Many landlords will be weighing up their options in light of the new regime to restrict tax relief for interest costs. Some of those who decide it’s cheaper to ‘sell up’ may have a nasty surprise in store.
The new regime for restricting income tax relief on the finance costs of buy-to-let (BTL) properties threatens to punish many residential property businesses, to the extent that some landlords will almost certainly conclude that they are better off either fully or partly selling up and exiting the BTL sector. Unfortunately, the costs of exit may prove prohibitive.
The new regime applies only for income tax purposes, so companies are largely unaffected. While it is potentially possible to incorporate a property business relatively tax-efficiently, some portfolios will not be suitable, and in other cases landlords may wish to shed certain properties before incorporating the remainder.
Risks vs rewards
Rationalising a rental property business may allow the landlord to pay down some or all of the debt that generates the finance costs at the heart of the problem. This must, however, be weighed up against the costs incurred on the property disposal:
- negative equity and a depressed market;
- finance cancellation costs; and
- capital gains tax.
Whilst one factor may be manageable on its own, it will probably be a combination of factors that will see the worst outcomes.
Negative equity and a depressed market
While many areas in the UK have more than ‘bounced back’ from the depths of the recession in 2008/09, it has been reported in the press that house prices in 53% of towns and cities were still below their peak 2007 values, with a particular concentration in the North of England. The average house price in Liverpool at the beginning of 2016, for example, was 23% down on the 2007 figure.
Given the current economic uncertainty over Brexit, it seems unlikely that house prices will have fared significantly better by the end of this year. If, as some fear, a large proportion of landlords are forced to sell properties as the new regime starts to bite, BTL property values may be harder hit as availability rises and appetite wanes. It is to be hoped, however, that given enough time, property values will more than recover.
Where landlords have historically re-mortgaged to maximise the capital that they can then apply to finance additional property acquisitions (which is very common), they may well find they are stretched on their borrowings, against even a relatively small reduction in market value.
Finance cancellation costs
A further potential problem is the cost of cancelling mortgage deals early, within a discount or similar period. One of the key saving graces of the recent recession has been that interest costs have been low and stable, allowing some landlords to tread water over the last few years in spite of negative equity. Some deals, however, have long clawback periods that trigger financial penalties if the mortgage is settled too soon.
This issue is not necessarily limited just to discount periods over the first few years of a mortgage term: some agreements trigger penalties if ‘too much’ of the outstanding capital (say more than 10%) is paid off in one go, broadly over the life of the loan.
On the plus side, such penalties are usually tax-deductible – in this regard non-corporate property businesses follow trading rules and as such would normally fall within the scope of an expense incurred ‘wholly and exclusively for the purposes of obtaining the finance, providing security for it or repaying it’ (see HMRC’s Business Income manual at BIM45815 and BIM45820). Of course, even these tax-deductible finance costs will be subject to the new restriction.
Capital gains tax
It seems that Mr Osborne was determined to milk landlords for every penny that he could: aside from the new interest restriction regime, he arranged for capital gains tax (CGT) on dwellings to remain at 28% while practically everything else was reduced to 20%. It seems doubtful that this was mere coincidence. Of course, most homeowners will be able to avoid CGT thanks to ‘only or main residence relief’; a point strangely overlooked when the former Chancellor was busy claiming that he was introducing the interest restriction to create a ‘level playing field’ for homeowners and landlords in business. The 28% CGT charge will most likely fall most often on BTL landlords.
The (now) special 28% rate will potentially apply even if the property is no longer a dwelling at the point of sale, so long as the property has been a dwelling for a period during the landlord’s ownership.
It would be unsafe to assume that these problems cannot arise in the same property.
Example: Out of pocket on property sale
Philip is a 40% taxpayer, and has a small property portfolio. He bought his first property 20 years ago, for £60,000. It has accumulated in value over the years, and he has re-mortgaged on several occasions to finance further property business acquisitions. At its peak in 2008, the property was worth £225,000, and Philip had borrowed £180,000 against it, on an interest-only mortgage. The property’s value slumped in 2008 and even now is worth just £190,000. However, Philip wants to sell the property quickly, to pay off his mortgage and avoid a significant hike in tax costs.
Let’s assume that Philip has already used his CGT annual exemption, and the property has been used as a dwelling for all of the time that Philip has owned it. Philip will have to pay £3,000 in agents’ and solicitors’ fees just to sell the property.
Philip’s lender wants to charge a 3% early settlement penalty:
£180,000 x 3% = £5,400.
So, Philip would have to pay £5,400 in redemption penalties leaving him with:
£190,000 - £3,000 selling costs - £5,400 redemption penalty = £181,600.
Philip therefore has enough money to pay off the loan of £180,000, leaving him with £1,600.
Unfortunately, sometime later, he will have some CGT to pay as well.
Costs of Sale 3,000
Net Proceeds 187,000
Improvements (say) 12,000
Acquisition costs 50,000
Net gain 125,000
Taxed at: 28%
CGT due: 35,000
Philip therefore has a CGT bill of £35,000 to settle on the property (assuming he has used his CGT annual exemption already). But he has only £1,600 cash left, after paying off his other bills on the property, leaving him £33,400 out of pocket.
It could be argued that Philip will save £5,400 x (40% - 20%) = £1,080 in income tax, thanks to the extra income tax relief he will get on his early repayment penalty. But he will still be more than £32,000 down on that single property – despite substantial capital growth – and he will have to weigh that net deficit against the increased annual income tax cost of paying finance charges against that property.
If we assume that the interest cost is £8,000 annually, then by 2020/21, when the interest is fully disallowed, it will cost him £8,000 x (40% - 20% basic rate tax relief still allowed) = £1,600 a year.
Some landlords are still struggling with negative or substantially reduced equity, together with high gearing and early redemption penalties.
In this scenario, Philip faces a dilemma. If he sells that one property now, he will be roughly £32,000 out of pocket – although he will save himself £1,600 a year of increased tax cost, indefinitely. But if he can afford to suffer the additional tax cost of finance, and he believes that the property will ultimately claw back the value lost in the last few years, then he could be better off biding his time.
Assuming the tax regime stays reasonably constant over the next several years, Philip will have to hope that property values will grow and that interest costs will not rise significantly. If he can recover the value reasonably quickly without it costing too much tax and interest, then it may well be worth postponing the disposal. Philip needs to evaluate his portfolio on a property-by-property basis: if one of the properties that he has re-mortgaged to buy is standing at a lesser gain, then he may be able to pay off a good chunk of his overall borrowings without triggering such a substantial CGT cost.
This article was first printed in Property Tax Insider in December 2016.