Introduction

The arrival of the buy-to-let (BTL) mortgage product in the mid-1990s, allied with ‘interest only’ deals, spawned a new generation of landlords. Investors clamoured into the property market often seeing this asset class as an alternative to traditional retirement saving.

The inevitable happened. Residential property prices soared and development land rocketed in price. Following the Lehman Brothers collapse and the ensuing financial crisis, property prices slumped. When the music stopped, far too many BTL investors were left in terrible negative equity situations. Many remain so to this day, desperately hoping for a price recovery and surviving because they have an interest only mortgage and can offset all of that interest against rental income. At least they don’t have a tax bill to pay on the rents. However, that is set to change from April 2016.

In his Summer Budget, the Chancellor announced two adverse tax measures for BTL investors. The first is the removal of the 10 per cent wear and tear allowance for furnished lettings commencing in April 2016. The second is a restriction of tax relief for interest paid on BTL debt to the basic rate of income tax (20 per cent). This is to be phased in over 4 years starting in April 2017. In the 2015 Autumn Statement an increase in stamp duty land tax payable on second homes was also announced.

The wear and tear allowance

The 10 per cent wear and tear allowance will be replaced with a relief that enables all landlords to deduct the cost of replacing furnishings in the property. However the initial cost of furnishing will not be allowed.

Under the new rules, the relief will cover the capital cost of replacing items in a furnished BTL including (inter alia) carpetsand curtains, moveable furniture, electrical appliances and crockery and cutlery.

Integral features such as fitted kitchens, boilers, baths etc. are excluded as their replacement will continue to be a deductible expense as a ‘repair’ on a like-for-like basis.

The change in the wear and tear allowance will apply from April 2016. It will not apply to furnished holiday letting businesses and lettings of commercial properties, because these businesses receive relief through the capital allowances regime.

Restricting finance cost tax relief

The restriction of finance cost relief for residential landlords to the basic rate of income tax will be phased in over 4 years commencing in April 2017. The term ‘finance costs’ refers to interest and the incidental costs of obtaining/repaying loans such as arrangement fees.

The restriction only applies to amounts borrowed for the purpose of generating income from land consisting of a dwelling-house and excludes borrowings for property development trades or borrowings for trades that are secured on a let dwelling-house. Furnished holiday lets are excluded however overseas residential property is included.

The restriction only applies for income tax purposes and applies to individuals, partnerships and trusts however importantly, the restriction does not apply to companies.

The way in which the restriction operates is likely to cause BTL investors the biggest issue in that finance costs will no longer be given as a deduction from property income. Instead, a basic rate income tax reduction will be given. This will potentially affect investors with incomes nearing £50,000 as they stand to be affected by the high income child benefit charge (which starts at incomes over £50,000). Those with incomes nearing £100,000 may lose some or all of their personal allowance.

The examples below highlight how the impact of the interest relief restriction is far more wide ranging as the measure also re-defines the computation of property income via the way in which basic rate relief for interest is given.

Example 1 – Robert

Robert is a manager for a supermarket chain. His gross salary is £40,000. His only other income is rental income from 2 BTL properties that he acquired on 100 per cent interest only mortgages for £200,000 each (interest rate of 2.5 per cent) before he married his wife Maureen. His wife doesn’t work and looks after their three small children. The gross rents from the properties are £16,800, allowable expenses are £5,250 per annum, wear and tear (W&T) is £1,680 (10 per cent of gross rents).

Robert heard about the interest relief restriction but isn’t worried because he thinks it won’t affect him. He’s making an annual loss on the property rental and is a basic rate taxpayer so it has no impact on him. Or does it?

	2015/16	2020/21
Salary	40,000	40,000
Property account:
Rent	16,800	16,800
Interest	(10,000)	–
Expenses	(5,250)	(5,250)
W&T	(1,680)	–
Property profit/(loss)	(120)	11,550
Taxable income	40,000	51,550
Personal allowance: 10,600 @ 0%	0
Personal allowance: 11,000 @ 0%		0
29,400 @ 20%	5,880	–
32,000 @ 20%	–	6,400
8,550 @ 40%	–	3,420
Income tax reducer – £10,000 × 20%	–	(2,000)
High income child benefit charge	–	388
Total	5,880	8,208

(This computation assumes that the personal allowance and basic rate income tax band in 2020/21 are the same as that in 2016/17. Child benefit and the calculation of the high income child benefit charge is assumed to be the same in 2020/21 as it is in 2015/16)

Robert now has an extra £2,328 of tax to pay as a result of the changes in tax legislation. Furthermore where is he going to get the money to pay this bill? He only has a cash surplus of £1,550 from his lettings.

The cost is even more significant for taxpayers on the verge of exceeding taxable income of £100,000 as they will start losing their personal allowance moving more profits into the higher rate tax.

Example 2 – Jimmy

Jimmy earns £95,000 per annum. He has 6 BTL properties which cost £1.5 million, yielding rent of £50,000, allowable expenses are £7,500, wear and tear (W&T) is £5,000 and interest costs are £37,500.

He is concerned about the interest restriction changes and loss of wear and tear and thinks it will cost him £9,500 per annum (i.e. £5,000 lost W&T × 40 per cent plus 20% × £37,500).

However a detailed computation reveals the following:

	2015/16	2020/21
Salary	95,000	95,000
Property account:
Rent	50,000	50,000
Interest	(37,500)	–
Expenses	(7,500)	(7,500)
W&T	(5,000)	–
Property profit/(loss)	nil	42,500
Taxable income	95,000	137,500
Personal allowance: 10,600 @ 0%	0	n/a (lost)
31,785 @ 20%	6,357	6,357
52,615 @ 40%	21,046	–
105,715 @ 40%	–	42,286
Income tax reducer – £37,500 × 20%	–	(7,500)
Total	27,403	41,143

(For comparison purposes, this computation assumes that the personal allowance and basic rate income tax band in 2020/21 are the same as that in 2015/16)

Jimmy’s tax has actually increased £13,740. This is due to:

• Loss of tax relief on wear & tear – £5,000 × 40% = £2,000
• Loss of higher rate tax relief on interest – £37,500 × 20% = £7,500
• Loss of personal allowance – £10,600 × 40% = £4,240

The manner in which the interest relief restriction is applied can therefore have more tax impact than the restriction itself.

Incorporation?

When the dust had settled on the Summer Budget the knee jerk reaction was to incorporate residential property letting businesses. Highly leveraged portfolios will not be easily re-mortgaged in the current banking environment particularly as many are in negative equity and the days of 90 per cent BTL mortgages are long gone with lenders now typically requiring 40 per cent equity.

Landlords fortunate enough to have a mix of residential and commercial borrowings may be able to restructure and shift the majority of their borrowings onto the commercial portfolio.

Incorporation may be a viable option for some landlords. However having overcome the costs of re-financing their portfolio inside a corporate they will have a double tax charge with corporation tax on the property profit and income tax on profit extraction especially as the new dividend tax regime comes into force in April 2016. Some may prefer to let the net of corporation tax profits accumulate and hope that the rumours of the return of the dreaded ‘close company apportionment surcharge’ do not materialise!

Incorporation has also to be weighed up against the capital gains tax (CGT) cost of selling properties into a company however if the property business is actively managed it may to be possible to have it treated as a ‘business’ and secure CGT incorporation relief on the movement of the properties into the company by deferring the CGT via rollover into the base cost of the shares of the new company.

Stamp duty land tax

The final hurdle on incorporation is stamp duty land tax. The acquisition of the properties by the company will result in a stamp duty land tax liability however multiple dwellings relief may be available – this can reduce the stamp duty land tax cost by permitting an averaging method to be applied across a portfolio’s value rather than stamping each property on its individual value.

The Autumn Statement however added 3 percentage points to the rate of stamp duty land tax paid by those who already own property from April 2016.

As a result, the tax bill on a buy-to-let property costing £150,000 will jump tenfold from £500 to £5,000.

New buy-to-let stamp duty land tax (SDLT): How much extra will you pay?

Value of second property/buy to let (£)	Current SDLT (£)		SDLT from 1 April 2016 (£)	Increase (£)
150,000	500		5,000	4,500
250,000	2,500		10,000	7,500
350,000	7,500		18,000	10,500
450,000	12,500		26,000	13,500

Conclusion

The buy-to-let sector faces a turbulent tax future. Tax is set to go up significantly and this is highly likely to place upward pressure on rents which will have knock on social consequences as the UK is currently struggling to deal with a burgeoning homelessness problem.

In early December 2015, Fergus and Judith Wilson decided to sell their entire BTL portfolio. With a 900 house portfolio valued at £250 million, the Wilsons are the UK’s biggest landlord. They are now in their late sixties and have decided to retire. However, maybe the former maths teachers digested the 2015 Summer Budget and Autumn Statement and decided that as an asset class BTL no longer adds up?

Paddy Harty is a Director with PKF-FPM Accountants Limited. He is the current Chairman of the Institute’s Northern Ireland Tax Committee.

Email: p.harty@pkffpm.com

Website: www.pkffpm.com