently.
So, Father Time moves us forward another ten years and here’s how it looks then…
Revaluation after say 20 years at £400k assuming property prices have doubled again
Remortgage again at same 75% LTV results in a new £300k loan
Additional non-taxable 'income' replacement of £150k is released being the new loan of £300k less the old loan of £150k
On the tax-free ‘income’ replacement, that looks like an equivalent to c£15k per annum in today's value…sound enticing doesn’t it?
Once again, however, mortgage interest relief is only allowed on interest payments on £100k of the loan and not the full £300k and will also be capped at the basic rate of tax as well, so you might need an abacus to work things out at this stage!
Let's do another round of this circuit and quickly look at the same result in around 30 years, when most are probably in or thinking of retirement…
Revaluation at £800k following the property prices double every ten years assumption as before
Remortgage at £600k or 75% LTV
Cash released of £300k being the £600k new loan less the £300k old loan
That’s around £30k per annum in today's value as a tax-free ‘income’ replacement
Interest relief is capped on the first £100k and at the basic rate of tax as before
Variation of the Model
A variation is to avoid the regular remortaging and skip to remortgage in around 30 years’ time. This may look a little like the last item above but with £525k released at that time instead. That would be a new mortgage of £600k less the old loan of £75k (ignoring mortgage expiry terms for the moment). At face value then, a £50k annual ‘tax-free income; from a single property for the next 10 years does sound extremely appealing...but hold that thought...
What about the latest changes to mortgage interest relief or Clause 24, The Alice in Wonderland Tax Grab?
Without going into the detailed maths, you will note that from 2020, you could offset 100% of your interest payments as a basic rate taxpayer and about 50% as a higher rate taxpayer. If you remortgage around 2026 as planned in our model, these percentages fall to approximately 67% & 33% and by the time we remortgage again around 2036 they would fall to around 25% & 12.5% and then to 17% & 8% from 2046.
In other words, what was previously a decent tax deduction has now become quite insignificant. Don't forget that at the same time, our rental income has most likely also quadrupled by this time as well...so our tax bill, in theory, could be quite high. Yes, I know personal allowances and tax brackets also shift over time...however, that’s more moving parts and unknowns to consider!
OK, so back to the elephant in the room...my controversial statement that a ‘remortgage for tax-free income and hold forever’ strategy is fundamentally flawed.
Here's why I think this...
- Note what I said about the impact on interest relief earlier - it could hamper our normal income tax position, as there are in fact two limitations to consider here: the cap at the original purchase price being one and the basic rate relief cap being the other.
- It relies on property prices increasing sufficiently to be able to remortgage and in particular at the precise time we require the income...consider if we wanted some money to live on in the equivalent of the entire 1990s or between 2009 to 2014, when property prices either dropped or flat-lined...that would be like being asked to wait to draw our salary or pension for between 5 and 10 years?!
- It relies on credit being both available & affordable - it was not available, certainly after the global financial crisis and nor was it affordable when interest rates were in double figures for periods of the 70s, 80s & 90s - that's a 30-year time span! Consider, if we have a change of circumstances, or what if we have more legislation like the Mortgage Market Review or the European Mortgage Directive or are just too old, uncreditworthy or otherwise non-viable to even get a mortgage or indeed any number of unpredictable events outside of our control that affected our ability to remortgage so far into the future?
- It largely ignores the cost of repayment on the debt as an income deduction – even at an interest rate of 5%, our tax-free income in our final round would have been either £30k or £50k per annum depending on which model we adopted. However, factor in the cost of our mortgage and at a 5% interest rate that will reduce our ‘income’ by £30k per annum…mmm. OK, so we should be able to service the debt repayment from our rent now shouldn’t we? Did I mention high interest rates yet? OK, best not right now I guess…
- Also inflation - just as asset values grow through inflationary effects, so does the purchasing power of our income fall through those same inflationary effects. In other words, £30k or £50k per annum won’t be worth anything like the same in 30 years as it is today. For example, £30k will be the equivalent of about £14k assuming a 2.5% annual inflation rate, which is very low.
- It leaves us extremely vulnerable should we ever need to sell in retirement - in my examples above and ignoring CGT annual exemptions for a minute, if we needed to sell or transfer our property in 30 years say, then we would have a taxable gain of £700k and a tax bill of around £126k or £196k depending on our tax bracket...BUT we would only have £200k in cash to pay the bill AND then we would have no asset and no future income source either! That could be our pension gone! Plus, who knows what CGT will be like by then as well…
- Which brings me to my last point...it assumes that the tax rules will be the same decades into the future. We can see just from the past 9 months how the tax landscape can shift quite quickly and who knows if debt will ever become a taxable income source in 20 or 30 years’ time...? It is simply too far off and too subject to the unknown to contemplate, surely?
There are possibly more reasons but I sense that I am on a bit of rant here
I know this is an attractive concept and at face value it seems like a real winner. But, just look at what is happening to some in the property community right now. Some people are selling up or even emigrating as a result of the changes that made this refinancing merry-go-round come to an abrupt halt over the past few months.
Oh…and if you were thinking of merely switching this model into a limited company structure to avoid the interest relief issues raised, just consider how you will get the money out of the company to spend without paying tax on it first won’t you?
Now, I am sure there are some counter-arguments that I have omitted or overlooked…but seriously, can ALL of my points be safely countered to eliminate them all? I have to be very honest with you in saying that a few years ago, I myself did wonder if this was the way to go with property investing in a tax-free way. That’s until I really thought it through that is.
So, that’s my advice to you therefore…just think it through and model the scenarios, assuming you are capable of writing an algorithm to model all of the moving parts that is. But, if you do make sure you also have one with a crystal ball built in as that would be ideal 😉
Anyway, I guess my views on this strategy are pretty plain and clear. Therefore, I would severely caution anyone intent on adopting this 'hold forever and keep refinancing for tax-free cash approach', as in my opinion, it is extremely risky and uncertain.
As sad and poo-pooing as my message appears to be this week; as I said at the start, it gets the elephant in the room right out into plain view at least. By all means, do let me know if I have got this all wrong. Or, on the other hand if this has been your strategy all along and now I have blown it to smithereens…sorry about that! Email me, podcast@thepropertyvoice.net and we can kick the cat together if you like. I am mixing my animal metaphors now aren’t I?
OK, so that’s my vote for My Popular in Property out of the window for this year isn’t it? Next week I intend to be in a slightly more jovial frame of mind, as it’s our Birthday J In fact, we intend to celebrate 3 Birthdays next week…one being The Property Voice Podcast; join me next time to find out what the others are, unless you want to hazard a guess?
If all those numbers and references were a little too much to follow when listening, then worry-not as the show notes can be found over at our website, www.thepropertyvoice.net
For now, and in closing, thank you very much for joining me on the show today and until next time on The Property Voice Podcast…it’s ciao ciao!