In the Budget three months ago, George Osborne announced a number of changes on the taxation of income from property, but didn’t give any details as to how the changes might affect you if you are a landlord.
Now that the Finance Bill has been passed in the House of Commons, the detailed rules have been published, so here they are:
1.Increase in rent a room relief
Rent a room relief is available to householders who rent space in their own home and might more appropriately be called “lodger relief” as it does not restrict the relief to a single room.
Under the relief, the property owner can choose how to be taxed on the income he receives from a lodger. He can choose to be taxed only on the amount of rent received in excess of the financial limit, or he can compute the “profit or loss” from his letting activity and be taxed on that instead. For most people taking in lodgers the exemption is the simplest and often the cheapest method for them.
The amount of the relief will rise from £4,250 to £7,500 from April 2016. Small B&B establishments will also benefit as they can claim the relief too, provided the owners live on the premises. This increase is an above inflation rise over the period from April 1992 when the allowance was introduced. Updating in line with inflation to today would bring the allowance to £6,854.
2. Removal of the wear and tear allowance
Landlords letting furnished properties are permitted to claim a tax deduction of 10% of the rent received each year to cover the cost of replacing furniture; this is known as the wear and tear allowance. They can also claim when they replace things like crockery, utensils and linen, as and when they spend the money.
From April 2016 the wear and tear allowance will end, to be replaced by a deduction for landlords when they actually spend the money. It remains to be seen whether the deduction for money spent will apply to all expenditure, including that on kitchen appliances such as ovens, and whether it will be subject to a “cap”. Landlords of partly furnished properties were stopped from claiming for the replacement cost of white goods in 2013 – a move that has been very unpopular. Some of those landlords have now started to provide fully furnished homes – so they will be very disappointed if their tax relief is restricted.
3. Restriction of tax relief on interest
At present, full tax relief is available for interest on a loan used in a property business at your highest rate of tax; but from April 2017, tax relief on interest in property businesses (including single buy to lets) will be restricted so that by 2020, interest will not be an allowable expense in computing the profits of the business, but will attract tax relief at 20%.
This will have very little effect on landlords that have a low level of interest in relation to the borrowings, especially if they’re 20% taxpayers; but larger property businesses using debt to expand the portfolio will find that their business model has been effectively blown out of the water.
Example 1: Single buy to let
Joe is a HR manager and is 55 years old; he is a 40% taxpayer. He has purchased a buy to let property as an investment as part of his retirement planning. As he has owned the property for some time, the outstanding debt on the property is relatively low. Here is the effect of the change:
| 2016-17 | 2020-21 | |
| Gross rents | £7,200 | £7,200 |
| Repairs and other tax deductible costs | £1,000 | £1,000 |
| Interest on mortgage | £2,500 | – |
| Net rental profit | £3,700 | £6,200 |
| Tax at 40% | £1,480 | £2,480 |
| Less interest relief at 20% on £2,500 | £500 | |
| Net tax liability on rental income | £1,480 | £1,980 |
| Tax Increass | £500 | |
| Effective rate on “real” rental profit | 40% | 53.5% |
If Joe decided to increase his borrowings to allow him to buy a second buy to let, he would see his tax rate rise still further.
Example 2: Substantial property portfolio
John and Julie are married and together run a sizeable rental property business. They have not run this through a limited company due to the difficulty in obtaining finance for purchases with limited company status.
| 2016-17 | 2020-21 | |
| Gross rents | 600,000 | 600,000 |
| Repairs and other tax deductible costs | £200,000 | £200,000 |
| Interest on mortgage | £350,000 | – |
| Net rental profit | £50,000 | £400,000 |
| Personal allowances (x2) | £22,000 | – |
| Taxable income | £28,000 | £400,000 |
| Basic rate tax (2 taxpayers) | £5,600 | £17,200 |
| Tax at 40% | – | £85,600 |
| Tax at 45% | – | £45,000 |
| 147,800 | ||
| Less interest relief at 20% on £350,000 | – | £70,000 |
| Net tax liability on rental income | £5,600 | £77,800 |
| Tax Increase | £72,200 | |
| Effective rate on “real” rental profit | 11.2% | 144.4% |
Although John and Julie spend at least 35 hours a week on the business (and their cash return is modest) that is because they have ploughed most of their profits back into building up the portfolio, and taken risks to allow them to grow their business. Their current business structure is now clearly unsustainable.
Possible Solutions
Landlords have until 6 April 2017 to start addressing this issue, as the relief will then be phased out over four years, but some careful thought will be required. In many cases the landlord may have little choice but to sell their let properties, unless they have other resources from which to reduce their borrowings. Other landlords may be able to restructure their lettings business in one of the following directions:
- sell residential property and reinvest in commercial buildings
- slet the residential property as furnished holiday lettings
- stransfer the properties into a company.
Any of those options will allow a full deduction of interest and other finance costs from the rents received, but the transition will involve CGT and SDLT (LBTT in Scotland) costs. Also the mortgage provider must co-operate with the transfer of loans to a company, and it may require higher rates of interest on a corporate loan.
CGT liabilities
The sale of the properties, or transfer into a company controlled by the individual, will generate capital gains. CGT will be due unless those gains can be covered by a relief. Unfortunately, most CGT reliefs (entrepreneurs’ relief, business asset roll-over) can’t be used for gains made within a property letting business, as letting is not regarded as a “trading business”.
Where there are a small number of properties carrying relatively low gains those could be transferred or sold gradually, and the gains covered by the taxpayer’s annual exemption for each year (£11,100 for 2015/16). Where a property is held in joint names the annual exemption of both owners can be set against their proportion of the gain.
If the entire property lettings business is transferred to a company in one go, in return for shares, incorporation relief may be available to roll the gains into the value of those shares. Incorporation relief can apply to a significant property lettings business and a claim isn’t required as incorporation relief is applied automatically if all the conditions are met.
David Jones is the Senior Partner and Founder of Morgan Jones & Company. Born in Liverpool and an Accountancy graduate of the University of Wolverhampton, David spent twenty years working for the Customs & Excise in London then Shrewsbury before starting his own business. David's depth of knowledge of the UK tax system and his ability to communicate this learning has seen Morgan Jones & Company grow into Shropshire's most respected Accountancy Practice.