The rapid growth of buy-to-let has seen the number of private landlords reach almost two million, owning one in ten homes in the UK.
Against this backdrop, however, the government has been making life more expensive for landlords, taxing them at every step from mortgage to purchase and ongoing letting through to sale.
As a result, advisers need to be wary of potential tax traps when managing the affairs of clients with second homes.
Reduction in tax relief
Changes in the taxation of buy-to-let properties could leave clients facing higher tax bills.
Under reforms introduced in April 2017, tax relief on residential property finance costs is being restricted from a landlord's highest marginal tax rate to the basic rate of tax over the next four years.
This could increase a landlord's property profits (their taxable property income) significantly, meaning that, apart from paying increased income tax, many will be pushed into the higher rate tax band and various tax traps.
The higher rate threshold is £50,000 for clients in England and Wales, and £43,431 for Scottish clients this tax year.
Take, for example, an English landlord earning £45,000 a year, plus receiving £12,000 rental income and paying £2,000 in expenses, plus £6,000 mortgage interest...
||Basic rate tax relief reducer
As the chart shows, the calculation of the property profits/taxable income and income tax could change significantly.
In this instance, not only will a client's annual income tax liability have increased by £1,200 by 2020/21 (the difference between higher and basic rate tax relief), but because of the change in the calculation basis their taxable property income will have soared by 150% to £10,000.
While some landlords may consider moving their portfolio into a limited company to sidestep this and some of the other tax changes, this can be a minefield fraught with alternative taxes and costs, and few appear to have done so with existing properties.
Child benefit tax trap
As their taxable income increases from the buy-to-let tax changes, clients could also fall into the child benefit tax trap.
Using the above example again, if the client was married with three kids claiming child benefit of £2,501 a year, the high income child benefit tax charge would now apply as their total taxable income would be £55,000, meaning they would lose £1,250 in child benefit (1% for each £100 in excess of £50,000), making a total tax increase of £2,450 a year from 2020/21.
Do not forget the personal allowance and tapered pensions annual allowance tax traps could apply at higher income levels. To avoid this, consider tax planning opportunities including transferring the property and rental income to a spouse/civil partner or making a personal pension contribution.
With so many other tax changes afoot, landlords could have overlooked the inheritance tax (IHT) liability they will be building up, which is unlikely to be covered by the new residence nil rate band (unless the property was previously a main residence).
Property prices continue to rise: the average UK house price in April 2019 was £236,619 according to the Halifax, some 5% higher than a year ago and representing average growth of 4.3% every year in the decade since the 2009 low point following the financial crisis. This trend continues to stoke IHT liabilities for landlords.
Advisers have an opportunity to discuss the possible use of a guaranteed whole-of-life policy written in trust to cover the IHT liability or, alternatively, convertible term assurance, which can provide the cover they need now at a price they can afford, but with the flexibility to convert to a guaranteed whole-of-life policy in future with no further medical evidence.
Potentially exempt transfers
To avoid IHT, some landlords may have made outright gifts of second properties to adult children. While taking care not to give rise to a gift with reservation of benefit or trigger pre-owned assets tax, this is a potentially exempt transfer (PET) for IHT purposes.
Should they die within seven years, the failed PET will use up the donor’s nil rate band first with any excess gift value taxed on the beneficiary.
The traditional use of a gift inter-vivos policy (or a series of level term assurances) can cover the beneficiary's potential liability, but it is the loss of the nil rate band to the donor's estate (increasing IHT by up to £130,000) that is often overlooked. This can be covered by a seven-year term assurance written in trust.
Andy Woollon is a wealth specialist at Zurich UK