Recent tax changes take the shine off buy-to-let properties

The buy-to-let sector has enjoyed considerable expansion over the course of the past two decades with privately rented houses in the UK mushrooming in number from 2 million to more than 5.3 million over the same period. The allure of a tangible asset, with a stream of rental income and the potential for capital growth has given rise to a love affair with bricks and mortar. 

The proliferation of the buy-to-let landlord has been cited as a causal factor in affordability pressures experienced by first- time buyers and the amplification of peaks and troughs in the housing market cycle. As a result, buy-to-let landlords have found themselves firmly in the Government’s crosshairs with a series of tax changes being introduced in an effort, as George Osborne put it, to ‘make the tax system fairer’. 

In a bid to temper the growth in the buy-to-let sector the government has deployed a raft of tax measures. These include the introduction of a stamp duty surcharge of 3% on the purchase of additional residential properties, the restriction on finance cost relief for individual landlords, the abolishment of the ‘wear and tear’ allowance and changes to the capital gains tax regime. The confluence of tax measures has created a less accommodative tax regime for the buy-to-let landlord to contend with. As such, it is vital that landlords understand and consider the implications of these tax changes on their personal circumstances. 

The reduction in finance cost tax relief

In the summer Budget of 2015 the then Chancellor George Osborne confirmed the government’s intention to initiate a phased withdrawal of higher and additional rate tax relief on finance payments (e.g. mortgage interest) relating to residential properties. 

The old rules (prior to 6th April 2017) 

Historically, many landlords would borrow heavily against the value of the rental property in order to take full advantage of the benefits conferred by the ability to obtain income tax relief on mortgage interest payments. Under the old rules an investment in bricks and mortar was highly tax efficient as landlords effectively got tax relief on associated finance costs at their marginal rate of income tax. 

The new rules (post 5th April 2017) 

Historically, many landlords would borrow heavily against the value of the rental property in order to take full advantage of the benefits conferred by the ability to obtain income tax relief on mortgage interest payments. Under the old rules an investment in bricks and mortar was highly tax efficient as landlords effectively got tax relief on associated finance costs at their marginal rate of income tax. 

The new rules (post 5th April 2017) 

In broad terms, the measure, which was introduced on 6th April 2017, effectively restricts tax relief for finance costs associated with residential properties to 20% i.e. the basic rate of tax.

In a nutshell, this will result in mortgaged residential landlords, who are higher or additional rate taxpayers, having to pay more income tax. This represents a major shake up to the buy-to-let tax regime and a significant departure from what was historically a highly tax efficient asset class. 

The government has committed to minimising the short-term disruption associated with the introduction of this measure and therefore the changes will be phased in from 6th April 2017 to 6th April 2020 as follows: 

• 2017/18 – the deduction against rental income will be restricted to 75% of the related finance costs and the remaining 25% of the finance costs will receive relief at 20%, 
• 2018/19 – 50% finance costs deduction and 50% deduction of finance costs at 20%, 
• 2019/20 – 25% finance costs deduction and 75% deduction of finance costs at 20%, and 
• 2020/21 – 0% finance costs deduction and 100% deduction of finance costs at 20%. 

From 6th April 2020 landlords will be unable to deduct finance costs from their rental income when calculating their rental profits. Instead, a tax credit equivalent to 20% of the finance costs will be deducted against the residential landlord’s income tax liability. 

Who will be affected? 

The new measure applies to individual landlords who own buy-to-let properties on which there is an outstanding mortgage. 

Residential property held through a company will be unaffected, as will landlords who own commercial property and furnished holiday lettings. 

It will largely be business as usual for landlords who are basic rate taxpayers. However, they should be vigilant given that their rental income may push them into the higher rate of tax at which point they may be impacted. 

As a general rule, the greater the mortgage outstanding on the property, the greater the tax hit resulting from the change. In the case of a higher rate tax payer, if the mortgage interest payments exceed 75% of the rental income, having deducted other costs, the restriction of finance cost relief will give rise to a loss. As such, highly leveraged properties stand to be the worst affected. 

Those fortunate enough to hold buy-to-let properties that do not have an associated mortgage will be unaffected by the restriction on finance cost relief. 

What impact will the new rules have? 

Whilst the tax changes to interest relief may sound like semantics, the implications can be significant. The impact of the restriction is best illustrated by way of a worked example: 

Let’s consider the case of Tom. Tom is a higher rate taxpayer. He owns a buy-to-let property which generates rental income of £20,000 per annum. There is an interest -only mortgage outstanding on the property which costs £12,000 per annum and there are other costs of £2,000 per annum. The Table 1 illustrates the impact of the new rules.

Table 1: Worked Example: The Financial Implicationss

Source: Davy

Table 1 above illustrates a crucial point. Despite the fact that Tom is no better off economically (as the rental income and expenses remain static throughout the period under analysis) his tax liability associated with the property will double from £2,400 (tax year 2016/17) to £4,800 (tax year 2020/21) resulting in a reduction in net profit of more than 66%. 

This example is based on a historically low interest rate environment. What should really worry landlords is if and when interest rates, and in turn mortgage rates, rise. 

If we consider the same scenario as above but assume that UK interest rates rise, leading to the mortgage cost increasing to £15,000 per annum. This will result in the rental property making a loss of £1,200 for the tax year 2020/21, all other things being equal. 

This illustrates how the returns achieved by landlords holding highly leveraged properties are acutely sensitive to mortgage rate rises. Those worst affected will see the restriction on finance cost relief result in them being pushed into loss making territory, potentially undermining the financial viability of the investment property and forcing them to take countermeasures to reduce the impact of the new provision.

Stamp duty surcharge  

Since 1st April 2016, a stamp duty surcharge of 3% has been levied on the purchase of additional residential properties, such as second homes and buy-to-lets. The 3% stamp duty is in addition to the stamp duty that remains payable across the stamp duty bands and represents a significant increase in expenses associated with the purchase of a buy-to-let property. 

Perhaps unsurprisingly, since the introduction of this measure there has been a marked reduction in mortgage lending within the buy-to-let sector. According to figures published by the Council of Mortgage Lenders, 71,100 loans were made to landlords in the 12 months to 31st March 2017, which compares with 142,100 loans made one year earlier. This provides some evidence to suggest that this measure has curbed the appetite of the buy-to-let landlord whilst going some way to shoring up the coffers of the Treasury with additional tax receipts. 

The end of the ‘wear-and-tear’ allowance 

Residential landlords had long been accustomed to being able to claim the generous ‘wear-and-tear’ allowance which was a tax relief equivalent to 10% of their rental profits for the wear and tear of soft furnishings and white goods. This allowance was available to landlords of furnished properties even if the cash had not been spent on renewing furnishings.

Since April 2016, the 10% ‘wear and tear’ allowance has been consigned to fiscal history. In lieu of this generous relief, landlords are now only able to claim tax relief for the cost of replacing such items on a like-for-like basis. 

Whilst not universally bad news, many landlords will now face an increased tax liability as a result of this change. 

Capital Gains Tax considerations 

In the 2016 Budget it was announced that the rates of Capital Gains Tax would decrease to 10% for gains falling in the basic rate tax band and 20% for gains falling in the higher or additional rate tax bands, for gains accruing on or after 6th April 2016. 

Adding to the tax woes of the residential landlord, the rates of Capital Gains Tax for gains made on residential property transactions were not included in the capital gains tax reductions and continue to be taxed at 18% for gains falling in the basic rate tax band and 28% for gains falling in the higher or additional rate tax bands. 

As if all of this wasn’t enough, the Treasury has proposed bringing the deadline for payment of capital gains tax on the sale of residential property forward to 30 days. Due to take effect from April 2019, this is a significant reduction from the current timeframe of up to 21 months and will only serve to further compound the woes of residential landlords. 

Conclusion 

The battery of tax measures introduced over recent years has fundamentally changed the tax landscape of the private rental sector. Residential landlords should, in conjunction with their tax adviser, examine how the tax changes will impact them personally. For some, the measures will call into question the economic viability of their buy-to-let properties. It may now be the case that the traditionally unbridled love for bricks and mortar as an investment proposition has been somewhat dampened.