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Landlord clients? How to tackle tricky world of property tax

Andy Woollon, 01 May 2019

With numerous property tax changes already in place (and more due in 2020/21), there are a number of opportunities for advisers to help clients...

Homes

Whenever I ask a roomful of advisers if any of their clients are landlords or own second properties – and I often do – most of the hands in the room shoot up.

Which tells me there is both a very real advice need for these clients, and work for me to do to help advisers navigate an evolving space.

The world of the landlord is changing. Research suggests that, over the next two years, 15% are considering either reducing their number of rental properties or getting out of the rental market altogether, largely due to legislative changes.

The same study found that 59% of landlords are aged 55 or over, and a third are retired.

With a number of tweaks to the tax system due to arrive in April next year, the considerations (and opportunities) for advisers are numerous. As we shall see.

A variety of tax rules

For the Treasury, residential and commercial property make attractive tax targets. Unlike individuals and companies, bricks and mortar can’t cross borders in search of lower tax rates (as owners sometimes do).

For proof, consider the fact that business rates, council tax and property transaction taxes (stamp duty and the like) are projected to raise £80.2 billion in 2019/20, more than 10% of the total tax take. To that can be added tax on rental income and capital gains tax (CGT) on disposal profits.

Property investors face a variety of tax rules, many of which have been – and still are – in a state of flux.

The basic property regime

Property income is essentially taxed as a form of business income with a range of allowable expenses that can be offset against rental income.

These expenses have to be ‘wholly and exclusively’ incurred for the rental business (such as insurance, water rates, general maintenance/decoration and the costs associated with lettings).

Mortgage interest is an allowable cost, but whereas it can be fully set against rent for commercial property lettings (and any lettings made by a company), different – and changing – rules apply for individually owned buy-to-let (BTL) residential property.

Residential buy-to-let

This is an area which has undergone a series of reforms since April 2016, aimed at angling the playing field more towards the first time buyer than the BTL investor.

The first major change, from 2016/17, was the replacement of the wear and tear allowance (broadly speaking a 10% allowable deduction of the net rent from a furnished letting) with a more restrictive allowance based on actual – as opposed to hypothetical – expenditure on replacement furniture.

A year later, the first stage of a phased restructuring of mortgage interest relief took effect. This gradually replaces the ability to offset finance costs against rent with a tax deduction equal to 20% of the interest paid.

In 2019/20, the final year of the phasing process, only 25% of interest can be offset against rent, with the balance attracting the 20% tax deduction. From next tax year, only the 20% tax deduction will apply.

The move to the tax reduction approach means the amount of taxable rent increases, all other things being equal.

As a result, some BTL investors have suddenly found their total income triggering one or more of the various frozen thresholds littering the UK income tax system (£50,000 for the high income child benefit charge, £100,000 for personal allowance tapering or £110,000/£150,000 annual allowance taper limits).

One response to this additional income problem has been an increase in the use of companies to hold newly purchased BTL property with income drawn as required in the form of dividends.

However, with a dividend allowance of only £2,000 and the potential for both corporate and personal tax on gains, this strategy has its own drawbacks.

Another response has been to sell up, or at least consider the option of doing so. This may be one explanation for the recently reported 19% rise in CGT receipts between 2017/18 and 2018/19.

Furnished holiday lets

Special tax rules apply to a property that qualifies as a furnished holiday letting (FHL). To qualify, the property must be in the UK or European Economic Area (so a Spanish villa qualifies, but not a Florida apartment). It must also be furnished and, finally, it must meet three occupancy conditions:

1 The property must let commercially as furnished holiday accommodation to the public for at least 105 days in the year (normally taken as the tax year), with lets of more than 31 days generally excluded;

2 The property must be available for letting for at least 210 days in the year; and

3 Lettings that exceed 31 continuous days cannot total more than 155 days in a year.

If these requirements are met, a FHL offers a range of benefits, including:

1 Profits are treated as earnings for pension purposes;

2 Business rates will apply rather than council tax. However, small business rate relief means that there is nothing to pay if the property has a rateable value of no more than £12,000, with tapered relief applying up to £15,000 of rateable value;

3 Plant and machinery capital allowances can be claimed for furniture, equipment and fixtures;

4 If the letting activities amount to a business rather than simply an investment, class 2 national insurance contributions are payable, giving entitlement to contributory state benefits, including the single tier state pension; and

5 Various CGT reliefs, such as business asset rollover relief and entrepreneurs’ relief are available.

Rent-a-room relief

This relief was introduced in 1992 with the aim of stimulating the supply of low cost rented accommodation. It applies to owner occupiers and tenants who sublet all or part of their main home on a furnished basis, whether or not the letting amounts to a trade (e.g. food and cleaning is provided).

The relief exempts £7,500 a tax year of gross receipts from tax (£3,750 each for joint owners/tenants). If gross income exceeds £7,500, then the basic property regime described above will apply unless the taxpayer opts instead to pay tax on the excess gross income above the £7,500/£3,750 limit and ignores any claims for expenses.

In 2017 the Treasury published a consultation paper suggesting a radical revamp for rent-a-room relief after 25 years of existence. The paper’s unspoken targets were users of Airbnb and those Wimbledon residents who go on holiday during the Championships fortnight and let their home for a high, mostly (or completely) tax-free rent. A proposal to introduce a ‘shared occupancy test’ that would have effectively prevented a claim if an entire property was let reached draft legislation stage but was then abandoned, to the relief of many.

Property allowance

The property allowance was introduced in 2017/18. It operates in a similar way to rent-a-room relief, but instead of exempting £7,500 of gross property income from tax, the property allowance exemption is just £1,000 per tax year.

If gross property income exceeds £1,000, then the taxpayer has the choice of paying tax on the excess or using the basic property regime. Unlike rent-a-room relief, the £1,000 is not halved for joint ownership.

There are several restrictions on the use of the property allowance. For example, it cannot be claimed for:

1 Income that would otherwise qualify for rent-a-room relief if the individual had not chosen to be taxed on the standard basis;

2 Distributions from a property authorised investment fund (PAIF); and

3 Property income distributions (PIDs) from a real estate investment trust (REIT). 

In terms of capital taxes and property, two need to be considered...

Capital gains tax

Since 2016/17 there has been an 8% surcharge on the rate applied to residential property gains, making the rates for 2019/20 18% (below UK higher rate) and 28% (UK higher and additional rate).

Currently, CGT is generally payable on 31 January in the tax year of assessment following disposal (31 January 2021 for a sale in 2019/20).

However, from 2020/21, CGT on UK residential property disposals by UK residents will be due within 30 days of the completion of the sale, along with a tax return for the sale. This could prompt an increased flow of BTL properties onto the market later this year.

The 2018 Budget contained two proposals for changes to private residence relief (PRR) which could have an indirect effect on residential landlords. Both are currently out for consultation until 1 June, with implementation scheduled for 2020/21.

The more significant change is that to the final exemption period – in effect the period during which it is possible to benefit from PRR on two properties. The proposal is to reduce this from 18 months to nine months, subject to special rules for those with a disability or in care.

The second planned change is to limit lettings relief, which currently exempts up to £40,000 of gains, to only those instances in which the property owner shares occupancy with the tenant (which rarely happens!).

Inheritance tax

Inheritance tax (IHT) generally applies to residential property investments. Even for furnished holiday lets, which are regarded as business for some tax purposes, a claim for IHT business property relief will usually fail.

The residence nil rate band (RNRB) can be of help in limited circumstances, as the legislation only requires that the ‘qualifying residential interest’ was at some time – not just at death – occupied as a home.

In 2019/20 the RNRB is £150,000 (plus up to another £150,000 ‘transferable RNRB’), subject to £1 for £2 tapering on estates above £2 million (before any reliefs and exemptions).

In practice the future of the RNRB is now uncertain as it is clearly in the sights of the Office of Tax Simplification, which is due to issue the second part of its IHT simplification review soon.

The opportunity

All of this underlines the opportunities for advisers with clients in the BTL or related markets.

The ‘amateur’ landlord is disappearing, caught in a pincer movement of greater taxation and government regulation on one side and, on the other, a more professional, volume-based approach as institutional investors enter the market with build-to-rent properties.

Landlords who decide to retreat from the market will not only want advice on tax – particularly mitigating CGT on disposals – but also guidance on where to reinvest the substantial sums they realise to provide income.

And many will be looking to take action in the near term, with an eye on the potential tax changes due in 2020/21, and revived talk about enhancing security of tenure.

The well-informed adviser can provide a one-stop shop to deliver the transformation from property-focussed investor to diversified portfolio owner, upon which they can receive adviser income.

Andy Woollon is a wealth specialist at Zurich