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The Landlord Survival Guide
January 13, 2017Article by Paul Avery
Except for respectable incomes and growing equity, the past couple of years have not been kind to UK landlords. The government has attempted to give first-time buyers more purchase on the housing ladder by greasing the rungs beneath landlords’ feet.
The practical merits of this effort and the ways it could impinge on renters are hotly debated in the press, but its wider consequences are not our subject here. Now that 2016’s biggest change – a 3% stamp duty surcharge for second homes – has sunk in, it is time to turn to the main challenge arriving in 2017 – and some practical ways to overcome it.
Mortgage payments will no longer be subtracted from rental income when calculating taxable profit. This will be phased in incrementally from April 2017, when 75% of mortgage costs will be tax except, and take full effect in 2020, when all mortgage financing costs will be taxable (minus a flat 20% credit).
Also, as of January 2017, the Bank of England will exert influence on buy to let mortgage affordability rules. Rental income must exceed 125% of mortgage payments calculated at a notional interest rate of 5.5% (Sunday Times).
This creates relatively serious yield compression for landlords in some circumstances – mainly those in high tax brackets with large mortgages.
Higher-rate tax payers could even end up making a loss. If their loan to value is greater than 75%, gross income needs to reach at least 4.1% in order to break even (Property Partners). Tighter lending rules may sound like salt in the wound, but they effectively safeguard landlords from exceeding profit killing loan-to-value ratios: if mortgage payments are way out of proportion with rental income, the investment may not be a good idea in the first place.
Conversely, basic-rate tax paters will pay no extra tax, though they do risk entering a higher overall tax bracket as their total taxable income rises. The National Landlords Association estimates that 22% of landlords could face this problem and risk losing benefits associated with low incomes as a result.
Landlords will certainly have to work harder to protect their revenue streams, especially if interest rates go up (keep an eye on that next year), but with a little work there are many ways to come out on top.
As more landlords exit the market, the supply of rental properties will decrease and returns will increase. If your mortgage is nearly paid off, this is a very enviable situation to be in. It is also a good reminder for everyone else that mortgage payments are not lost expenses: you do get to keep the property in the end.
Sell (and buy elsewhere):
The housing market remains at peak levels in many parts of the country. Selling heavily leveraged London property and buying in secondary cities with greater growth potential and low entry points can still be quite lucrative. Look for places with vibrant job markets and plenty of inward investment where yields upwards of 7% will far exceed profits from bank interest, even for top-rate tax payers.
Start a company:
The change to mortgage payment taxation does not apply to businesses. Starting an LLC to hold new assets can be the perfect solution for those intending to create a large portfolio, and mortgage products for the purpose are becoming more readily available. However, this strategy is not advisable for existing properties: transferring them into a company risks triggering both capital gains tax and stamp duty at the same time.
Keep it in the family:
Existing properties can be transferred to a lower earning spouse or immediate family member to reduce your overall tax liability. This will only work for a few properties before the lower taxpayer reaches a higher band themselves, but is a simple fix where possible.
Many landlords will understandably feel compelled to raise rents to protect their profits, though this is exactly the outcome the government hopes to avoid. It tends to make bad business sense to raise prices above fair market rate, but there is an argument that a dearth of rental properties and squeezed profits for the landlords who remain will actually push up the market rate. Not the happiest option, but a last resort for many.
The wear and tear tax allowance is also changing. Previously, landlords were able to deduct 10% from taxable profits for maintenance and improvements, whether they occurred or not. Now they will only be able to deduct actual costs, based on like-for-like replacement prices, but with no limit relative to income. This is a great opportunity to make positive changes with direct tax benefits, and can be used to attract better tenants, justify higher rents, and improve resale value. The tax break does not include extensions or significant renovations, but it can be applied across an entire portfolio. Expect a refurbishing bonanza in 2020.
Commercial property, which includes office space, retail units, and even hotel rooms, is not subject to the additional 3% stamp duty, or any stamp duty at all if the price is below £150,000. Investing in hotel rooms can be structured similarly to residential buy to let, and even offers superior yields, but it is not usually eligible for financing. This means that tax changes to mortgage payments are irrelevant. It can be an excellent strategy for cash investors.
In our view the UK market is still an excellent long term prospect, and often the most attractive option for British investors. However, over the years we have both observed and participated in a shift toward emerging international markets, where very impressive yields are achievable. With rigorous due diligence, international property is a great way to invest in the fortunes of the fastest growing markets around the world, spread risk across different regions, and even justify a few holidays.
If you’re thinking about international investment, take a look at our 2017 Global Market Predictions, to help you make the best informed decision.