A bitter pill for landlords

Effectively, the change is from tax on profits to tax on turnover – a controversial shift in the process of how tax works.  

This is part of the legal challenge being pursued through the courts to declare the new regime unlawful. BTL landlords are too easy a target, politically and economically, for the government to give up, so we expect to see the changes implemented in some form, even if the current approach is overturned.

The mechanics are subtle but significant.

From 2020, all income from BTLs (after deduction of operating expenses) will be taxed at the taxpayer’s marginal rate but mortgage interest will only be offset at basic rate (hence the hit on higher-rate taxpayers).  

The effect of this can be seen in the example in Table 1, based on a purchase of £650,000 with a £400,000 mortgage at 4.25 per cent interest and an annual income of £32,500. Annual running costs are 10 per cent of the rent: £3,250. Table 1 shows the position pre-April 2017 and how it will look once the new rules are fully in place post April 2020.  

Table one

Between 2017 and 2020 there will be a phased introduction, but when the changes are fully in place there is the possibility of almost doubling the tax on a typical investment. In some cases this could result in a net loss, with the total of mortgage interest and tax taking more out of the investment than the rent brings in. Table 2 uses the same figures as Table 1, but shows what can happen if the operational expenses increase to £10,000. for example, if it is necessary to replace the central heating system. 

Table 2         

Unlike commercial investments, the BTL mortgage market started with investors buying in their own names mainly to supplement their pensions, especially where saving in a traditional pension is restricted, and there has been little incentive to change.  

Now the mood has shifted. Corporate structures are not affected by this fiscal earthquake, and we are now seeing landlords looking to move personally held BTL portfolios into limited companies. Lenders seem more willing to lend into this market and it suits the owners to take advantage of the differential tax treatment.

At present, it may be possible to make this move in a way that is tax-neutral for capital gains tax and stamp duty land tax, but there are traps for the unwary.

For best effect the portfolio must move from a property investment partnership to a limited company owned by the same owners. The new company will issue shares to the investors in exchange for the properties, and no other payment or transfer will be made.

There are several pitfalls that need to be considered in this process and we explain some of the more significant issues below. First, for optimum tax relief, the properties must previously have been held in a property investment partnership (PIP). Problems arise where the property is held by a single individual, or where the property is a passive investment.  

There has to be an existing business, with owners involved at an operational level. Those who buy properties, hand them over to agents to manage and have no practical input may not qualify. Those who run advertising, viewings and lettings and arrange repairs themselves should do so. In the middle is a dividing line, but this is now a strong incentive to become more involved in the day-to-day operations.

It is also important that the transfer is a transfer of the business, rather than simply the properties. So, for example, if the PIP accounts show claims for equipment such as computers they must also be transferred to the company at the same time and as part of the same transaction.

Second, after the transfer, the limited company must be owned by the partners in the PIP, so agreement of all of the owners is required, and this should not generally be used as an opportunity for any owners to withdraw from the business.

Third, the transfer must take place in return for shares and nothing else. There may be good reason to consider releasing some equity, for example annual CGT exemptions, but if the transfer is for shares and any amount of cash – even £1 – then there may be tax to pay.  

Fourth, previous refinancing can raise problems. If the portfolio has been re-geared, it is possible that the value of the property net of debt may not be enough to allow full rollover of any capital gain. In this case, transferring the property would mean CGT has to be paid.  

The restriction on income deductions for finance costs may be a significant factor in reconsidering the optimum structure for a BTL portfolio, but there are other factors that will need to be considered.  

Although a company will not be taxed on profit that it does not receive, the individuals are likely to be taxed when they take profit out of the company. Even allowing for any dividends that may be tax-free, the overall tax on extracting profit from the company may outweigh the benefit of the company’s higher tax deductions, especially where the property is not heavily geared. Each case will need to be considered on its own merits.  

The transaction costs are not inconsiderable as they require a transfer of ownership and a complete restructuring of the funding arrangements, but for those with a long term interest in the residential BTL market, and who are not affected by high early redemption penalties on mortgages, the financial logic may well be unassailable.

There may also be other benefits to incorporation, such as the greater liquidity of shares. It can be easier to sell 10 per cent of a company than 10 per cent of a property, and it is easier to transfer shares in the company to family members in small tranches rather than shares in the property.  

The tax change is a bitter pill for landlords and the cost of a transfer that does not affect ultimate beneficial ownership will make that even harder to swallow. However, if the government sees significant movement in properties from personal to company ownership, there is the risk that it will move to tax the transfer so the early movers may well reap the greatest benefits. 

Peter Birkett is a senior associate in the real estate team and Leigh Sayliss a partner and head of tax at law firm Howard Kennedy

Key points

The impending changes to the taxation of income from residential buy-to-lets will hit higher rate taxpayers hard.  

From 2020, all income from BTLs will be taxed at the taxpayer’s marginal rate, but mortgage interest will only be offset at the basic rate.

Corporate structures are not affected by this fiscal earthquake.