Welcome to the second issue of Property Trends the monthly bulletin that focusses on property trends for residential property investors.
This month I look at the Section 24 tax – also known as ‘the Alice in Wonderland tax’ and ‘the turnover tax’. It is a tax which is being phased in over 4 years from the tax year 2017-18. As we will go into the second tax year this month, it is a good time to look at the tax and consider what effects it may be having and how investors can meet the huge challenges it presents.
FOCUS ON THE ALICE IN WONDERLAND TAX
The Alice in Wonderland tax – also known as the Section 24 tax and the turnover tax to give it but two of its names – refers to the decision of the government to restrict the amount of income tax relief individual landlords can get on finance costs to the basic rate of tax.
This is achieved by progressively reducing the amount of finance costs (typically mortgage interest) that can be deducted from rental income.
On the government’s website www.gov.uk under ‘Policy objective’ we are told the change is to ‘make the tax system fairer’ and ‘This will ensure that landlords with higher incomes no longer receive the most generous tax treatment.’
Change being phased in over 4 years from April 2017
The change is being phased in over 4 tax years, starting in 2017-18. The amount of finance costs that can be deducted from rental income reduces from 100% in the tax year 2016-17 to 0% in the tax-year 2020-21. We move into the second tax year of the changes this month.
The changes apply to individual landlords not corporate landlords. If a property is held by a limited company the deduction of finance costs remains at 100%.
How the changes are taking effect
· Tax year 2016-17 – before the change; 100% of finance costs deductible from rental income
· Tax year 2017-18 – 75% of finance costs deductible from rental income; 25% available as a basic rate tax reduction
· Tax year 2018-19 – 50% of finance costs deductible from rental income; 50% available as a basic rate tax reduction
· Tax year 2019-20 – 25% of finance costs deductible from rental income; 75% available as a basic rate tax reduction
· Tax year 2020-21 – 0% of finance costs deductible from rental income; 100% available as a basic rate tax reduction.
In simple terms, you get a basic rate tax credit (currently 20%) on the amount that is not deductible.
Example of how the changes could pan outNote 1 – The gross profit in each year is £5,000
Note 2 – The profit reduces by 66.66% over the 4 years
This example is of course for illustrative purposes only and does not take account of possible changes in the various variables – such as tax rate, tax band, property running costs, rent and mortgage interest – which may impact on the overall tax position.
What are the effects of the changes?
The profits of many BTL landlords will be greater as a result of being able to deduct less of their financial costs and so they will be liable to more tax. Some will pay tax when they paid none before; some will be pushed into a higher tax band. Some will have a tax bill greater than their profit – and that is where the tax goes into the realm of fantasy – hence the name ‘Alice in Wonderland tax.’
What can be done about the changes?
DO NOTHING – This is obviously not the greatest of responses. Your income tax may increase and you could increasingly lose out financially as a result of your inactivity.
INCREASE RENTS – This option clearly has pros and cons. Will the market allow you to increase rents? Will your tenants be able afford any increase?
SELL UP – This may or may not be attractive depending on your situation; if you have been holding property for many years, a sale may lead to huge capital gains and liability to eye-watering capital gains tax.
TRANSFER TO A LIMITED COMPANY – As the tax changes do not apply to properties owned by a limited company, you could transfer any property you own to a limited company, if it is tax efficient to do so. However, transferring to a limited company could involve a range of costs and expenses including payment of capital gains tax, stamp duty and legal fees.
Effect on remortgaging strategies
Some buy-to-let investors have a strategy whereby they remortgage on a regular basis, raising capital for further investment or to assist with overheads or income.
However, increasing borrowing becomes less attractive under the new rules. As the percentage of finance costs you can deduct decreases, your tax liability is likely to increase. Higher borrowing could push you from profits to losses.
Impact of the changes to date
There are several indicators that the tax changes are bringing about changes in the market.
LOWER MORTGAGE ACTIVITY BY BTL LANDLORDS – According to the Council of Mortgage Lenders (CML), buy-to-let activity nearly halved in the year after the announcement of the Section 24 tax changes. CML expects lending to BTL landlords to decrease in 2018 compared to 2017.
According to a report last month by IMLA, the trade body of lenders, money raised to invest in BTL fell a huge 80% from 2015 to 2017.
An article in the Economist published in December of last year simply read ‘Britain’s buy to let boom is coming to an end’.
FALLING YIELDS – Figures from the Bank of England in September of last year found yields at below 5%, the lowest figure since records began in 2001.
FEWER BUY TO LET LANDLORDS – There is a clear and growing impression that the number of buy to let landlords is falling. In a report out last November estate agents Savills predicted that buy to let purchases would fall by 27% over the next 5 years.
In the same month Lucian Cook, Savills’ research director highlighted the ‘first real evidence that some investors are shedding stock’.
A growing number observers are now talking about ‘buy-to-lexit’.
Anecdotal evidence suggests BTL landlords are moving from residential property to commercial property to mitigate the impact of the negative tax changes.
Of course the prospect of higher income tax on rental properties is not the only threat to the buy-to-let market. In recent years there have been other body blows including:
· The 3% stamp duty surcharge on buy to let properties
· The ending of landlord’s 10% wear and tear allowance
· More stringent mortgage affordability tests.
Whatever the reasons, there does appear to be a clear and perhaps growing trend that BTL landlords are exiting the market.
At the same time as BTL landlords seem to be in retreat, first-time buyers seem to be on the march.
NUMBER OF FIRST TIME BUYERS INCREASING – According to the Halifax First- Time Buyer Review released in January 2018, there were 390,000 first time buyers in 2017 – a 6% increase in the previous 12 months and the sixth consecutive year of growth. The growth occurred even though deposits have been increasing.
The number of first time buyers was a little short of the 2007 total.
However growth was not nationwide. In London and the North the number of first time buyers actually fell.
Overall, there is little doubt that first time buyers are increasing and BTL investors are decreasing. The signs are that this trend will continue. The future for BTL investors is far from bright.
What can you do?
The steps you can take to protect your position or minimise risk will of course depend on your own specific circumstances.
However all current and potential BTL landlords should conduct a full, honest and far-reaching consideration or review of their property goals and plans, identifying the likely impact of not only the Section 24 tax changes but also the other financial body blows of recent times.
It is good practice to seek expert advice to identify the best way forward for you. Engaging advisers involves expense, but in a fast-changing, difficult and complex property environment the cost of not engaging advisers may prove more costly.
IF YOU DON’T OWN A BTL PROPERTY – If you are not yet in the BTL market it seems essential to speak to an expert or two before taking the plunge; looking not only at issues of affordability, profitability and growth but also taxation.
You should carefully assess if there are forms of property investment more tax-efficient than residential BTL. You also need to decide if you should buy as an individual or through a limited company.
IF YOU OWN ONE BTL PROPERTY – 6 out of 10 BTL landlords own just one property. Many are ‘accidental’ landlords. If you have just the one property, the general view is that you are under greatest threat by the changes.
The ever-growing regulatory burden on landlords particularly impacts on landlords with just one property. Often it is not cost effective for them to develop the level of knowledge and professionalism increasingly expected of landlords. If they are in employment, the cut in mortgage interest relief could push them into a higher tax band.
BTL landlords with just one property need to take a long and realistic look at their future in the buy-to-let market – asking themselves if it is worth it – speaking to an accountant or tax adviser as to how the tax changes may affect them once the effects of the mortgage interest relief changes are fully in place in the1920-21 tax year.
IF YOU OWN MORE THAN ONE BTL PROPERTY – The more buy-to-let properties you own, the more complex and challenging your decision making. Your portfolio may be too highly geared to keep it profitable going forward. It may or may not be financially viable to transfer your properties to a tax-efficient limited company or business structure.
If you are a ‘portfolio landlord’ with mortgages on 4 or more properties, your ability to buy new properties or remortgage may be curtailed.
With more than one property you will have the potential to take on the regulatory and taxation challenges and develop to become the professional landlord which the government clearly wants all buy-to-let landlords to be. However, do you have the time, inclination, resources and temperament to be a professional landlord?
The key thing is to conduct a thorough assessment and audit of your property objectives and portfolio now – before the tax changes take full effect – before the avenues and options available to you are closed – perhaps permanently.
PROPERTY DIARY 2018
Here are some key matters those in the residential letting sector should be aware of in 2018:
Energy Performance certificates
From 1st April 2018 landlords (residential and commercial) must not renew a tenancy or grant a new tenancy where the EPC rating is below E, unless the landlord gets an exemption.
From 1st April 2020 a residential landlord must not continue to let a building which has an EPC rating below E unless the landlord gets an exemption. In the case of commercial property, the compliance date is 1st April 2023.
Breach by a landlord can lead to a penalty of £5,000 to £150,000
Year 2 of the restriction of mortgage interest relief
This year, we will be into the second year of the phased reduction of mortgage interest relief for BTL landlords owning property in an individual capacity. There will be further upward pressure on their tax bill as a greater share of their profit becomes taxable.
Such landlords, if they have not yet done so, would be well advised to seek expert advice as to whether it would be beneficial to hold their properties in a limited company structure – which retains the tax benefit of full deduction of mortgage interest.
Limited company mortgages
Expect the number and affordability of BTL mortgages to limited companies to improve further in 2018. In November of last year, one of the big high street lenders Nationwide (through its BTL arm TMW) began a pilot to lend to limited companies.
As more and more BTL investors are operating through limited companies, other major players can be expected to join TMW, increasing competition and reducing the cost of corporate mortgages, both in terms of interest and fees.
Extension of HMO licensing
From 1st October 2018 the definition of a HMO will be widened to cover any property occupied by five or more people forming two or more households.
The new definition will bring in many two-storey student houses which previously were not affected.
The owners of affected properties will need to prove that they are ‘fit and proper’ to hold a licence and the properties will need to meet strict minimum requirements aimed at improving overall standards and safety of lettings.
If you own a property to which the new rules may apply, it is obviously sensible to plan now for the likely financial expense of compliance.
Ban on leasehold houses
The government has decided to ban the controversial practice of selling new houses as leaseholds – often with rapidly escalating ground rents. The practice caused public outcry when exposed by the media as little more than a device to add additional income streams for developers and builders.
It is expected that home buyers will no longer be obliged to pay a ground rent.
The changes will require legislation, and that seems likely later this year.
Ban on letting agent fees
It seems very likely that the planned ban on letting agent fees (payable by tenants when looking for a property to rent) announced in 2016, will finally take effect this year
WANT THIS NEWSLETTER TO BE SENT TO YOU EVERY MONTH? IF SO, PLEASE SUBSCRIBE.
Rebel Property Coach
DISCLAIMER: This bulletin, which is provided for information purposes only, is fully intended to be accurate but no representation as to its accuracy is intended. It does not provide legal or any other advice to be relied upon. All liability to all persons acting or not acting on anything in this bulletin is disclaimed. NOTE: Where you require advice to rely on in any matter, it is best practice to consult and retain a suitably qualified expert in the relevant field.