Change to taxation of Landlords

Changes
to the Taxation
of Landlords
What Your Clients Need to Know

Introduction
The Chancellor unveiled a number of major
changes to the taxation of landlords at the
Summer Budget 2015 – brought into effect
under the Finance (No.2) Bill 2015 – with the
potential to significantly increase the tax
burden on property portfolios in coming
years.
The most significant change for landlords is
the capping of tax relief on mortgage
interest payments. This relief has been an
integral part of the growth in the buy-to-let
market, and a restriction will of course have
pronounced implications. As an indication,
an additional £665million in taxes is
expected to be levied on landlords in 2020
alone.
This hand-out is written to provide landlords
and their advisers with an awareness of
these changes and the implications, and the
steps that can be taken to help ensure that
property investments continue to perform in
this new tax context.

Current position
First the basics. Where property
portfolios are owned personally rental
profits are subject to income tax. In
calculating rental profits, under the
current rules landlords are allowed to
deduct the “finance costs” (primarily
mortgage interest payments) associated
with let property against their rental
receipts.
As a result of this favourable relief, highly
leveraged portfolios have often proved
commercially advantageous, with many
landlords focusing on reinvesting rental
profits into acquiring new properties,
rather than paying down existing debt.

Example
Additional Rate – Alex’s Current Position
Consider a landlord, Alex, paying tax at
the additional rates (i.e. 45%) owning a
highly leveraged portfolio, receiving
£200,000 per year in rent and paying
£150,000 a year on an interest-only
mortgage:
Here, even though Alex’s portfolio is
highly leveraged, it continues to be
profitable, in part due to tax relief
ensuring that any amount spent on
finance costs is fully deductible against
his rental income subject to taxation.
Rent:
Mortgage:
Tax Liability* at 45%:
Rental Profits:
£ 200,000
£(150,000)
£ (22,500)
£ 27,500
* The tax relief on mortgage interest
payments reduces the amount of rent
subject to tax to £50,000 (i.e. rent of
£200,000 minus £150,000 mortgage
interest payments), which in this example
is subject to tax at 45%.

Understanding the
changes
From April 6th 2017 onwards these rules
will begin to change. The relief on
finance costs will begin to be restricted
until tax relief will be available at the
basic rate of income tax (i.e. 20%) only:
- Tax Year 2017-18:
75% full finance costs relievable, 25%
restricted to basic rate tax deduction
- Tax Year 2018-19:
50% full finance costs relievable, 50%
restricted to basic rate tax deduction.
Significant additional costs will arise to
landlords as a result of these changes,
with the worst affected being those that
own property portfolios that are highly
leveraged.
It is important to note that, although the
relief will be restricted to basic rate, even
landlords that currently pay tax at basic
rate may find themselves significantly
worse off. See the example further in this
hand out for illustration.
- Tax Year 2019-20:
25% full finance costs relievable, 75%
restricted to basic rate tax deduction.
- Tax Year 2020-21:
all basic rate tax deduction

Example
Additional Rate – Alex’s Position from 2020
Alex, the landlord, still pays tax at the
additional rates on his highly leveraged
portfolio.
The new rules on the rules on
deductibility of finance costs are now
fully in place (i.e. from 2020-21 onwards),
but no changes were made by Alex to
adapt:
Rent:
Mortgage:
£ 200,000
£(150,000)
As a result of these new rules, Alex’s
property portfolio, which was previously
profitable, now makes a loss of £10,000
p/a.
Insufficient income is retained after tax to
make the mortgage payments, putting
the landlord in a precarious position. This
simple scenario highlights how the
changing tax context may affect the
viability of property investments unless
steps are taking to adjust to these
changes.
Tax Liability at 45%*:
Rental Profits:
£ (60,000)
£ (10,000)
* The tax calculation is now a little more
complicated. We first look treat the entire
rent as assessable on Alex (i.e. £200,000
@ 45% = £90,000) and deduct tax relief
on the mortgage payments as a “tax
reducer” at basic rate (£150,000 @ 20%
= £30,000), leaving a tax liability of
£60,000.

Example
Additional Rate – Bob’s Position 2016 vs.
2020
Let’s look at a different scenario, which
helps highlight how even basic rate
taxpayers can be significantly affected
by these new rules.
Bob, a landlord and retiree, receives
rental income from his property portfolio,
however, due to the significant mortgage
interest payments, and his lack of other
sources of income, the net rental profits
are low, and assessable to tax at basic
rate.
In 2016 the position is as follows:
Rent:
Mortgage:
Tax Liability at 20%
Rental Profits:
£ 150,000
£(125,000)
£ ( 5,000)
£ 20,000
As we can see, at the moment Bob’s
income from the rental portfolio is firmly
within his personal allowance / basic rate
band, allowing him to generate an
acceptable level income during his
retirement.
However, by 2020 Bob’s entire rental
income of £150,000 per annum will be
assessable to income tax, pushing him
well into the higher rates of tax.
Although relief on mortgage interest is
given as a “tax reducer” at 20%, this will
not fully offset the significant amount of
rental income that will be taxed at the
higher rates as a result of these changes.
Without any change to his investment
structure Bob will may find himself living
a much more frugal existence during his
retirement as a result.

Adapting to
the Changes
We have illustrated the implications of
these changes to the taxation of
landlords.
Let’s now take a look at some of the
options that are available for landlords to
adapt:
1. Deleveraging the Portfolio:
First, the most obvious “solution”. Many
commentators have touted the
deleveraging of property portfolios (i.e.
selling properties and using the
proceeds to repay mortgages) to be the
obvious solution for the worst hit
landlords. However, the difficulties
associated with this approach are often
overlooked.
Highly leveraged portfolios typically arise
from regular refinancing, the cash from
which is spent on growing the portfolio
further.
Where this has occurred over a number
of years of ownership and capital growth,
there may be insufficient equity – after
lending has been repaid – to meet the
costs associated with the disposal.
We now consider an example of the
implications of a sale of a highly
leveraged property.

Example
Disposals – Dan’s Position on Sale of
Properties
Dan, is a higher rate taxpayer who is selling part of his portfolio to help
deleverage. The property in question has been owned since 1990, during which
time the value has increased from £100,000 to £350,000. Dan has regularly
refinanced and used these funds to expand his portfolio, with the property
currently subject to a mortgage of £300,000. The implications of a sale are
detailed below:
Tax Position:
Overall Position:
Proceeds on sale:
£ 350,000
Proceeds on sale:
£ 350,000
Base cost:
£(100,000)
Mortgage Repayment:
£(300,000)
Taxable Gain
£ 250,000
Taxable Gain
£ 250,000
CGT @ 28%:
£ (70,000)
CGT @ 28%:
£ (70,000)
This represents a net loss of £20,000 on sale of the properties.
We can see that, for Dan and other landlords in this position, a sale of a property
isn’t always going to improve the position (and can even make matters worse).
Unfortunately those worst hit by these changes – landlords with highly leveraged
property portfolios – will be those with the least flexibility to reduce lending.
Clients are advised to look closely at their portfolio when identifying suitable
properties for disposal, in light of the tax as well as commercial implications.
As a final thought in this area, it is worth considering that improving the equity to
lending ratio on property portfolios may ultimately not be the decision of the
landlords. Given the implications of these changes on profitability of rental
investments, lenders are expected to become more stringent in their lending
criteria.

Adapting to
the Changes
Continued...
We have illustrated the implications of
these changes to the taxation of
landlords.
Let’s now take a look at some of the
options that are available for landlords to
adapt:
1. Deleveraging the Portfolio:
First, the most obvious “solution”. Many
commentators have touted the
deleveraging of property portfolios (i.e.
selling properties and using the
proceeds to repay mortgages) to be the
obvious solution for the worst hit
landlords. However, the difficulties
associated with this approach are often
overlooked.
Highly leveraged portfolios typically arise
from regular refinancing, the cash from
which is spent on growing the portfolio
further.
Where this has occurred over a number
of years of ownership and capital growth,
there may be insufficient equity – after
lending has been repaid – to meet the
costs associated with the disposal.
We now consider an example of the
implications of a sale of a highly
leveraged property.

Example
Incorporation – Iain’s Position from 2020
with Incorporation
In the earlier example we saw that these
changes resulted in the landlord, Alex,
being unable to meet their mortgage
payments by £10,000 per year. Let’s take
a look at Iain, a landlord in the same
scenario, who instead chose to
incorporate his portfolio:
Rent:
£ 200,000
* As there is no restriction for tax relief for
companies, the mortgage interest
payment reduces the amount of rent
subject to tax to £50,000 (i.e. rent of
£200,000 minus £150,000 mortgage
interest payments), which in this example
is subject to tax at 18% (the reduced rate
effective from 2020/21).
Mortgage:
Tax Liability at 18%*:
Rental Profits:
£(150,000)
£ (9,000)
£ 40,100
We can see that the property portfolio of
Iain is significantly more profitable than
Alex’s in 2020-21, with the only difference
being that incorporation has taken place.
It is important to note that, due to the
limited liability nature of corporates,
banks will often look to impose more
costly interest terms, which can increase
the costs of lending. Furthermore, if the
rental profits were extracted via
dividends further tax would be due (and
readers may be aware that the taxation
of dividends also saw change in the
Budget). However, depending on the
scenario (and certainly where the profits
are reinvested rather than extracted), the
additional tax may be small or nil.

Considering
Incorporation?
Two important questions must be
considered when discussing the
incorporation of a property portfolio:
1. Will incorporation be more efficient
than personal ownership?
2. What costs will be incurred in
incorporation?
Looking at the first question, in
considering whether incorporation is a
better structure than personal ownership
there are a number of points that must be
considered:
- Does the client require the income for
subsistence, or would prefer it was
retained / reinvested in the property
business?
- Are they a basic, higher or additional
rate taxpayer?
- How highly leveraged is the portfolio,
and therefore, how affected might your
client’s property portfolio be by these
changes?
- Are they primarily focused on reducing
costs, or are the other advantages of a
limited company (such as limitation of
liability) also considered attractive?
If there’s one thing we’ve learned on
advising landlords over the years, it’s that
there really is no one-size-fits-all
approach to advice in this area. Only by
ensuring the landlord discusses their
objectives in detail with an experienced
practitioner is it possible to determine the
right investment structure.
Next, when determining the costs on
incorporation, we must first mention that
we can’t go into detail. However, in
general terms, alongside the set up and
compliance costs of a company (which
are not too expensive), a transfer of
property into a limited company would
typically result in capital gains tax and
stamp duty land tax consequences (as if
it were a market value sale to a third
party).
This can be costly. However, statutory
reliefs are available to reduce – or even
eliminate – these tax charges where
certain conditions are met and, where
appropriately structured, additional tax
advantages can arise, such as an uplift
in base cost of the properties. It’s
important to note that this is all about
making use of tax reliefs in the way they
are intended in light of recent case law
and HMRC practice.

Adapting to
the Changes
Continued...
We’d always recommend professional
advice is taken from a tax specialist
when considering these matters to
ensure the appropriate structure is
identified and implemented without
incurring unnecessary tax charges.
OneE would be happy to assist in this
area, and have expertise which can
assist not only with mitigating the
potentially significant effect of these
punitive new tax rules, but can also
proactively assist clients with their
succession / estate planning objectives,
and/or planning for future disposals.

Other changes to
Property taxation
In other news, wear and tear allowance
(worth 10% of gross rental receipts for
landlords of furnished accommodation)
is to be abolished from April 2016
onwards. It will be replaced with a
deduction for costs as they actually incur
on replacement – notably no deduction
will be available on initial purchase. This
was a significant tax relief for landlords,
given that it was offset against gross
rental receipts. It will no doubt be sorely
missed, and may factor into the
decisions of landlords over whether to
offer furnished accommodation in the
future.
There is some good news for property
owners – after many years of being fixed
at £4,250, rent-a-room relief is to be
increased to £7,500 per annum.
Rent-a-room relief applies to income from
providing furnished residential
accommodation in the taxpayer’s only or
main home, i.e. lodgers.

Final thoughts
In summary, the recent changes to the
taxation of property portfolios are broad in
scope and will significantly alter the
economics of property investment.
The new rules will be brought in gradually,
and although plenty of time is available to
plan ahead, we’d recommend landlords
consider the implications at the earliest
opportunity. Only by doing so can they
remain ahead of the curve, and continue to
maintain healthy returns on their
investments.
As a specialist tax advisory firm in the area
of property taxation, OneE are always on
hand to discuss individual scenarios on a
no-obligation basis, and help identify the
most suitable options. If your client may be
affected by these new rules, and would like
expert advice, please do not hesitate to get
in touch.